Corporate Finance A Focused Approach 5th Edition Ehrhardt Test Bank

Corporate Finance A Focused Approach 5th Edition Ehrhardt Test Bank

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT TRUE/FALSE 1. The form of organization for a business is not an important issue, as this decision has very little effect on the income and wealth of the firm's owners.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Knowledge 2. The major advantage of a regular partnership or a corporation as a form of business organization is the fact that both offer their owners limited liability, whereas proprietorships do not.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Knowledge 3. There are three primary disadvantages of a regular partnership: (1) unlimited liability, (2) limited life of the organization, and (3) difficulty of transferring ownership. These combine to make it difficult for partnerships to attract large amounts of capital and thus to grow to a very large size.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Partnership KEY: Bloom’s: Knowledge 4. Two disadvantages of a proprietorship are (1) the relative difficulty of raising new capital and (2) the owner's unlimited personal liability for the business' debts.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Proprietorship KEY: Bloom’s: Knowledge 5. One key value of limited liability is that it lowers owners' risks and thereby enhances a firm's value.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Limited liability KEY: Bloom’s: Knowledge 6. If a firm's goal is to maximize its earnings per share, this is the best way to maximize the price of the common stock and thus shareholders' wealth.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Value maximization KEY: Bloom’s: Knowledge © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. If Firm A's business is to obtain savings from individuals and then invest them in financial assets issued by other firms or individuals, Firm A is a financial intermediary.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Financial intermediaries KEY: Bloom’s: Knowledge 8. If an individual investor buys or sells a currently outstanding stock through a broker, this is a primary market transaction.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial markets KEY: Bloom’s: Knowledge 9. Recently, Hale Corporation announced the sale of 2.5 million newly issued shares of its stock at a price of $21 per share. Hale sold the stock to an investment banker, who in turn sold it to individual and institutional investors. This is a primary market transaction.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial markets KEY: Bloom’s: Knowledge 10. One of the functions of NYSE specialists is to facilitate trading by keeping an inventory of shares of the stocks in which they specialize, buying when investors want to sell and selling when they want to buy. They change the bid and ask prices of the securities so as to keep supply and demand in balance.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Stock market transactions KEY: Bloom’s: Knowledge 11. The disadvantages associated with a proprietorship are similar to those under a partnership. One exception relates to the more formal nature of the partnership agreement and the commitment of all partners' personal assets. As a result, partnerships do not have difficulty raising large amounts of capital.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Partnership KEY: Bloom’s: Comprehension 12. The facts that a proprietorship, as a business, pays no corporate income tax, and that it is easily and inexpensively formed, are two key advantages to that form of business.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Proprietorship KEY: Bloom’s: Comprehension

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MULTIPLE CHOICE 13. Which of the following statements is CORRECT? a. One of the disadvantages of incorporating a business is that the owners then become subject to liabilities in the event the firm goes bankrupt. b. Sole proprietorships are subject to more regulations than corporations. c. In any type of partnership, every partner has the same rights, privileges, and liability exposure as every other partner. d. Sole proprietorships and partnerships generally have a tax advantage over many corporations, especially large ones. e. Corporations of all types are subject to the corporate income tax.

ANS: D Sole proprietorships and partnerships pay personal income tax, but they avoid the corporate income tax. Small corporations that meet certain requirements can elect to be classified as S Corporations, and then the business is taxed as a partnership.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 14. Which of the following statements is CORRECT? a. One of the disadvantages of a sole proprietorship is that the proprietor is exposed to unlimited liability. b. It is generally easier to transfer one's ownership interest in a partnership than in a corporation. c. One of the advantages of the corporate form of organization is that it avoids double taxation. 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.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 15. Which of the following statements is CORRECT? a. It is generally more expensive to form a proprietorship than a corporation because, with a proprietorship, extensive legal documents are required. b. Corporations face fewer regulations than sole proprietorships. c. One disadvantage of operating a business as a sole proprietorship is that the firm is subject to double taxation, at both the firm level and the owner level. d. One advantage of forming a corporation is that equity investors are usually exposed to less liability than in a regular partnership. e. If a regular partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

ANS: D Corporations have limited liability; however, they face more regulations than the other forms of organization. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 16. Cheers Inc. operates as a partnership. Now the partners have decided to convert the business into a regular corporation. Which of the following statements is CORRECT? a. Assuming Cheers is profitable, less of its income will be subject to federal income taxes. b. Cheers will now be subject to fewer regulations. c. Cheers' shareholders (the ex-partners) will now be exposed to less liability. d. Cheers' investors will be exposed to less liability, but they will find it more difficult to transfer their ownership. e. Cheers will find it more difficult to raise additional capital.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 17. Which of the following statements is CORRECT? a. It is usually easier to transfer ownership in a corporation than it is to transfer ownership in a sole proprietorship. b. Corporate shareholders are exposed to unlimited liability. c. Corporations generally face fewer regulations than sole proprietorships. d. Corporate shareholders are exposed to unlimited liability, and this factor may be compounded by the tax disadvantages of incorporation. e. Shareholders in a regular corporation (not an S corporation) pay higher taxes than owners of an otherwise identical proprietorship.

ANS: A If ownership in a proprietorship or partnership is transferred, the basic documents under which the firm operates must be rewritten, whereas for a corporation the seller simply sells shares to a buyer, and the corporation records the transfer on its books.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 18. Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership? a. Corporations generally find it relatively difficult to raise large amounts of capital. b. Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership. c. Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization. d. Corporate investors are exposed to unlimited liability. e. Corporations generally face relatively few regulations.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: Corporate form of organization MSC: TYPE: Multiple Choice: Conceptual

KEY: Bloom’s: Comprehension

19. You recently sold 100 shares of your new company, XYZ Corporation, 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 statements best describes this transaction? a. This is an example of an exchange of physical assets. b. This is an example of a primary market transaction. c. This is an example of a direct transfer of capital. d. This is an example of a money market transaction. e. This is an example of a derivatives market transaction ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-4 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial transactions KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 20. Which of the following statements is CORRECT? a. If expected inflation increases, interest rates are likely to increase. b. If individuals in general increase the percentage of their income that they save, interest rates are likely to increase. c. If companies have fewer good investment opportunities, 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.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-6 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Interest rates KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 21. Which of the following statements is CORRECT? a. In Europe and Asia hedge funds are legal, but they are not permitted to operate in the United States. b. Hedge funds have more in common with commercial banks than with any other type of financial institution. c. Hedge funds have more in common with investment banks than with any other type of financial institution. d. In the United States hedge funds are legal, but in Europe and Asia they are not permitted to operate. e. The justification for the "light" regulation of hedge funds is that only "sophisticated" investors with high net worths and high incomes are permitted to invest in these funds, and such investors supposedly can do the necessary "due diligence" on their own rather than have it done by the SEC or some other regulator.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-7 NAT: BUSPROG: Analytic STA: DISC: Investments and hybrid financing LOC: TBA TOP: Hedge funds KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. Money markets are markets for a. Foreign stocks. b. Consumer automobile loans. c. U.S. stocks. d. Short-term debt securities. e. Long-term bonds.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-8 NAT: BUSPROG: Analytic STA: DISC: Investments and hybrid financing LOC: TBA TOP: Money markets KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 23. Which of the following is a primary market transaction? a. You sell 200 shares of Johnson & Johnson stock on the NYSE through your broker. b. Johnson & Johnson issues 2,000,000 shares of new stock and sells them to the public through an investment banker. c. You buy 200 shares of Johnson & Johnson stock from your younger brother. You just give him cash and he gives you the stock⎯the trade is not made through a broker. d. One financial institution buys 200,000 shares of Johnson & Johnson stock from another institution. An investment banker arranges the transaction. e. You invest $10,000 in a mutual fund, which then uses the money to buy $10,000 of Johnson & Johnson shares on the NYSE. ANS: B Statement b is a primary market transaction, since the money and the security pass directly between the issuing firm and the investor.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-8 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial markets KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 24. Which of the following statements is CORRECT? a. If Apple issues additional shares of common stock through an investment banker, this would be a secondary market transaction. b. If you purchased 100 shares of Apple stock from your sister-in-law, this would be an example of a primary market transaction. c. The IPO market is a subset of the secondary market. d. Only institutions, and not individuals, can participate in derivatives market transactions. e. As they are generally defined, money market transactions involve debt securities with maturities of less than one year.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-8 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial markets KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 25. You recently sold 200 shares of Apple stock to your brother. The transfer was made through a broker, and the trade occurred on the NYSE. This is an example of: a. A futures market transaction. b. A primary market transaction. c. A secondary market transaction. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. A money market transaction. e. An over-the-counter market transaction.

ANS: C It is a secondary market transaction because the stock is transferred from one investor to another.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-8 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial markets KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 26. Which of the following statements is CORRECT? a. The New York Stock Exchange is an auction market with a physical location. b. Capital market transactions involve only the purchase and sale of equity securities, i.e., common stocks. c. If an investor sells shares of stock through a broker, then this would be a primary market transaction. d. Consumer automobile loans are evidenced by legal documents called "promissory notes," and these individual notes are traded in the money market. e. While the distinctions are blurring as investment banks are today buying commercial banks, and vice versa, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-9 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial markets KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 27. Which of the following statements is CORRECT? a. Capital market instruments include both long-term debt and common stocks. b. An example of a primary market transaction would be your uncle transferring 100 shares of Wal-Mart stock to you as a birthday gift. c. The NYSE does not exist as a physical location; rather, it represents a loose collection of dealers who trade stocks electronically. 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.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-9 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial markets KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 28. Which of the following statements is CORRECT? a. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties. b. A security whose value is derived from the price of some other "underlying" asset is called a liquid security. c. Money market mutual funds usually invest most of their money in a well-diversified © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

portfolio of liquid common stocks. d. Money markets are markets for common stocks and long-term debt. e. The NYSE operates as an auction market, whereas the Nasdaq is a dealer market.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 1-9 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial markets KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 29. One drawback of switching from a partnership to the corporate form of organization is the following: a. It subjects the firm to additional regulations. b. It cannot affect the amount of the firm's operating income that goes to taxes. c. It makes it more difficult for the firm to raise additional capital. d. It makes the firm's investors subject to greater potential personal liabilities. e. It makes it more difficult for the firm's investors to transfer their ownership interests.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Corporate form of organization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 30. Which of the following statements is CORRECT? a. The main method of transferring ownership interest in a corporation is by means of a hostile takeover. b. Two key advantages of the corporate form over other forms of business organization are unlimited liability and limited life. c. A corporation is a legal entity that is generally created by a state; its life and existence is separate from the lives of its individual owners and managers. d. Limited liability of its stockholders is an advantage of the corporate form of organization, but corporations have more trouble raising money in financial markets because of the complexity of this form of organization. e. Although its stockholders are insulated by limited legal liability, the corporation's legal status does not protect the firm's managers in the same way; i.e., bondholders can sue its managers if the firm defaults on its debt, even if the default is the result of poor economic conditions.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Corporate form of organization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 31. Which of the following statements is CORRECT? a. In a regular partnership, liability for other partners' misdeeds is limited to the amount of a particular partner's investment in the business. b. Attracting large amounts of capital is more difficult for partnerships than for 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. 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. The limited partners in a limited partnership have voting control, while the general partner has operating control over the business. Also, the limited partners are individually responsible, on a pro rata basis, for the firm's debts in the event of bankruptcy. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. A major disadvantage of all partnerships compared to all corporations is the fact that federal income taxes must be paid by the partners rather than by the firm itself.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Partnership form of organization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 32. Which of the following statements is CORRECT? a. Corporations are at a disadvantage relative to partnerships because they have to file more reports to state and federal agencies, including the Securities and Exchange Administration, even if they are not publicly owned. b. In a regular partnership, liability for the firm's debts is limited to the amount a particular partner has invested in the business. c. A fast-growth company would be more likely to set up as a partnership for its business organization than would a slow-growth company. d. Partnerships have difficulty attracting capital in part because of their unlimited liability, the lack of impermanence of the organization, and difficulty in transferring ownership. e. A major disadvantage of a partnership relative to a corporation as a form of business organization is the high cost and practical difficulty of its formation.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Partnership form of organization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 33. Which of the following statements is CORRECT? a. Most businesses (by number and total dollar sales) are organized as partnerships or proprietorships because it is easier to set up and operate in one of these forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, mainly because corporations have important tax advantages over proprietorships and partnerships. b. 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. c. Most business (measured by dollar sales) is conducted by corporations in spite of large corporations' often less favorable tax treatment, due to legal considerations related to ownership transfers and limited liability. d. Large corporations are taxed more favorably than sole proprietorships. e. Corporate stockholders are exposed to unlimited liability.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 34. Jane Doe, who has substantial personal wealth and income, is considering the possibility of starting a new business in the chemical waste management field. She will be the sole owner, and she has enough funds to finance the operation. The business will have a relatively high degree of risk, and it is expected that the firm will incur losses for the first few years. However, the prospects for growth and positive future income look good, and Jane plans to have the firm pay out all of its income as dividends to her once it is well established. Which of the legal forms of business organization would probably best suit her needs? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

Proprietorship, because of ease of entry.

S corporation, to gain some tax advantages and also to obtain limited liability.

Partnership, but only if she needs additional capital.

Regular corporation, because of the limited liability.

In this situation, the various forms of organization seem equally desirable.

ANS: B The S corporation would allow her to take early losses as deductions against her other income, hence save some taxes. Then, when the firm became profitable, she would receive dividends and pay taxes on them, but the firm itself would avoid corporate taxes and double taxation.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Firm organization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 35. Which of the following statements is CORRECT? a. The corporate bylaws are a standard set of rules established by the state of incorporation.

These rules are identical for all corporations in the state, and their purpose is to ensure that the firm's managers run the firm in accordance with state laws. b. The corporate charter is a standard document prescribed by the state of incorporation, and its purpose is to ensure that the firm's managers run the firm in accordance with state laws.

Procedures for electing corporate directors are contained in bylaws, while the declaration of the activities that the firm will pursue and the number of directors are included in the corporate charter. c. Companies must establish a home office, or domicile, in a particular state, and that state must be the one in which most of their business (sales, manufacturing, and so forth) is conducted. d. Attorney fees are generally involved when a company develops its charter and bylaws, but since these documents are voluntary, a new corporation can avoid these costs by deciding not to have either a charter or bylaws. e. The corporate charter is concerned with things like what business the company will engage in, whereas the bylaws are concerned with things like procedures for electing the board of directors.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-2 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Corporate charter and bylaws KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 36. With which of the following statements would most people in business agree? a. The short-run profits of a corporation will almost always increase if the firm takes actions the government has determined are in the nation's best interests. b. Government agencies and firms almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees. c. Although people's moral characters are probably developed before they get into a business school, it is still useful for business schools to cover ethics, including giving students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. d. Developing a formal set of rules defining ethical and unethical behavior is not useful for a large corporation. Such rules generally can't be applied in many specific instances, so it is better to deal with ethical issues on a case-by-case basis. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. Because of the courage it takes to blow the whistle, "whistle blowers" are generally promoted more rapidly than other employees.

ANS: C It is important to have a specific set of rules that all employees are expected to follow. This helps constrain actions, and it is also important to "prove" that the company is trying to do right if some employee does something wrong.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-3 NAT: BUSPROG: Ethics STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Business ethics KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 37. The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to a. Maximize the stock price per share over the long run, which is the stock's intrinsic value. b. Maximize the firm's expected EPS. c. Minimize the chances of losses. d. Maximize the firm's expected total income. e. Maximize the stock price on a specific target date.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-3 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Goal of firm KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 38. Which of the following statements is CORRECT? a. The financial manager's proper goal should be to attempt to maximize the firm's expected cash flows, since that will add the most to the individual shareholders' wealth. b. The financial manager should seek that combination of assets, liabilities, and capital that will generate the largest expected projected after-tax income over the relevant time horizon, generally the coming year. c. The riskiness inherent in a firm's earnings per share (EPS) depends on the characteristics of the projects the firm selects, and thus on the firm's assets. However, EPS is not affected by the manner in which those assets are financed. d. Potential agency problems can arise between managers and stockholders, because managers hired as agents to act on behalf of the owners may instead make decisions favorable to themselves rather than the stockholders. e. Large, publicly owned firms like IBM and GE are controlled by their management teams.

Ownership is generally widely dispersed; hence managers have great freedom in how they run the firm. Managers may operate in stockholders' best interests, but they also may operate in their own personal best interests. As long as they stay within the law, there is no way to either force or motivate managers to act in the stockholders' best interests.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-3 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Corporate goals and control KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 39. Suppose the U.S. Treasury announces plans to issue $50 billion of new bonds. Assuming the announcement was not expected, what effect, other things held constant, would that have on bond prices and interest rates? a. Prices and interest rates would both rise. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

Prices would rise and interest rates would decline.

Prices and interest rates would both decline.

There would be no changes in either prices or interest rates.

Prices would decline and interest rates would rise.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-6 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Security prices and interest rates KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 40. Which of the following would be most likely to lead to higher interest rates on all debt securities in the economy? a. Households start saving a larger percentage of their income. b. The economy moves from a boom to a recession. c. The level of inflation begins to decline. d. Corporations step up their expansion plans and thus increase their demand for capital. e. The Federal Reserve uses monetary policy in an attempt to stimulate the economy.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-6 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Interest rates KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 41. Which of the following factors would be most likely to lead to an increase in interest rates in the economy? a. Households reduce their consumption and increase their savings. b. The Federal Reserve decides to try to stimulate the economy. c. There is a decrease in expected inflation. d. The economy falls into a recession. e. Most businesses decide to modernize and expand their manufacturing capacity, and to install new equipment to reduce labor costs.

ANS: E An increase in the demand for capital by businesses will increase interest rates in the economy.

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates TOP: Interest rates KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual

OBJ: LO: 1-6 LOC: TBA

42. Which of the following statements is CORRECT? a. If General Electric were to issue new stock this year it would be considered a secondary market transaction since the company already has stock outstanding. b. Capital market transactions only include preferred stock and common stock transactions. c. The distinguishing feature between spot markets versus futures markets transactions is the maturity of the investments. That is, 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. d. Both Nasdaq "dealers" and NYSE "specialists" hold inventories of stocks. e. An electronic communications network (ECN) is a physical location exchange.

ANS: D

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 1-11 NAT: BUSPROG: Analytic STA: DISC: Financial markets, institutions, and interest rates LOC: TBA TOP: Financial transactions KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 43. Which of the following statements is CORRECT? a. Corporations generally are subject to more favorable tax treatment and fewer regulations than partnerships and sole proprietorships, which is why corporations do most of the business in the United States. b. Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value than are managers who do not face the threat of hostile takeovers. c. One advantage of the corporate form of organization is that liability of the owners of the firm is limited to their investment in the firm. d. Because of their simplified organization, it is easier for sole proprietorships and partnerships to raise large amounts of outside capital than it is for corporations. e. Bond covenants are an effective way to resolve conflicts between shareholders and managers.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-3 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Miscellaneous concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 44. Which of the following statements is CORRECT? a. A good goal for a firm's management is 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. Because most stock ownership is concentrated in the hands of a relatively small segment of society, firms' actions to maximize their stock prices have little benefit to society. d. Corporations and partnerships have an advantage over proprietorships because a sole proprietor is exposed to unlimited liability, but the liability of all investors in the other types of businesses is more limited. e. The potential exists for agency conflicts between stockholders and managers.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-3 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Miscellaneous concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 45. 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 partners. b. There is no good reason to expect a firm's bondholders and stockholders to react differently to the types of new asset investments a firm makes. c. Bondholders are generally more willing than stockholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns. d. Stockholders are generally more willing than bondholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns. e. Relative to sole proprietorships, corporations generally face fewer regulations, which © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

makes raising capital easier for corporations.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 1-3 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Miscellaneous concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 46. Which of the following statements is NOT CORRECT? a. When a corporation's shares are owned by a few individuals and are not traded on public markets, we say that the firm is "closely, or privately, held." b. "Going public" establishes a firm's true intrinsic value, and it also insures that a highly liquid market will always exist for the firm's shares. c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called "going public," and the market for such stock is called the new issue market. d. Publicly owned companies have shares owned by investors who are not associated with management, and public companies must register with and report to a regulatory agency such as the SEC. e. It is possible for a firm to go public and yet not raise any additional new capital at the time.

ANS: B PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 1-8 NAT: BUSPROG: Analytic STA: DISC: Goals of the firm, role of finance, and analysis of public information LOC: TBA TOP: Ownership and going public KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 2—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES TRUE/FALSE 1. The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of stockholders' equity.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual report KEY: Bloom’s: Knowledge 2. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual report and expectations KEY: Bloom’s: Knowledge 3. Consider the balance sheet of Wilkes Industries as shown below. Because Wilkes has $800,000 of retained earnings, the company would be able to pay cash to buy an asset with a cost of $200,000.

Cash Inventory Accounts receivable Total CA Net fixed assets Total assets

$

50,000 200,000 250,000 $ 500,000 $ 900,000 _________ $1,400,000

Accounts payable Accruals Total CL Debt Common stock Retained earnings Total L & E

$

100,000 100,000 $ 200,000 200,000 200,000 800,000 $1,400,000

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Retained earnings versus cash KEY: Bloom’s: Knowledge 4. On the balance sheet, total assets must always equal total liabilities and equity.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet KEY: Bloom’s: Knowledge 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 values at which these assets are carried on the books.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet: non-cash assets KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. 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, not all reported income comes in the form or cash, and reported costs likewise may not correctly reflect cash outlays. Therefore, there may be a substantial difference between a firm's reported profits and its actual cash flow for the same period.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income statement KEY: Bloom’s: Knowledge 7. Net operating working capital is equal to operating current assets minus operating current liabilities.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net operating working capital KEY: Bloom’s: Knowledge 8. Total net operating capital is equal to net fixed assets.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Total net operating capital KEY: Bloom’s: Knowledge 9. Net operating profit after taxes (NOPAT) is the amount of net income a company would generate from its operations if it had no interest income or interest expense.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net operating profit after taxes (NOPAT) KEY: Bloom’s: Knowledge 10. The fact that 70% of the interest income received by a corporation is excluded from its taxable income encourages firms to use more debt financing than they would in the absence of this tax law provision.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Federal income taxes: interest income KEY: Bloom’s: Knowledge 11. If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, this would probably encourage companies to use more debt financing than they presently do, other things held constant.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Federal income taxes: interest expense KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. The interest and dividends paid by a corporation are considered to be deductible operating expenses, hence they decrease the firm's tax liability.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Federal income taxes: interest expense and dividends KEY: Bloom’s: Knowledge 13. The balance sheet is a financial statement that 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial statements KEY: Bloom’s: Knowledge 14. 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. Retained earnings are kept in cash or near cash accounts and, thus, these cash accounts, when added together, will always be equal to the firm's total retained earnings.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Retained earnings KEY: Bloom’s: Comprehension 15. The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of stockholders' claims against the firm's existing assets. This implies that retained earnings are in fact stockholders' reinvested earnings.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Retained earnings KEY: Bloom’s: Comprehension 16. In accounting, emphasis is placed on determining net income in accordance with generally accepted accounting principles. In finance, the primary emphasis is also on net income because that is what investors use to value the firm. However, a secondary financial consideration is cash flow, because cash is needed to operate the business.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Cash flow and net income KEY: Bloom’s: Comprehension 17. To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash charge that has been deducted from revenue.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Statement of cash flows KEY: Bloom’s: Comprehension © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. The current cash flow from existing assets is highly relevant to the investor. However, since the value of the firm depends primarily upon its growth opportunities, profit projections from those opportunities are the only relevant future flows with which investors are concerned.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Future cash flows KEY: Bloom’s: Comprehension 19. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Federal income taxes: interest expense and dividends KEY: Bloom’s: Comprehension 20. 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 changes in the firm's accounts over that period of time.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial stmts: time dimension KEY: Bloom’s: Comprehension MULTIPLE CHOICE 21. Which of the following statements is CORRECT? a. The statement of cash needs tells us how much cash the firm will require during some future period, generally a month or a year. b. 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. c. The balance sheet gives us a picture of the firm's financial position at a point in time. d. The income statement gives us a picture of the firm's financial position at a point in time. e. The statement of cash flows tells us how much cash the firm has in the form of currency and demand deposits.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-1 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial statements KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 22. Which of the following statements is CORRECT? a. A typical industrial company's balance sheet lists the firm's assets that will be converted to cash first, and then goes on down to list the firm's longest lived assets last. b. The balance sheet for a given year, say 2012, is designed to give us an idea of what happened to the firm during that year. c. The balance sheet for a given year, say 2012, tells us how much money the company © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

earned during that year. d. The difference between the total assets reported on the balance sheet and the debts 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). e. For most companies, the market value of the stock equals the book value of the stock as reported on the balance sheet.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 23. Other things held constant, which of the following actions would increase the amount of cash on a company's balance sheet? a. The company purchases a new piece of equipment. b. The company repurchases common stock. c. The company pays a dividend. d. The company issues new common stock. e. The company gives customers more time to pay their bills.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 24. Which of the following items is NOT included in current assets? a. Short-term, highly liquid, marketable securities. b. Accounts receivable. c. Inventory. d. Bonds. e. Cash.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current assets KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 25. Which of the following items cannot be found on a firm's balance sheet under current liabilities? a. Accrued payroll taxes. b. Accounts payable. c. Short-term notes payable to the bank. d. Accrued wages. e. Cost of goods sold.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current liabilities KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 26. Which of the following statements is CORRECT? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. The income statement for a given year, say 2012, is designed to give us an idea of how much the firm earned during that year. b. The focal point of the income statement is the cash account, because that account cannot be manipulated by "accounting tricks." c. The reported income of two otherwise identical firms cannot be manipulated by different accounting procedures provided the firms follow Generally Accepted Accounting Principles (GAAP). d. 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). e. If a firm follows Generally Accepted Accounting Principles (GAAP), then its reported net income will be identical to its reported net cash flow.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income statement KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 27. Below are the year-end balance sheets for Wolken Enterprises: Assets: Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets Liabilities and equity: Accounts payable Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total common equity Total liabilities and equity

2013 200,000 864,000 2,000,000 $3,064,000 6,000,000 $9,064,000

2012 170,000 700,000 1,400,000 $2,270,000 5,600,000 $7,870,000

$

$

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

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

Wolken has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year non-callable, long-term debt in 2012. As of the end of 2013, none of the principal on this debt had been repaid. Assume that the company's sales in 2012 and 2013 were the same. Which of the following statements must be CORRECT? a. Wolken increased its short-term bank debt in 2013. b. Wolken issued long-term debt in 2013. c. Wolken issued new common stock in 2013. d. Wolken repurchased some common stock in 2013. e. Wolken had negative net income in 2013.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

28. On its 2012 balance sheet, Barngrover Books showed $510 million of retained earnings, and exactly that same amount was shown the following year in 2013. Assuming that no earnings restatements were issued, which of the following statements is CORRECT? a. Dividends could have been paid in 2013, but they would have had to equal the earnings for the year. b. If the company lost money in 2013, they must have paid dividends. c. The company must have had zero net income in 2013. d. The company must have paid out half of its earnings as dividends. e. The company must have paid no dividends in 2013.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 29. Below is the common equity section (in millions) of Fethe Industries' last two year-end balance sheets:

Common stock Retained earnings Total common equity

2012 $2,000 2,000 $4,000

2011 $1,000 2,340 $3,340

The company has never paid a dividend to its common stockholders. Which of the following statements is CORRECT? a. The company's net income in 2011 was higher than in 2012. b. The company issued common stock in 2012. c. The market price of the company's stock doubled in 2012. d. The company had positive net income in both 2011 and 2012, but the company's net income in 2009 was lower than it was in 2011. e. The company has more equity than debt on its balance sheet.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 30. Which of the following statements is CORRECT? a. The more depreciation a firm has in a given year, the higher its EPS, other things held constant. b. Typically, a firm's DPS should exceed its EPS. c. Typically, a firm's EBIT should exceed its EBITDA. d. If a firm is more profitable than average (e.g., Google), we would normally expect to see its stock price exceed its book value per share. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: EPS, DPS, BVPS, and stock price KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

31. Which of the following statements is CORRECT? a. Depreciation and amortization are not cash charges, so neither of them has an effect on a firm's reported profits. b. The more depreciation a firm reports, the higher its tax bill, other things held constant. c. People sometimes talk about the firm's net cash flow, which is shown as the lowest entry on the income statement, hence it is often called "the bottom line." d. Depreciation reduces a firm's cash balance, so an increase in depreciation would normally lead to a reduction in the firm's net cash flow. e. Net cash flow (NCF) is often defined as follows: Net Cash Flow = Net Income + Depreciation and Amortization Charges.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Depreciation, amortization, and net cash flow KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 32. Which of the following would be most likely to occur in the 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 are not affected, and assume that the same depreciation method is used for tax and stockholder reporting purposes. a. Companies' reported net incomes would decline. b. Companies' net operating profits after taxes (NOPAT) would decline. c. Companies' physical stocks of fixed assets would increase. d. Companies' net cash flows would increase. e. Companies' cash positions would decline.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Changes in depreciation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 33. Which of the following factors could explain why Regal Industrial Fixtures had a negative net cash flow last year, even though the cash on its balance sheet increased? a. The company repurchased 20% of its common stock. b. The company sold a new issue of bonds. c. The company made a large investment in new plant and equipment. d. The company paid a large dividend. e. The company had high amortization expenses.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net cash flow KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 34. Analysts following Armstrong Products recently noted that the company's operating net cash flow increased over the prior year, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation? a. The company issued new long-term debt. b. The company cut its dividend. c. The company made a large investment in a profitable new plant. d. The company sold a division and received cash in return. e. The company issued new common stock. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net cash flow KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 35. A security analyst obtained the following information from Prestopino Products' financial statements: • • • • •

Retained earnings at the end of 2011 were $700,000, but retained earnings at the end of 2012 had declined to $320,000.

The company does not pay dividends.

The company's depreciation expense is its only non-cash expense; it has no amortization charges.

The company has no non-cash revenues.

The company's net cash flow (NCF) for 2012 was $150,000.

On the basis of this information, which of the following statements is CORRECT? a. Prestopino had negative net income in 2012. b. Prestopino's depreciation expense in 2012 was less than $150,000. c. Prestopino had positive net income in 2012, but its income was less than its 2011 income. d. Prestopino's NCF in 2012 must be higher than its NCF in 2011. e. Prestopino's cash on the balance sheet at the end of 2012 must be lower than the cash it had on the balance sheet at the end of 2011.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net cash flow and net income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 36. Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its net cash flow from operations declined. Which of the following could explain this performance? a. The company's operating income declined. b. The company's expenditures on fixed assets declined. c. The company's cost of goods sold increased. d. The company's depreciation and amortization expenses declined. e. The company's interest expense increased.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net cash flow and net income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 37. Which of the following statements is CORRECT? a. The statement of cash flows shows how much the firm's cash⎯the total of currency, bank deposits, and short-term liquid securities (or cash equivalents)⎯increased or decreased during a given year. b. The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of buying or selling fixed assets. c. 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. d. The statement of cash flows reflects cash flows from continuing operations, but it does not © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

reflect the effects of changes in working capital. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Statement of cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 38. Which of the following statements is CORRECT? a. In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash. 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 reported as a use of cash. d. In the statement of cash flows, depreciation charges are reported as a use of cash. e. In the statement of cash flows, a decrease in inventories is reported as a use of cash.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Statement of cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 39. 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, for valuation purposes we need to discount cash flows, not accounting income. Moreover, since many firms have a number of separate divisions, and since division managers should be compensated on their divisions' performance, not that of the entire firm, information that focuses on the divisions is needed. These factors have led to the development of information that is focused on cash flows and the operations of individual units. 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 are 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.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Modifying acct data for managerial purposes KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

40. Which of the following statements is CORRECT? a. Net cash flow (NCF) is defined as follows: NCF = Net income - Depreciation and Amortization. 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 required to sustain operations − Required changes in net operating working capital. d. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 − T)+ Depreciation and Amortization + Capital expenditures. e. Net cash flow is the same as free cash flow (FCF).

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Depreciation, amortization, and free cash flow KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 41. Which of the following statements is CORRECT? a. 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. b. MVA gives us an idea about how much value a firm's management has added during the last year. c. MVA stands for market value added, and it is defined as follows: MVA = (Shares outstanding)(Stock price) + Book value of common equity. d. EVA stands for economic value added, and it is defined as follows: EVA = EBIT(1 − T) − (Investor-supplied op. capital)  (A − T cost of capital). e. EVA gives us an idea about how much value a firm's management has added over the firm's life.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: MVA and EVA KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 42. Which of the following statements is CORRECT? a. The maximum federal tax rate on personal income in 2010 was 50%. b. 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. c. Interest paid to an individual is counted as income for tax purposes and taxed at the individual's regular tax rate, which in 2010 could go up to 35%, but dividends received were taxed at a maximum rate of 15%. d. The maximum federal tax rate on corporate income in 2010 was 50%. e. 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.

ANS: C

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 2-9 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Federal income tax system KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 43. Which of the following statements is CORRECT? a. All corporations other than non-profit corporations are subject to corporate income taxes, which are 15% for the lowest amounts of income and 35% for the highest amounts of income. b. The income of certain small corporations that qualify under the Tax Code is completely exempt from corporate income taxes. Thus, the federal government receives no tax revenue from these businesses. c. All businesses, regardless of their legal form of organization, are taxed under the Business Tax Provisions of the Internal Revenue Code. d. Small businesses that qualify under the Tax Code can elect not to pay corporate taxes, but then their owners must report their pro rata shares of the firm's income as personal income and pay taxes on that income. e. Congress recently changed the tax laws to make dividend income received by individuals exempt from income taxes. Prior to the enactment of that law, corporate income was subject to double taxation, where the firm was first taxed on the income and stockholders were taxed again on the income when it was paid to them as dividends.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-9 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Federal income tax system KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 44. Danielle's Sushi Shop last year had (1) a negative net cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation? a. The company had a sharp increase in its depreciation and amortization expenses. b. The company had a sharp increase in its inventories. c. The company had a sharp increase in its accrued liabilities. d. The company sold a new issue of common stock. e. The company made a large capital investment early in the year.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: NCF, FCF, and cash KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 45. Assume that Congress recently passed a provision that will enable Barton's Rare Books (BRB) to double its depreciation expense for the upcoming year but will have no effect on its sales revenue or tax rate. Prior to the new provision, BRB's net income after taxes was forecasted to be $4 million.

Which of the following best describes the impact of the new provision on BRB'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. Net fixed assets on the balance sheet will decrease. b. The provision will reduce the company's net cash flow. c. The provision will increase the company's tax payments. d. Net fixed assets on the balance sheet will increase. e. The provision will increase the company's net income. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-9 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Changes in depreciation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 46. The LeMond Corporation just purchased a new production line. 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. LeMond's tax liability for the year will be lower. b. LeMond's taxable income will be lower. c. LeMond's net fixed assets as shown on the balance sheet will be higher at the end of the year. d. LeMond's cash position will improve (increase). e. LeMond's reported net income after taxes for the year will be lower.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-9 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Changes in depreciation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 47. Lucy's Music Emporium opened its doors on January 1, 2012, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 20 years, but in December 2012 management realized that the assets would last for only 15 years. The firm's accountants plan to report the 2012 financial statements based on this new information. How would the new depreciation assumption affect the company's financial statements? a. The firm's net liabilities would increase. b. The firm's reported net fixed assets would increase. c. The firm's EBIT would increase. d. The firm's reported 2012 earnings per share would increase. e. The firm's cash position in 2012 and 2013 would increase.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Changes in depreciation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 48. DeYoung Devices Inc., a new high-tech instrumentation firm, is building and equipping a new manufacturing facility. 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 reported net income would increase. b. The firm's operating income (EBIT) would increase. c. The firm's taxable income would increase. d. The firm's net cash flow would increase. e. The firm's tax payments would increase.

ANS: D

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 2-9 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Changes in depreciation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 49. Which of the following statements is CORRECT? a. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year's balance. b. Dividends paid reduce the net income that is reported on a company's income statement. c. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, this will cause a decline in its current assets as shown on the balance sheet. d. If a company issues new long-term bonds during the current year, this will increase its reported current liabilities at the end of the year. e. Accounts receivable are reported as a current liability on the balance sheet.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial statements KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 50. Which of the following statements is CORRECT? a. One way to increase EVA is to achieve the same level of operating income but with more investor-supplied capital. b. If a firm reports positive net income, its EVA must also be positive. c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free. d. One way to increase EVA is to generate the same level of operating income but with less investor-supplied capital. e. Actions that increase reported net income will always increase net cash flow.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: EVA, CF, and net income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 51. Which of the following statements is CORRECT? a. If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet will be negative. b. Since depreciation is a source of funds, the more depreciation a company has, the larger its retained earnings will be, other things held constant. c. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments. d. Common equity includes common stock and retained earnings, less accumulated depreciation. e. The retained earnings account as shown on the balance sheet shows the amount of cash that is available for paying dividends.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Retained earnings KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

52. Olivia Hardison, CFO of Impact United Athletic Designs, plans to have the company issue $500 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur? a. The company would have to pay less taxes. b. The company's taxable income would fall. c. The company's interest expense would remain constant. d. The company would have less common equity than before. e. The company's net income would increase.

ANS: E PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 2-9 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Changes in leverage KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 53. Jessie's Bobcat Rentals' operations provided a negative net cash flow last year, 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? a. The company had high depreciation expenses. b. The company repurchased some of its common stock. c. The company dramatically increased its capital expenditures. d. The company retired a large amount of its long-term debt. e. The company sold some of its fixed assets.

ANS: E PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 2-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net cash flow KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 54. Tucker Electronic System's current balance sheet shows total common equity of $3,125,000. The company has 125,000 shares of stock outstanding, and they sell at a price of $52.50 per share. By how much do the firm's market and book values per share differ? a. $27.50 b. $28.88 c. $30.32 d. $31.83 e. $33.43 ANS: A Shares outstanding Price per share Total book common equity Book value per share Difference between book and market values

125,000 $52.50 $3,125,000 $25.00 $27.50

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet: market value vs. book value KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

arithmetic.

55. Hunter Manufacturing Inc.'s December 31, 2012, balance sheet showed total common equity of $2,050,000 and 100,000 shares of stock outstanding. During 2013, Hunter had $250,000 of net income, and it paid out $100,000 as dividends. What was the book value per share at 12/31/13, assuming that Hunter neither issued nor retired any common stock during 2013? a. $20.90 b. $22.00 c. $23.10 d. $24.26 e. $25.47 ANS: B 12/31/2012 common equity 2013 net income 2013 dividends 2013 addition to retained earnings 12/31/2013 common equity Shares outstanding 12/31/2013 BVPS

$2,050,000 $250,000 $100,000 $150,000 $2,200,000 100,000 $22.00

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet: change in BVPS from RE addition KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

56. Companies generate income from their "regular" operations and from other sources like interest earned on the securities they hold, which is called non-operating income. Lindley Textiles recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,000 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was Lindley's operating income, or EBIT? a. $3,462 b. $3,644 c. $3,836 d. $4,038 e. $4,250 ANS: E Sales Operating costs excluding depr'n Depreciation Operating income (EBIT)

$12,500 $7,250 $1,000 $4,250

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income statement: EBIT KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

57. Frederickson Office Supplies recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was the firm's taxable income, or earnings before taxes (EBT)? a. $3,230.00 b. $3,400.00 c. $3,570.00 d. $3,748.50 e. $3,935.93 ANS: B Bonds Interest rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income

$8,000.00 7.50% $12,500.00 $7,250.00 $1,250.00 $4,000.00 −$600.00 $3,400.00

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income statement: taxable income KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

58. JBS Inc. recently reported net income of $4,750 and depreciation of $885. How much was its net cash flow, assuming it had no amortization expense and sold none of its fixed assets? a. $4,831.31 b. $5,085.59 c. $5,353.25 d. $5,635.00 e. $5,916.75 ANS: D Net income Depreciation NCF

$4,750.00 $885.00 $5,635.00

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net cash flow KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

59. Swinnerton Clothing Company's balance sheet showed total current assets of $2,250, all of which were required in operations. Its current liabilities consisted of $575 of accounts payable, $300 of 6% short-term notes payable to the bank, and $145 of accrued wages and taxes. What was its net operating working capital that was financed by investors? a. $1,454 b. $1,530 c. $1,607 d. $1,687 e. $1,771 ANS: B Current assets Accounts payable Accrued wages and taxes Net operating working capital

$2,250 $575 $145 $1,530

Note that NOWC represents the current assets required in operations that are financed by investors, given that payables and accruals are generated spontaneously by operations and are thus "free."

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net operating working capital KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

60. Over the years, Janjigian Corporation's stockholders have provided $15,250 of capital, part when they purchased new issues of stock and part when they allowed management to retain some of the firm's earnings. The firm now has 1,000 shares of common stock outstanding, and it sells at a price of $42.00 per share. How much value has Janjigian's management added to stockholder wealth over the years, i.e., what is Janjigian's MVA? a. $21,788 b. $22,935 c. $24,142 d. $25,413 e. $26,750 ANS: E Total book value of equity Stock price per share Shares outstanding Market value of equity MVA =

$15,250 $42.00 1,000 42,000 26,750

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: MVA KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

arithmetic.

61. Meric Mining Inc. recently reported $15,000 of sales, $7,500 of operating costs other than depreciation, and $1,200 of depreciation. The company had no amortization charges, it had outstanding $6,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was the firm's net income after taxes? Meric uses the same depreciation expense for tax and stockholder reporting purposes. a. $3,284.55 b. $3,457.42 c. $3,639.39 d. $3,830.94 e. $4,022.48 ANS: D Bonds Interest rate Tax rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income Taxes Net income

$6,500 6.25% 35% $ 15,000 $ 7,500 $ 1,200 $6,300.00 −$ 406.25 $5,893.75 −$2,062.81 $3,830.94

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income statement: net after-tax income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

62. On 12/31/2013, Heaton Industries Inc. reported retained earnings of $675,000 on its balance sheet, and it reported that it had $172,500 of net income during the year. On its previous balance sheet, at 12/31/2012, the company had reported $555,000 of retained earnings. No shares were repurchased during 2013. How much in dividends did Heaton pay during 2013? a. $47,381 b. $49,875 c. $52,500 d. $55,125 e. $57,881 ANS: C 12/31/2013 RE 12/31/2012 RE Change in RE Net income for 2013 Dividends = net income − change PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic

$675,000 $555,000 $120,000 $172,500 $52,500 OBJ: LO: 2-4

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Statement of stockholders' equity: dividends KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

63. Ullrich Printing Inc. paid out $21,750 of common dividends during the year. It ended the year with $187,500 of retained earnings versus the prior year's retained earnings of $132,250. How much net income did the firm earn during the year? a. $77,000 b. $80,850 c. $84,893 d. $89,137 e. $93,594 ANS: A Net income = The change in retained earnings plus the dividends paid: Current RE $187,500 $132,250 Previous RE = Current RE − increment Change in RE $55,250 Plus dividends paid $21,750 = Net income $77,000 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 2-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Statement of stockholders' equity: NI KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

64. NNR Inc.'s balance sheet showed total current assets of $1,875,000 plus $4,225,000 of net fixed assets.

All of these assets were required in operations. The firm's current liabilities consisted of $475,000 of accounts payable, $375,000 of 6% short-term notes payable to the bank, and $150,000 of accrued wages and taxes. Its remaining capital consisted of long-term debt and common equity. What was NNR's total investor-provided operating capital? a. $4,694,128 b. $4,941,188 c. $5,201,250 d. $5,475,000 e. $5,748,750 ANS: D Current assets Net fixed assets Total assets (all are operating assets) Spontaneous "free" capital:

Acc'ts payable Accruals Total investor-provided operating capital

$1,875,000 $4,225,000 $6,100,000 $475,000 $150,000 $5,475,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Note that the total operating capital is the amount of the capital, or assets, that are required in operations and that must be financed by investors, given that payables and accruals are generated spontaneously by operations and do not have to be financed by investors.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Total operating capital KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: Students may need to use a significant amount of simple arithmetic to solve this problem.

Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

65. Last year Tiemann Technologies reported $10,500 of sales, $6,250 of operating costs other than depreciation, and $1,300 of depreciation. The company had no amortization charges, it had $5,000 of bonds that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $750. By how much will net after-tax income change as a result of the change in depreciation? The company uses the same depreciation calculations for tax and stockholder reporting purposes. a. −463.13 b. −487.50 c. −511.88 d. −537.47 e. −564.34 ANS: B This problem can be worked very easily⎯just multiply the increase in depreciation by (1 − T) to get the decrease in net income: Change in depreciation Tax rate Reduction in net income

$750 35% −$487.50

We can also get the answer a longer way, which explains things more clearly: Item Bonds Interest rate Tax rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income Taxes Net income

Old $ 5,000.00 6.5% 35% $10,500.00 $ 6,250.00 $ 1,300.00 $ 2,950.00 $ 325.00 $ 2,625.00 $ 918.75 $ 1,706.25

New $ 5,000.00 6.5% 35% $10,500.00 $ 6,250.00 $ 2,050.00 $ 2,200.00 $ 325.00 $ 1,875.00 $ 656.25 $ 1,218.75

Change 0.00 0.0% 0% $ 0.00 $ 0.00 $750.00 −$750.00 $0.00 −$750.00 −$262.50 −$487.50 $

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income statement: change in net income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

66. TSW Inc. had the following data for last year: Net income = $800; Net operating profit after taxes (NOPAT) = $700; Total assets = $3,000; and Total operating capital = $2,000. Information for the just-completed year is as follows: Net income = $1,000; Net operating profit after taxes (NOPAT) = $925; Total assets = $2,600; and Total operating capital = $2,500. How much free cash flow did the firm generate during the just-completed year? a. $383 b. $425 c. $468 d. $514 e. $566 ANS: B NOPAT = EBIT(1 − T) Total operating capital

Prior Year $700 $2,000

Current Year $925 $2,500

FCF this year = NOPAT − Net investment in new operating capital FCF this year = $925 − $500 FCF this year = $425 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Free cash flow KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 67. Rao Corporation has the following balance sheet. How much net operating working capital does the firm have?

Cash Short-term investments Accounts receivable Inventory Current assets Net fixed assets Total assets a. b. c. d. e.

$

10 Accounts payable Accruals 50 Notes payable 40 Current liabilities $130 Long-term debt 100 Common equity Retained earnings $230 Total liab. & equity

$ 20 20 50 $ 90 0 30 50 $230

$54.00 $60.00 $66.00 $72.60 $79.86

ANS: B Net operating working capital = Operating current assets − Operating current liabilities NOWC = $100.00 − $40.00 NOWC = $60.00 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net operating working capital KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 68. Bae Inc. has the following income statement. How much net operating profit after taxes (NOPAT) does the firm have?

Sales Costs Depreciation EBIT Interest expense EBT Taxes (35%) Net income a. b. c. d. e.

$2,000.00 1,200.00 100.00 $ 700.00 200.00 $ 500.00 175.00 $ 325.00

$370.60 $390.11 $410.64 $432.25 $455.00

ANS: E EBIT Tax rate NOPAT =

$700.00 35% $455.00

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net operating profit after taxes (NOPAT) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 69. EP Enterprises has the following income statement. How much net operating profit after taxes (NOPAT) does the firm have?

Sales Costs Depreciation EBIT Interest expense EBT Taxes (40%) Net income a. b. c. d. e.

$1,800.00 1,400.00 250.00 $ 150.00 70.00 $ 80.00 32.00 $ 48.00

$81.23 $85.50 $90.00 $94.50 $99.23

ANS: C EBIT Tax rate NOPAT =

$150.00 40% $90.00

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Net operating profit after taxes (NOPAT) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 70. Tibbs Inc. had the following data for the year ending 12/31/12: Net income = $300; Net operating profit after taxes (NOPAT) = $400; Total assets = $2,500; Short-term investments = $200; Stockholders' equity = $1,800; Total debt = $700; and Total operating capital = $2,300. What was its return on invested capital (ROIC)? a. 14.91% b. 15.70% c. 16.52% d. 17.39% e. 18.26% ANS: D NOPAT Total operating capital

$400 $2,300

ROIC = NOPAT/Total operating capital ROIC = $400/$2,300 ROIC = 17.39% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Return on invested capital (ROIC) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 71. Zumbahlen Inc. has the following balance sheet. How much total operating capital does the firm have?

Cash Short-term investments Accounts receivable Inventory Current assets Gross fixed assets Accumulated deprec.

Net fixed assets Total assets a. b. c. d. e.

$ 20.00 50.00 20.00 60.00 $150.00 $140.00 40.00 $100.00 $250.00

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

$ 30.00 50.00 30.00 $110.00 70.00 30.00 40.00 $ 70.00 $250.00

$114.00 $120.00 $126.00 $132.30 $138.92

ANS: B Total op. capital = Operating current assets − Operating current liabilities + Net fixed assets Total operating capital = $100.00 − $80.00 + $100.00 Total operating capital = $120.00 PTS: 1

DIF: Difficulty: Moderate

OBJ: LO: 2-7

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Total operating capital KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 72. Barnes' Brothers has the following data for the year ending 12/31/12: Net income = $600; Net operating profit after taxes (NOPAT) = $700; Total assets = $2,500; Short-term investments = $200; Stockholders' equity = $1,800; Total debt = $700; and Total operating capital = $2,100. Barnes' weighted average cost of capital is 10%. What is its economic value added (EVA)? a. $399.11 b. $420.11 c. $442.23 d. $465.50 e. $490.00 ANS: E NOPAT Total operating capital WACC

$700 $2,100 10.00%

EVA = NOPAT − Total operating capital  WACC EVA = $700.00 − $2,100.00  10.00% EVA = $490.00 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Economic Value Added (EVA) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 73. Edwards Electronics recently reported $11,250 of sales, $5,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges, it had $3,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was its net cash flow? a. $3,284.75 b. $3,457.63 c. $3,639.61 d. $3,831.17 e. $4,032.81 ANS: E Bonds Interest rate Tax rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income Taxes Net income Net cash flow = Net income + deprn

$ 3,500.00 6.25% 35.00% $11,250.00 $ 5,500.00 $ 1,250.00 $ 4,500.00 $ 218.75 $ 4,281.25 $ 1,498.44 $ 2,782.81 $ 4,032.81

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income statement: net cash flow KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 74. Wells Water Systems recently reported $8,250 of sales, $4,500 of operating costs other than depreciation, and $950 of depreciation. The company had no amortization charges, it had $3,250 of outstanding bonds that carry a 6.75% interest rate, and its federal-plus-state income tax rate was 35%.

In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to spend $750 to buy new fixed assets and to invest $250 in net operating working capital.

How much free cash flow did Wells generate? a. $1,770.00 b. $1,858.50 c. $1,951.43 d. $2,049.00 e. $2,151.45 ANS: A Bonds Interest rate Tax rate Required addition to net operating working capital Required capital expenditures (fixed assets) Sales Operating costs excluding depr'n Depreciation Operating income (EBIT)

$3,250.00 6.75% 35% $250.00 $750.00 $8,250.00 $4,500.00 $950.00 $2,800.00

FCF = EBIT(1 − T) + Depr'n − Cap Ex − Net Op WC FCF = $1,820 + $950 − $750 − $250 FCF = $1,770.00 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income statement: free cash flow KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 75. HHH Inc. reported $12,500 of sales and $7,025 of operating costs (including depreciation). The company had $18,750 of investor-supplied operating assets (or capital), the weighted average cost of that capital (the WACC) was 9.5%, and the federal-plus-state income tax rate was 40%. What was HHH's Economic Value Added (EVA), i.e., how much value did management add to stockholders' wealth during the year? a. $1,357.13 b. $1,428.56 c. $1,503.75 d. $1,578.94 e. $1,657.88 ANS: C Sales Operating costs Operating income (EBIT)

$12,500 $7,025 $5,475

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

WACC Tax rate Investor-supplied capital

9.5% 40% $18,750

EVA = EBIT(1 − T) − Investor Capital  WACC EVA = $3,285.00 − $1,781.25 EVA = $1,503.75 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 2-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Economic Value Added (EVA) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 76. Last year, Michelson Manufacturing reported $10,250 of sales, $3,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges, it had $3,500 of bonds outstanding that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%.

This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $725. By how much will the depreciation change cause the firm's net after-tax income and its net cash flow to change? Note that the company uses the same depreciation calculations for tax and stockholder reporting purposes. a. −$383.84; $206.68 b. −$404.04; $217.56 c. −$425.30; $229.01 d. −$447.69; $241.06 e. −$471.25; $253.75 ANS: E This problem can be worked very easily⎯just multiply the increase in depreciation by (1 − T) to get the decrease in net income, and then add to the change in income the change in depreciation to get the change in net cash flow: Change in depreciation Tax rate Reduction in net income = Change in Depr'n (1 − Tax rate) Increase in net cash flow = Change in Depr'n − reduction in NI

$725 35.00% −$471.25 $253.75

We can also get the answer the long way, which explains things in more detail: Old Bonds $3,500 Interest rate 6.50% Tax rate 35% Sales $10,250 Operating costs excluding depr'n $3,500 Depreciation $1,250 Operating income (EBIT) $5,500 Interest charges $228 Taxable income $5,273 Taxes $1,845 Net income after taxes $3,427 Net cash flow $4,677 Check on NCF: NCF = change in depreciation  tax rate

New $3,500 6.50% 35% $10,250 $3,500 $1,975 $4,775 $228 $4,548 $1,592 $2,956 $4,931

Change $0.00 $0.00 $0.00 $0.00 $0.00 $725.00 −$725.00 $0.00 −$725.00 −$253.75 −$471.25 $253.75 $253.75

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

We like this problem because it illustrates that an increase in depreciation will decrease the firm's net income yet increase its net cash flow, and cash is king.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Changes in net income and NCF KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 77. Bartling Energy Systems recently reported $9,250 of sales, $5,750 of operating costs other than depreciation, and $700 of depreciation. The company had no amortization charges, it had $3,200 of outstanding bonds that carry a 5% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate sales and cash flows in the future, 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? a. $673.27 b. $708.70 c. $746.00 d. $783.30 e. $822.47 ANS: C Bonds Interest rate Tax rate Required capital expenditures (fixed assets) Required addition to net operating working capital Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income (EBT) Taxes Net income after taxes

$3,200.00 5.00% 35.00% $1,250.00 $300.00 $9,250.00 $5,750.00 $700.00 $2,800.00 $160.00 $2,640.00 $924.00 $1,716.00

FCF = BIT(1 − T) + Depr'n − Cap Ex − Net Op WC FCF = $1,820 + $700 − $1,250 − $300 FCF =

$970.00

Difference between net income and FCF =

$746.00

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 2-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Income stmt: FCF vs. net income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 3—ANALYSIS OF FINANCIAL STATEMENTS TRUE/FALSE 1. Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Ratio analysis KEY: Bloom’s: Knowledge 2. The current ratio and inventory turnover ratios both help us measure the firm's liquidity. The current ratio measures the relationship of a firm's current assets to its current liabilities, while the inventory turnover ratio gives us an indication of how long it takes the firm to convert its inventory into cash.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Liquidity ratios KEY: Bloom’s: Knowledge 3. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easy-to-use measures of a firm's liquidity position.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Liquidity ratios KEY: Bloom’s: Knowledge 4. High current and quick ratios always indicate that a firm is managing its liquidity position well.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current ratio KEY: Bloom’s: Knowledge 5. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its assets.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Asset management ratios KEY: Bloom’s: Knowledge 6. A decline in a firm's inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its liquidity position is improving, i.e., it is becoming more liquid.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA

TOP: Inventory turnover ratio

KEY: Bloom’s: Knowledge

7. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Debt management ratios KEY: Bloom’s: Knowledge 8. The times-interest-earned ratio is one, but not the only, indication of a firm's ability to meet its long-term and short-term debt obligations.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: TIE ratio KEY: Bloom’s: Knowledge 9. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Profitability ratios KEY: Bloom’s: Knowledge 10. Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Market value ratios KEY: Bloom’s: Knowledge 11. 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 measuring changes in a firm's performance over time.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Trend analysis KEY: Bloom’s: Knowledge 12. The "apparent," but not the "true," financial position of a company whose sales are seasonal can differ dramatically, depending on the time of year when the financial statements are constructed.

ANS: T Many of the ratios show sales over some past period such as the last 12 months divided by an asset such as inventories as of a specific date. Assets like inventories vary at different times of the year for a seasonal business, thus leading to big changes in the ratio.

PTS: 1

DIF: Difficulty: Easy

OBJ: LO: 3-1

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Balance sheet changes KEY: Bloom’s: Knowledge 13. Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Limitations of ratio analysis KEY: Bloom’s: Knowledge 14. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects.

ANS: F BEP = EBIT/Assets. This is before the effects of leverage (interest) and taxes, so the statement is false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Basic earning power ratio KEY: Bloom’s: Knowledge 15. 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.

ANS: T A high current ratio is consistent with a lot of inventory. A low inventory turnover is also consistent with a lot of inventory. If the CR exceeds industry norms and the turnover is below the norms, then the firm has more inventory than most other firms, given its sales. It could just be carrying a lot of good inventory, but it might also have a normal amount of "good" inventory plus some "bad" inventory that has not been written off. So the statement is true.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Inventory turnover ratio KEY: Bloom’s: Comprehension 16. 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.

ANS: F The FA turnover is Sales/FA, and it gives an indication of how effectively the firm utilizes its FA. The proportion of FA to TA is not relevant to this usage.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Fixed assets turnover KEY: Bloom’s: Comprehension © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. 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. ANS: F EBIT = Sales revenues − Operating costs Net income = EBIT − Interest − Taxes = (EBIT − Interest)  (1 − T) ROA = Net income after taxes/Assets Two firms could have identical EBITs but very different amounts of interest, different tax rates, and different assets, and thus very different ROAs. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: ROA KEY: Bloom’s: Comprehension 18. Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. Under these conditions, then firms that have high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios.

ANS: F Think about the DuPont equation: ROE = PM  TATO  Equity multiplier. Similar financing policies will lead to similar Equity multipliers. Moreover, competition in the capital markets will cause ROEs to be similar, because otherwise capital would flow to industries with high ROEs and drive returns down toward the average, given similar risks. To have similar ROEs, firms with relatively high PMs must have relatively low TATOs, and vice versa. Therefore, the statement is false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont equation KEY: Bloom’s: Comprehension 19. Even though Firm A's current ratio exceeds that of Firm B, Firm B's quick ratio might exceed that of A. However, if A's quick ratio exceeds B's, then we can be certain that A's current ratio is also larger than that of B. ANS: F This question can be answered by thinking carefully about the ratios: Demonstration that the first sentence is true: CR =

A>B

A:

1.67

0.67

B:

1.50

1.00

QR =

B>A

QR(B) > QR(A)

Demonstration that second sentence is false: © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CR =

A>B

QR =

B>A

A:

1.0

0.67

B:

1.5

0.50

QR(B) < QR(A)

The key is inventory, which is in the CR but not in the QR. The firm with more inventory can have the higher CR but the lower QR. PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Liquidity ratios KEY: Bloom’s: Comprehension 20. Firms A and B have the same current ratio, 0.75, the same amount of sales and cost of goods sold, and the same amount of current liabilities. However, Firm A has a higher inventory turnover ratio than B. Therefore, we can conclude that A's quick ratio must be smaller than B's.

ANS: F Firm A has the higher inventory turnover, so given the same cost of goods, it must have less inventory.

Thus, since the two firms have the same CR, then A must have the higher QR, not the lower one.

Therefore, the statement is false.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Liquidity ratios KEY: Bloom’s: Comprehension 21. 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.

ANS: T TIE = EBIT/Interest = (Sales − Op cost)/(Debt  Interest rate). If we know the op. costs, the amount of debt, and the interest rate, then we can solve for the sales level required to achieve the target TIE. PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: TIE ratio KEY: Bloom’s: Comprehension 22. Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate. However, Firm A has a higher debt 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.

ANS: T

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The easiest way to think about this is to realize that you can borrow at a cost of 10% and invest the proceeds to earn 11%, you'll earn a surplus. If you were previously earning an ROE of 10%, then after raising and investing additional funds, your income will be higher, your equity will be the same, and thus your ROE will increase. Similarly, if a firm earns more on assets than the interest rate, there will be a surplus after paying interest on the debt that will go to the equity, thus increasing the ROE. So, if BEP > rd, then the firm can increase its expected ROE by using more debt leverage.

The answer can also be seen by working out an example. The one below shows that leverage increases ROE if BEP > rd, but it could be varied to show no difference in ROE if interest rates and BEP are the same, and a reduction in ROE if the interest rate exceeds the BEP. Firm A Assets Debt Equity BEP Interest rate, rd Tax rate EBIT = BEP  Assets Interest Taxable income Taxes NI ROE

100% 60% 40% 15% 10% 40% 15.0 6.0 9.0 3.6 5.4 13.50%

Firm B Assets Debt Equity BEP Interest rate, rd Tax rate EBIT = BEP  Assets Interest Taxable income Taxes NI ROE

100% 0% 100% 15% 10% 40% 15.0 0 15.0 6.0 9.0 9.00%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: BEP and ROE KEY: Bloom’s: Comprehension 23. If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must be 0.667.

ANS: T Equity multiplier = Assets/Equity = 3.0, so Assets/Equity = 1/3.0 = 0.333.

By definition, Equity/Assets + Debt/Assets = 1.00, so 0.333 + Debt/Assets = 1.0.

Therefore, Debt/Assets = 1.0 − 0.333 = 0.667. Thus, the statement is true.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Equity multiplier KEY: Bloom’s: Comprehension 24. One problem with ratio analysis is that relationships can 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.

ANS: F

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The key here is to recognize that if the CR is greater than 1.0, then a given increase in both current assets and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial CR were less than 1.0. Here the initial CR is greater than 1.0, so borrowing on a short-term basis to build the cash account would lower the CR. For example: Original CA/CL 3/2 2/3

Plus $1 1/1 1/1

New CA/CL 4/3 3/4

Old CR 1.50 0.67

New CR 1.33 0.75

CR falls if initial CR is greater than 1.0 CR rises if initial CR is less than 1.0

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Limitations of ratio analysis KEY: Bloom’s: Comprehension 25. 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.

ANS: F The key here is to recognize that if the CR is less than 1.0, then a given reduction in both current assets and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial CR were greater than 1.0. In the question, the initial CR is less than 1.0, so using cash to reduce current liabilities would lower the CR. If the CR were greater than 1.0, the statement would have been true.

Here's an illustration: Original CA/CL 2/3 3/2

Less $1 −1/−1 −1/−1

New CA/CL 1/2 2/1

Old CR 0.67 1.5

New CR 0.50 2.0

CR falls if initial CR is less than 1.0 CR rises if initial CR is greater than 1.0

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Limitations of ratio analysis KEY: Bloom’s: Comprehension MULTIPLE CHOICE 26. Considered alone, which of the following would increase a company's current ratio? a. An increase in accounts payable. b. An increase in net fixed assets. c. An increase in accrued liabilities. d. An increase in notes payable. e. An increase in accounts receivable.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current ratio KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

27. Which of the following would, generally, indicate an improvement in a company's financial position, holding other things constant? a. The total assets turnover decreases. b. The TIE declines. c. The DSO increases. d. The EBITDA coverage ratio increases. e. The current and quick ratios both decline.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current ratio KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 28. A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio? a. Use cash to increase inventory holdings. b. Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. c. Use cash to repurchase some of the company's own stock. d. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year. e. Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current ratio KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 29. Which of the following statements is CORRECT? a. If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will decrease. b. A reduction in inventories held would have no effect on the current ratio. c. An increase in inventories would have no effect on the current ratio. d. If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. e. A reduction in the inventory turnover ratio will generally lead to an increase in the ROE. ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Inventories KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 30. Companies A and C each reported the same earnings per share (EPS), but Company A's stock trades at a higher price. Which of the following statements is CORRECT? a. Company A trades at a higher P/E ratio. b. Company A probably has fewer growth opportunities. c. Company A is probably judged by investors to be riskier. d. Company A must have a higher market-to-book ratio. e. Company A must pay a lower dividend. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial statement analysis KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 31. Which of the following statements is CORRECT? a. If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. b. If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. c. Other things held constant, the higher a firm's expected future growth rate, the lower its P/E ratio is likely to be. d. The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA). e. If a firm has a history of high Economic Value Added (EVA) numbers each year, and if investors expect this situation to continue, then its market/book ratio and MVA are both likely to be below average.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Market value ratios KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 32. Which of the following statements is CORRECT? a. "Window dressing" is any action that improves a firm's fundamental, long-run position and thus increases its intrinsic value. b. Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt is an example of "window dressing." Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is another example of "window dressing." c. Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of "window dressing." d. Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is an example of "window dressing." e. Using some of the firm's cash to reduce long-term debt is an example of "window dressing."

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-1 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Window dressing KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 33. The Cavendish Company 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 would occur as a result of this action? a. The company's debt ratio increased. b. The company's current ratio increased. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. The company's times interest earned ratio decreased. d. The company's basic earning power ratio increased. e. The company's equity multiplier increased.

ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Miscellaneous ratios KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 34. A firm's new president wants to strengthen the company's financial position. Which of the following actions would make it financially stronger? a. Increase inventories while holding sales and cost of goods sold constant. b. Increase accounts receivable while holding sales constant. c. Increase EBIT while holding sales constant. d. Increase accounts payable while holding sales constant. e. Increase notes payable while holding sales constant.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Miscellaneous ratios KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 35. If the CEO of a large, 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 DSO (days' sales outstanding) is 40, whereas the average for its competitors is 30. b. The division's basic earning power ratio is above the average of other firms in its industry. c. The division's total assets turnover ratio is below the average for other firms in its industry. d. The division's debt ratio is above the average for other firms in the industry. e. The division's inventory turnover is 6, whereas the average for its competitors is 8.

ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Miscellaneous ratios KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 36. Which of the following would indicate an improvement in a company's financial position, holding other things constant? a. The current and quick ratios both increase. b. The inventory and total assets turnover ratios both decline. c. The debt ratio increases. d. The profit margin declines. e. The EBITDA coverage ratio declines.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Miscellaneous ratios KEY: Bloom’s: Comprehension © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 37. If a bank loan officer were considering a company's request for a loan, which of the following statements would you consider to be CORRECT? a. Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm. b. The lower the company's EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm. c. Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm. d. Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm. e. The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Miscellaneous ratios KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 38. Which of the following statements is CORRECT? a. All else equal, increasing the debt ratio will increase the ROA. b. The use of debt financing will tend to lower the basic earning power ratio, other things held constant. c. 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. d. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE. e. Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favorable basis than income from stock.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Effects of leverage KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 39. A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio? a. Issue new common stock and use the proceeds to acquire additional fixed assets. b. 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. c. Issue new common stock and use the proceeds to increase inventories. d. Speed up the collection of receivables and use the cash generated to increase inventories. e. Use some of its cash to purchase additional inventories.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Quick ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

40. Amram Company's current ratio is 1.9. Considered alone, which of the following actions would reduce the company's current ratio? a. Use cash to reduce accounts payable. b. Borrow using short-term notes payable and use the proceeds to reduce accruals. c. Borrow using short-term notes payable and use the proceeds to reduce long-term debt. d. Use cash to reduce accruals. e. Use cash to reduce short-term notes payable.

ANS: C a is false, given that the initial CR > 1.0. b would leave the CR unchanged. c would indeed reduce the CR. d is false, given that the initial CR > 1.0. e is false, given that the initial CR > 1.0.

Original CA/CL 1.9/1

Minus .5 0/0.5

New CA/CL 1.9/1.5

Old CR 1.90

New CR 1.27

CR falls if initial CR is greater than 1.0

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 41. Which of the following statements is CORRECT? a. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline. b. If a security analyst saw that a firm's days' sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength. c. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding (DSO) will increase. d. There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things. e. A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Accounts receivable KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 42. Which of the following statements is CORRECT? a. If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales. b. If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. A firm's use of debt will have no effect on its profit margin on sales. d. If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales. e. The debt 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.

ANS: D a is incorrect. The reverse is true. b is false, because the TIE also depends on the interest rate and EBIT. c is false, because interest affects the profit margin. d is correct, because the more interest the lower the profits, hence the lower the profit margin. e is simply incorrect.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Leverage effects | Debt management KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 43. Which of the following statements is CORRECT? a. 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. b. If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be the same. c. 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. d. If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price earnings ratio. e. If Firm X's P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and also to be expected to grow at a faster rate.

ANS: C No reason for a to be true.

No reason for b to be true. c must be true, as EPS and P will be the same.

No reason for d to be true. e is wrong, because high risk and low growth lead to low P/Es. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Market value ratios KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 44. 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%. Under these conditions, the ROE will decrease. 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%. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Under these conditions, the ROE will increase. c. 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%.

Without additional information, we cannot tell what will happen to the ROE. d. The modified DuPont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE. e. Other things held constant, an increase in the debt ratio will result in an increase in the profit margin on sales.

ANS: B Old New



PM 9% 10%



TATO 1.0 0.9

Eq mult.

1.666667 2.5

=

ROE 15% 23%

We see that b is true, thus c must be false.

We can also see that d, e, and a are all false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 45. You observe that a firm's ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. Which of the following statements is CORRECT? a. Its total assets turnover must equal the industry average. b. Its total assets turnover must be above the industry average. c. Its return on assets must equal the industry average. d. Its TIE ratio must be below the industry average. e. Its total assets turnover must be below the industry average.

ANS: B Thinking through the DuPont equation, we can see that if the firm's PM and Equity multiplier are below the industry average, the only way its ROE can exceed the industry average is if its equity multiplier exceeds the industry average. The following data illustrate this point:

Firm Industry

ROE 30% 25%

=

PM 9% 10%



TATO 2.0 1



Eq mult.

1.67 2.50

ROA 18% 10%

The above demonstrates that b is correct, and that makes e and a incorrect.

Now consider the following: NI/Assets = NI/Sales  Sales/Assets ROA = PM  TATO If its ROA were equal to the industry average, then with its low debt ratio (hence low equity multiplier) its ROE would also be below the industry average. So c is incorrect. With its debt ratio below the industry average, its interest charges should also be low, which would increase its TIE ratio, making d incorrect.

PTS: 1

DIF: Difficulty: Moderate

OBJ: LO: 3-8

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 46. Companies Heidee and Leaudy are virtually identical in that they are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company Heidee has the higher debt ratio. Which of the following statements is CORRECT? a. Company Heidee has a lower operating income (EBIT) than Company LD. b. Company Heidee has a lower total assets turnover than Company Leaudy. c. Company Heidee has a lower equity multiplier than Company Leaudy. d. Company Heidee has a higher fixed assets turnover than Company Leaudy. e. Company Heidee has a higher ROE than Company Leaudy.

ANS: E Rule out all answers except e because they are false.

Alternative answer explanation using the DuPont equation: ROE = PM  TATO  Eq mult.

ROE = NI/S  S/TA  TA/Equity The first two terms are the same, but KB has higher equity multiplier, hence higher ROE. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 47. Cordelion Communications 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 Cordelion 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 times interest earned ratio will decrease. b. The ROA will decline. c. Taxable income will decrease. d. The tax bill will increase. e. Net income will decrease.

ANS: D a The TIE will increase, not decrease. b is false because reducing debt will lower interest, raise income, and thus raise ROA. c is false for the above reason. d is true for the above reason. e is false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial statement analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

48. Which of the following statements is CORRECT? a. An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin. b. 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. c. If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE. d. An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio. e. An increase in the DSO, other things held constant, could be expected to increase the ROE. ANS: A a. More debt would mean more interest, hence a lower NI, given a constant EBIT. This would lower the profit margin = NI/Sales. b. Sales fluctuations would have more effects on the DSO and S/Inventory ratios. c. ROE = ROA  Equity multiplier, so more debt, higher ROE for given ROA. d. DSO = Receivables/Sales per day. With sales constant, an increase in DSO would mean an increase in receivables, hence a decline, not a rise, in the TATO. e. An increase in the DSO might increase or decrease ROE, depending on how it affected sales and costs.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial statement analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 49. Heidee Corp. and Leaudy Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, Heidee uses more debt than Leaudy. Which of the following statements is CORRECT? a. Heidee would have the higher net income as shown on the income statement. b. Without more information, we cannot tell if Heidee or Leaudy would have a higher or lower net income. c. Heidee would have the lower equity multiplier for use in the DuPont equation. d. Heidee would have to pay more in income taxes. e. Heidee would have the lower net income as shown on the income statement.

ANS: E More debt would mean more interest, hence a lower NI, given a constant EBIT, so e is correct. Also, we can rule out b and a, and Heidee would also have the higher multiplier, which rules out c. And with more interest, Heidee would have to pay less taxes, not more.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial statement analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 50. Other things held constant, which of the following alternatives would increase a company's cash flow for the current year? a. Increase the number of years over which fixed assets are depreciated for tax purposes. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

Pay down the accounts payables.

Reduce the days' sales outstanding (DSO) without affecting sales or operating costs.

Pay workers more frequently to decrease the accrued wages balance.

Reduce the inventory turnover ratio without affecting sales or operating costs.

ANS: C a. Lengthening depreciable lives would lower depreciation, increase taxable income and taxes, and thus lower cash flow. b. Paying down accounts payable would use cash and thus reduce cash flow. c. Reducing the DSO would require collecting receivables faster, which would indeed increase cash flow. d. Decreasing accruals would lower cash flow. e. Reducing inventory turnover would mean increasing inventories, which would use cash.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 51. Companies Heidee and Leaudy have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Company Heidee has more net income. b. Company Heidee pays less in taxes. c. Company Heidee has a lower equity multiplier. d. Company Heidee has a higher ROA. e. Company Heidee has a higher times interest earned (TIE) ratio.

ANS: B Under the stated conditions, Heidee would have more interest charges, thus lower taxable income and taxes. Thus, b is correct. All of the other statements are incorrect.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Leverage, taxes, and ratios KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 52. Companies Heidee and Leaudy have the same tax rate, sales, total assets, and basic earning power.

Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Company Heidee has a lower times interest earned (TIE) ratio. b. Company Heidee has a lower equity multiplier. c. Company Heidee has more net income. d. Company Heidee pays more in taxes. e. Company Heidee has a lower ROE. ANS: A Heidee has higher interest charges. Basic earning power equals EBIT/Assets, and since assets are equal, EBIT must also be equal. TIE = EBIT/Interest. Therefore, Heidee higher interest charges means that its TIE must be lower. Thus, a is correct. All of the other statements are incorrect. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Leverage, taxes, and ratios KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 53. Lincoln Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio? a. Use cash to reduce long-term bonds outstanding. b. Borrow using short-term notes payable and use the cash to increase inventories. c. Use cash to reduce accruals. d. Use cash to reduce accounts payable. e. Use cash to reduce short-term notes payable.

ANS: B The key here is to recognize that if the CR is less than 1.0, then a given increase in both current assets and current liabilities would lead to an increase in the CR. The reverse would hold if the initial CR were greater than 1.0. Here the initial CR is less than 1.0, so borrowing on a short-term basis to build inventories would increase the CR. For example: Original CA/CL 1/2

Plus $1 1/1

New CA/CL 2/3

Old CR 0.50

New CR 0.67

CR rises if initial CR is less than 1.0

All of the other statements are incorrect, although c, d, and e would be correct if the initial CR had been >1.0.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 54. Lofland's has $20 million in current assets and $10 million in current liabilities, while Smaland'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 each plans 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 transaction would improve both firms' financial strength as measured by their current ratios. b. The transactions would raise Lofland's financial strength as measured by its current ratio but lower Smaland's current ratio. c. The transactions would lower Lofland's financial strength as measured by its current ratio but raise Smaland's current ratio. d. The transaction would have no effect on the firm' financial strength as measured by their current ratios. e. The transaction would lower both firm' financial strength as measured by their current ratios.

ANS: C

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The key here is to recognize that if the CR is less than 1.0, then a given increase to both current assets and current liabilities will increase the CR, while the reverse will hold if the initial CR is greater than 1.0. Thus, the transaction would make Smaland look stronger but Lofland look weaker. Here's an illustration:

Lofland

Original CA/CL 20/10

Plus $10 10/10

New CA/CL 30/20

Old CR 2.00

New CR 1.50

Smaland

Original CA/CL 10/20

Plus $10 10/10

New CA/CL 20/30

Old CR 0.50

New CR 0.67

CR falls because initial CR is greater than 1.0

CR rises because initial CR is less than 1.0

All of the statements except c are incorrect.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Current ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 55. Companies Heidee and Leaudy have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company Heidee has a higher debt ratio. Which of the following statements is CORRECT? a. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE. b. Given this information, Leaudy must have the higher ROE. c. Company Leaudy has a higher basic earning power ratio (BEP). d. Company Heidee has a higher basic earning power ratio (BEP). e. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company Heidee will have the higher ROE. ANS: A The companies have the same EBIT and assets, hence the same BEP ratio. If the interest rate is less than the BEP, then using more debt will raise the ROE. Therefore, statement a is correct. The others are all incorrect.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Effects of financial leverage KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 56. Arshadi Corp.'s sales last year were $52,000, and its total assets were $22,000. What was its total assets turnover ratio (TATO)? a. 2.03 b. 2.13 c. 2.25 d. 2.36 e. 2.48 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: D Sales Total assets TATO

$52,000 $22,000 2.36

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Total assets turnover KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 57. Hutchinson Corporation has zero debt⎯it is financed only with common equity. Its total assets are $410,000. The new CFO wants to employ enough debt to bring the debt/assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio? a. $155,800 b. $164,000 c. $172,200 d. $180,810 e. $189,851 ANS: B Total assets Target debt ratio Debt to achieve target ratio = amount borrowed

$410,000 40% $164,000

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Debt ratio: find the debt, given the D/A ratio KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 58. Orono Corp.'s sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500. What was the firm's times interest earned (TIE) ratio? a. 4.72 b. 4.97 c. 5.23 d. 5.51 e. 5.80 ANS: E Sales Operating costs Operating income (EBIT) Interest charges TIE ratio

$435,000 362,500 72,500 $ 12,500 5.80

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Times interest earned KEY: Bloom’s: Application © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 59. Rappaport Corp.'s sales last year were $320,000, and its net income after taxes was $23,000. What was its profit margin on sales? a. 6.49% b. 6.83% c. 7.19% d. 7.55% e. 7.92% ANS: C Sales Net income Profit margin

$320,000 $23,000 7.19%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Profit margin on sales KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 60. Branch Corp.'s total assets at the end of last year were $315,000 and its net income after taxes was $22,750. What was its return on total assets? a. 7.22% b. 7.58% c. 7.96% d. 8.36% e. 8.78% ANS: A Total assets Net income ROA

$315,000 $22,750 7.22%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Return on total assets (ROA) KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 61. Chambliss Corp.'s total assets at the end of last year were $305,000 and its EBIT was 62,500. What was its basic earning power (BEP)? a. 18.49% b. 19.47% c. 20.49% d. 21.52% e. 22.59% ANS: C Total assets EBIT BEP

$305,000 $62,500 20.49%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Basic earning power (BEP) KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 62. Nikko Corp.'s total common equity at the end of last year was $305,000 and its net income after taxes was $60,000. What was its ROE? a. 16.87% b. 17.75% c. 18.69% d. 19.67% e. 20.66% ANS: D Common equity Net income ROE

$305,000 $60,000 19.67%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Return on equity (ROE) KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 63. An investor is considering starting a new business. The company would require $475,000 of assets, and it would be financed entirely with common stock. The investor 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. $52,230 b. $54,979 c. $57,873 d. $60,919 e. $64,125 ANS: E Assets = equity Target ROE Required net income

$475,000 13.5% $64,125

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Return on equity (ROE): finding net income KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 64. Vang Corp.'s stock price at the end of last year was $33.50 and its earnings per share for the year were $2.30. What was its P/E ratio? a. 13.84 b. 14.57 c. 15.29 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. 16.06 e. 16.86 ANS: B Stock price EPS P/E

$33.50 $2.30 14.57

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Price/Earnings ratio (P/E) KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 65. Lindley Corp.'s stock price at the end of last year was $33.50, and its book value per share was $25.00.

What was its market/book ratio? a. 1.34 b. 1.41 c. 1.48 d. 1.55 e. 1.63 ANS: A Stock price Book value per share M/B ratio

$33.50 $25.00 1.34

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Price/Earnings ratio (P/E) KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 66. Northwest Lumber had a profit margin of 5.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8. What was the firm's ROE? a. 12.79% b. 13.47% c. 14.18% d. 14.88% e. 15.63% ANS: C Profit margin TATO Equity multiplier ROE

5.25% 1.50 1.80 14.18%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont equation: basic calculation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

67. Bostian, Inc. has total assets of $625,000. Its total debt outstanding is $185,000. The Board of Directors has directed the CFO to move towards a debt-to-assets ratio of 55%. How much debt must the company add or subtract to achieve the target debt ratio? a. $158,750 b. $166,688 c. $175,022 d. $183,773 e. $192,962 ANS: A Total assets Present debt Target debt ratio Target amount of debt Change in amount of debt outstanding

$625,000 $185,000 55% $343,750 $158,750

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Debt ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 68. Emerson Inc.'s would like to undertake a policy of paying out 45% of its income. Its latest net income was $1,250,000, and it had 225,000 shares outstanding. What dividend per share should it declare? a. $2.14 b. $2.26 c. $2.38 d. $2.50 e. $2.63 ANS: D Net income Shares outstanding Payout ratio EPS DPS

$1,250,000 225,000 45% $5.56 $2.50

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: EPS, DPS, and payout KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 69. Aziz Industries has sales of $100,000 and accounts receivable of $11,500, and it gives its customers 30 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? a. $267.34 b. $281.41 c. $296.22 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. $311.81 e. $328.22 ANS: E Rate of return on cash generated Sales A/R Days in year Sales/day Company DSO Industry DSO Excess DSO Cash flow from reducing the DSO

8.0% $100,000 $11,500 365 $273.97 42.0 27.0 15.0 $4,102.74

Alternative calculation: A/R at industry DSO Change in A/R Additional Net Income

$7,397.26 $4,102.74 $328.22

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Effect of lowering the DSO on net income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 70. Heaton Corp. sells on terms that allow customers 45 days to pay for merchandise. Its sales last year were $425,000, 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. a. 6.20 b. 6.53 c. 6.86 d. 7.20 e. 7.56 ANS: B Credit period Sales Sales/Day Receivables DSO Credit period − DSO = Days early (+) or late (−)

45 $425,000 $1,164 $60,000 51.53 6.53

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Days sales outstanding (DSO) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

71. Harper Corp.'s sales last year were $395,000, and its year-end receivables were $42,500. Harper sells on terms that call for customers to pay 30 days after the purchase, but many 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 365-day year when calculating the DSO. a. 7.95 b. 8.37 c. 8.81 d. 9.27 e. 9.74 ANS: D Sales Sales/Day Receivables DSO Credit period Credit period − DSO = Days late

$395,000 $1,082 $42,500 39.27 30 9.27

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DSO: days of free credit KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 72. Bonner Corp.'s sales last year were $415,000, 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. Bonner's new CFO believes the firm has excess assets that can be sold so as to bring the TATO down to the industry average without affecting sales. By how much must the assets be reduced to bring the TATO to the industry average, holding sales constant? a. $164,330 b. $172,979 c. $182,083 d. $191,188 e. $200,747 ANS: C Sales Total assets Target TATO Target assets = Sales/Target TATO Asset reduction

$415,000 $355,000 2.40 $172,917 $182,083

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Total assets turnover ratio (TATO) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

73. A new firm is developing its business plan. It will require $565,000 of assets, and it projects $452,800 of sales and $354,300 of operating costs for the first year. Management is quite sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 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. What is the maximum debt-to-assets ratio the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt ratio.) a. 47.33% b. 49.82% c. 52.45% d. 55.21% e. 58.11% ANS: E Assets Sales Operating costs Operating income (EBIT) TIE Maximum interest expense = EBIT/TIE Interest rate Max. debt = Max interest/Interest rate Maximum debt ratio = Debt/Assets

$565,000 $452,800 354,300 $ 98,500 4.00 $24,625 7.50% $328,333 58.11%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Max debt ratio consistent with given TIE ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 74. Ziebart Corp.'s EBITDA last year was $390,000 ( = EBIT + depreciation + amortization), its interest charges were $9,500, it had to repay $26,000 of long-term debt, and it had to make a payment of $17,400 under a long-term lease. The firm had no amortization charges. What was the EBITDA coverage ratio? a. 7.32 b. 7.70 c. 8.09 d. 8.49 e. 8.92 ANS: B EBITDA Interest charges Repayment of principal Lease payments Total financial charges Funds avail for fin charges (EBITDA + Lease pmts) EBITDA coverage

$390,000 $9,500 $26,000 $17,400 $52,900 $407,400 7.70

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

KEY: Bloom’s: Analysis

LOC: TBA TOP: EBITDA coverage MSC: TYPE: Multiple Choice: Problem

75. LeCompte Corp. has $312,900 of assets, and it uses only common equity capital (zero debt). Its sales for the last year were $620,000, and its net income after taxes was $24,655. 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 LeCompte need in order to achieve the 15% ROE, holding everything else constant? a. 7.57% b. 7.95% c. 8.35% d. 8.76% e. 9.20% ANS: A Total assets = equity Sales Net income Target ROE Net income req'd to achieve target ROE Profit margin needed to achieve target ROE

$312,900 $620,000 $24,655 15.00% $46,935 7.57%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Profit margin and ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 76. Last year Urbana Corp. had $197,500 of assets, $307,500 of sales, $19,575 of net income, and a debt-to-total-assets ratio of 37.5%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $33,000. Assets, sales, and the debt ratio would not be affected. By how much would the cost reduction improve the ROE? a. 9.32% b. 9.82% c. 10.33% d. 10.88% e. 11.42% ANS: D Assets Debt ratio Debt Equity Sales Old net income New net income New ROE Old ROE Increase in ROE

$197,500 37.5% $74,063 $123,438 $307,500 $19,575 $33,000 26.734% 15.858% 10.88%

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic

OBJ: LO: 3-5

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Effect of reducing costs on the ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 77. Stewart Inc.'s latest EPS was $3.50, its book value per share was $22.75, it had 215,000 shares outstanding, and its debt-to-assets ratio was 46%. How much debt was outstanding? a. $3,393,738 b. $3,572,356 c. $3,760,375 d. $3,958,289 e. $4,166,620 ANS: E EPS BVPS Shares outstanding Debt ratio Total equity Total assets Total debt

$3.50 $22.75 215,000 46.0% $4,891,250 $9,057,870 $4,166,620

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: EPS, book value, and debt ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 78. Last year Vaughn Corp. had sales of $315,000 and a net income of $17,832, and its year-end assets were $210,000. The firm's total-debt-to-total-assets ratio was 42.5%. Based on the DuPont equation, what was Vaughn's ROE? a. 14.77% b. 15.51% c. 16.28% d. 17.10% e. 17.95% ANS: A Sales Assets Net income Debt ratio Debt Equity Profit margin TATO Equity multiplier ROE

$315,000 $210,000 $17,832 42.5% $89,250 $120,750 5.66% 1.50 1.74 14.77%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont equation: basic calculation KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 79. Last year Central Chemicals had sales of $205,000, assets of $127,500, a profit margin of 5.3%, and an equity multiplier of 1.2. The CFO believes that the company could reduce its assets by $21,000 without affecting either sales or costs. Had it reduced its assets in this amount, and had the debt-to-assets ratio, sales, and costs remained constant, by how much would the ROE have changed? a. 1.81% b. 2.02% c. 2.22% d. 2.44% e. 2.68% ANS: B Sales Original assets Reduction in assets New assets TATO Profit margin Equity multiplier ROE Change in ROE

Old $205,000 $127,500

1.61 5.30% 1.20 10.23%

New $205,000 $ 21,000 $106,500 1.92 5.30% 1.20 12.24% 2.02%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont eqn: effect of reducing assets on ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 80. Last year Mason Inc. had a total assets turnover of 1.33 and an equity multiplier of 1.75. Its sales were $195,000 and its net income was $10,549. The CFO believes that the company could have operated more efficiently, lowered its costs, and increased its net income by $5,250 without changing its sales, assets, or capital structure. Had it cut costs and increased its net income in this amount, by how much would the ROE have changed? a. 5.66% b. 5.95% c. 6.27% d. 6.58% e. 6.91% ANS: C Sales Original net income Increase in net income New net income Profit margin TATO Equity multiplier ROE Change in ROE

Old $195,000 $ 10,549 $ 0 $ 10,549 5.41% 1.33 1.75 12.59%

New $195,000 $ 10,549 $ 5,250 $ 15,799 8.10% 1.33 1.75 18.86% 6.27%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont eqn: effect of reducing costs on ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 81. Last year Rosenberg Corp. had $195,000 of assets, $18,775 of net income, and a debt-to-total-assets ratio of 32%. Now suppose the new CFO convinces the president to increase the debt ratio to 48%.

Sales and total assets 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? a. 4.36% b. 4.57% c. 4.80% d. 5.04% e. 5.30% ANS: A Assets Old debt ratio Old debt Old equity New debt ratio New debt New Equity Net income New ROE Old ROE Increase in ROE

$195,000 32% $62,400 $132,600 48% $93,600 $101,400 $18,775 18.52% 14.16% 4.36%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DuPont equation: changing the debt ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 82. Last year Altman Corp. had $205,000 of assets, $303,500 of sales, $18,250 of net income, and a debt-to-total-assets ratio of 41%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets to $152,500. Sales, costs, and net income would not be affected, and the firm would maintain the 41% debt ratio. By how much would the reduction in assets improve the ROE? a. 4.69% b. 4.93% c. 5.19% d. 5.45% e. 5.73% ANS: C Assets Sales

Old $205,000 $303,500

New $152,500 $303,500

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Net income Debt ratio Debt Equity ROE Increase in ROE

$18,250 41.00% $84,050 $120,950 15.089%

$18,250 41.00% $62,525 $89,975 20.283% 5.19%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Asset reduction: turnover and ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 83. Muscarella 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 70,000 210,000 $294,000 126,000 $420,000 $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 70,000 280,000 $420,000

The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.70, 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? a. 4.28% b. 4.50% c. 4.73% d. 4.96% e. 5.21% ANS: B Sales Net income Actual current ratio Target current ratio

$280,000 $21,000 4.20 2.70

ORIGINAL BALANCE SHEET Cash Receivables Inventories Net fixed assets Total assets

$ 14,000 $ 70,000 $210,000 $126,000 $420,000

NI/Equity = ROE: Inv. at target CR Reduction in inv & equity

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

$ 42,000 $ 28,000 $ 70,000 $280,000 $420,000

7.50% $105,000 $105,000 = inventories and common equity decrease by this amount

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

New common equity New ROE ROE

$175,000 12.00% 4.50%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: DSO and its effect on net income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 84. Last year Swensen Corp. had sales of $303,225, operating costs of $267,500, and year-end assets of $195,000. The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.2%, and the firm's tax rate was 37%. The new CFO wants to see how the ROE would have been affected if the firm had used a 45% debt ratio. Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant. By how much would the ROE change in response to the change in the capital structure? a. 2.08% b. 2.32% c. 2.57% d. 2.86% e. 3.14% ANS: D Interest rate Tax rate Assets Debt ratio Debt Equity Sales Operating costs EBIT Interest paid Taxable income Taxes Net income ROE Change in ROE

Old 8.2% 37% $195,000 27% $52,650 $142,350

New 8.2% 37% $195,000 45% $87,750 $107,250

$303,225 $267,500 $ 35,725 $ 4,317 $ 31,408 $ 11,621 $ 19,787 13.90%

$303,225 $267,500 $ 35,725 $ 7,196 $ 28,530 $ 10,556 $ 17,974 16.76% 2.86%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: ROE changing with debt ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

85. For the coming year, Crane Inc. is considering two financial plans. Management expects sales to be $301,770, operating costs to be $266,545, assets to be $200,000, and its tax rate to be 35%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but the TIE ratio would have to be kept at 4.00 or more. Under Plan B the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure? a. 3.83% b. 4.02% c. 4.22% d. 4.43% e. 4.65% ANS: A Work down the Plan A column, find the Max Debt, then use it to complete Plan B and the ROEs. Plan A 8.80% 35% $200,000 25% $50,000 $150,000

Plan B 8.80% 35% $200,000

$301,770 $266,545 $ 35,225 $ 4,400 $ 30,825 $ 10,789 $ 20,036 13.36% 8.01 4.00

$301,770 Constant $266,545 Constant $ 35,225 Constant $ 8,806 $ 26,419 $ 9,247 $ 17,172 17.18%

Interest rate Tax rate Assets Debt ratio Debt Equity Sales Operating costs EBIT Interest Taxable income Taxes Net income ROE TIE Minimum TIE Interest consistent with minimum TIE = EBIT/Min TIE Max debt = Interest/interest rate Change in ROE

$100,071 $99,929

$8,806 $100,071 3.83%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Maximum debt constrained by TIE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 86. Refer to Exhibit 3.1. What is the firm's current ratio? a. 0.97 b. 1.08 c. 1.20 d. 1.33 e. 1.47 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: D Current ratio = Current assets/Current liabilities = 1.33 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 87. Refer to Exhibit 3.1. What is the firm's quick ratio? a. 0.49 b. 0.61 c. 0.73 d. 0.87 e. 1.05 ANS: B Quick ratio = (CA − Inventory)/CL = 0.61 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 88. Refer to Exhibit 3.1. What is the firm's days sales outstanding? Assume a 360-day year for this calculation. a. 48.17 b. 50.71 c. 53.38 d. 56.19 e. 59.14 ANS: E DSO = Accounts receivable/(Sales/360) = 59.14 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 89. Refer to Exhibit 3.1. What is the firm's total assets turnover? a. 0.90 b. 1.12 c. 1.40 d. 1.68 e. 2.02 ANS: C Total assets turnover ratio = Sales/Total assets = 1.40 PTS: 1

DIF: Difficulty: Moderate

OBJ: LO: 3-3

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 90. Refer to Exhibit 3.1. What is the firm's inventory turnover ratio? a. 4.17 b. 4.38 c. 4.59 d. 5.82 e. 5.07 ANS: A Inventory turnover ratio = (Cost of goods sold except depreciation + Depreciation)/Inventory = 4.17 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 91. Refer to Exhibit 3.1. What is the firm's TIE? a. 1.94 b. 2.15 c. 2.39 d. 2.66 e. 2.93 ANS: D TIE = EBIT/Interest charges = 2.66 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 92. Refer to Exhibit 3.1. What is the firm's EBITDA coverage? a. 3.29 b. 3.46 c. 3.64 d. 3.82 e. 4.01 ANS: C EBITDA covg = (EBITDA + lease)/(Int + principal + lease) = 3.64 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

93. Refer to Exhibit 3.1. What is the firm's debt-to-assets ratio? a. 45.93% b. 51.03% c. 56.70% d. 63.00% e. 70.00% ANS: E Debt ratio = Total debt/Total assets = 70.0% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-4 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 94. Refer to Exhibit 3.1. What is the firm's ROA? a. 2.70% b. 2.97% c. 3.26% d. 3.59% e. 3.95% ANS: A ROA = Net income/Total assets = 2.70% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 95. Refer to Exhibit 3.1. What is the firm's ROE? a. 8.54% b. 8.99% c. 9.44% d. 9.91% e. 10.41% ANS: B ROE = Net income/Common equity = 8.99% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 96. Refer to Exhibit 3.1. What is the firm's BEP? a. 6.00% b. 6.32% c. 6.65% d. 6.98% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. 7.33% ANS: C BEP = EBIT/Total assets = 6.65% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 97. Refer to Exhibit 3.1. What is the firm's profit margin? a. 1.40% b. 1.56% c. 1.73% d. 1.93% e. 2.12% ANS: D Profit margin = Net income/Sales = 1.93% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 98. Refer to Exhibit 3.1. What is the firm's dividends per share? a. $2.62 b. $2.91 c. $3.20 d. $3.53 e. $3.88 ANS: B DPS = Common dividends paid/Shares outstanding = $2.91 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 99. Refer to Exhibit 3.1. What is the firm's cash flow per share? a. $10.06 b. $10.59 c. $11.15 d. $11.74 e. $12.35 ANS: E CFPS = (Net income + Depreciation)/Shares outstanding = $12.35 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-5 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 100. Refer to Exhibit 3.1. What is the firm's EPS? a. $5.84 b. $6.15 c. $6.47 d. $6.80 e. $7.14 ANS: C EPS = Net income/common shares outstanding = $6.47 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 101. Refer to Exhibit 3.1. What is the firm's P/E ratio? a. 12.0 b. 12.6 c. 13.2 d. 13.9 e. 14.6 ANS: A P/E ratio = Price per share/Earnings per share = 12.0 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 102. Refer to Exhibit 3.1. What is the firm's book value per share? a. $61.73 b. $64.98 c. $68.40 d. $72.00 e. $75.60 ANS: D BVPS = Common equity/Shares outstanding = $72.00 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

103. Refer to Exhibit 3.1. What is the firm's market-to-book ratio? a. 0.56 b. 0.66 c. 0.78 d. 0.92 e. 1.08 ANS: E Market/book ratio (M/B) = Price per share/BVPS = 1.08 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part 104. Refer to Exhibit 3.1. What is the firm's equity multiplier? a. 3.33 b. 3.50 c. 3.68 d. 3.86 e. 4.05 ANS: A Equity multiplier = Total assets/Common equity = 3.33 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 3-8 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Calculating ratios given financial stmts KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Multi-part

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 4—TIME VALUE OF MONEY TRUE/FALSE 1. Starting to invest early for retirement increases the benefits of compound interest.

ANS: T OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

2. Starting to invest early for retirement reduces the benefits of compound interest.

ANS: F OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

3. A time line is meaningful even if all cash flows do not occur annually.

ANS: T OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

4. A time line is not meaningful unless all cash flows occur annually.

ANS: F OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

5. Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly.

ANS: T OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

6. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly.

ANS: F OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

7. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods.

ANS: T OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

8. Time lines cannot be constructed for annuities unless all the payments occur at the end of the periods.

ANS: F

PTS: 1

DIF: Difficulty: Easy

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 4-2 LOC: TBA

NAT: BUSPROG: Reflective Thinking TOP: Compounding

STA: DISC: Time value of money KEY: Bloom’s: Knowledge

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.

ANS: T OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

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.

ANS: F OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Knowledge

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.

ANS: F OBJ: LO: 4-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: PV versus FV KEY: Bloom’s: Knowledge

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.

ANS: T OBJ: LO: 4-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: PV versus FV KEY: Bloom’s: Knowledge

13. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value.

ANS: T OBJ: LO: 4-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: PV versus FV KEY: Bloom’s: Knowledge

14. Disregarding risk, if money has time value, it is impossible for the future value of a given sum to exceed its present value.

ANS: F OBJ: LO: 4-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: PV versus FV KEY: Bloom’s: Knowledge

15. If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate.

ANS: F OBJ: LO: 4-15 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Effective annual rate KEY: Bloom’s: Knowledge

16. If a bank compounds savings accounts quarterly, the effective annual rate will exceed the nominal rate.

ANS: T

PTS: 1

DIF: Difficulty: Easy

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 4-15 LOC: TBA

NAT: BUSPROG: Analytic TOP: Effective annual rate

STA: DISC: Time value of money KEY: Bloom’s: Knowledge

17. A "growing annuity" is a cash flow stream that grows at a constant rate for a specified number of periods.

ANS: T OBJ: LO: 4-18 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Growing annuity KEY: Bloom’s: Knowledge

18. A "growing annuity" is any cash flow stream that grows over time.

ANS: F OBJ: LO: 4-18 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Growing annuity KEY: Bloom’s: Knowledge

19. The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the greater the present value of a given lump sum to be received at some future date.

ANS: F OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Comprehension

20. The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the smaller the present value of a given lump sum to be received at some future date.

ANS: T OBJ: LO: 4-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Compounding KEY: Bloom’s: Comprehension

21. 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 risk, and assume that compounding occurs annually.)

ANS: T Work out the numbers with a calculator: PV 1000 Rate on A 5% Rate on B 12% Years 11

FVA = 2  FVA = FVB = FVB > 2  FVA, so TRUE

$1,710.34 $3,420.68 $3,478.55

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Comparative compounding KEY: Bloom’s: Comprehension 22. 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 risk, and assume that compounding occurs annually.) © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: F Work out the numbers with a calculator: PV 1000 Rate on A 5% Rate on B 12% Years 11

FVA = 2  FVA = FVB = FVB > 2  FVA, so FALSE

$1,710.34 $3,420.68 $3,478.55

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Comparative compounding KEY: Bloom’s: Comprehension 23. 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.

ANS: T OBJ: LO: 4-3 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: PV of a dollar KEY: Bloom’s: Comprehension

24. 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.

ANS: F OBJ: LO: 4-3 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: PV of a sum KEY: Bloom’s: Comprehension

25. All other things held constant, the present value of a given annual annuity decreases as the number of periods per year increases.

ANS: T One could make up an example and see that the statement is true. Alternatively, one could simply recognize that the PV of an annuity declines as the discount rate increases and recognize that more frequent compounding increases the effective rate.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of an annuity KEY: Bloom’s: Comprehension 26. All other things held constant, the present value of a given annual annuity increases as the number of periods per year increases.

ANS: F One could make up an example and see that the statement is false. Alternatively, one could simply recognize that the PV of an annuity declines as the discount rate increases and recognize that more frequent compounding increases the effective rate.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of an annuity KEY: Bloom’s: Comprehension 27. 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.

ANS: T

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 4-15 LOC: TBA

NAT: BUSPROG: Analytic TOP: Periodic and nominal rates

STA: DISC: Time value of money KEY: Bloom’s: Comprehension

28. 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.

ANS: F OBJ: LO: 4-15 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Periodic and nominal rates KEY: Bloom’s: Comprehension

29. 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).

ANS: T OBJ: LO: 4-15 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Effective and nominal rates KEY: Bloom’s: Comprehension

30. 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).

ANS: F OBJ: LO: 4-15 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Effective and nominal rates KEY: Bloom’s: Comprehension

31. 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.

ANS: F OBJ: LO: 4-17 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Amortization KEY: Bloom’s: Comprehension

32. 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.

ANS: T OBJ: LO: 4-17 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Amortization KEY: Bloom’s: Comprehension

33. 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.

ANS: T OBJ: LO: 4-17 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Amortization KEY: Bloom’s: Comprehension

34. 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.

ANS: F OBJ: LO: 4-17 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Time value of money TOP: Amortization KEY: Bloom’s: Comprehension

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

35. 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.

ANS: F There is no reason to think that this statement would always be true. The portion of the payment representing interest declines, while the portion representing principal repayment increases. Therefore, the statement is false. We could also work out some numbers to prove this point. Here's an example for a 3-year loan at a 10% and a 41.45% annual interest rate. The interest component is not equal to the principal repayment component except at the high interest rate.

Original loan Rate Life Payment

1 2 3

Beg. Balance $1,000.00 $697.89 $365.56

Interest $100.00 $69.79 $36.56

Principal $302.11 $332.33 $365.56

$1,000 10% 3 $402.11

Original loan Rate Life Payment

End Bal. $697.89 $365.56 $0.00

Beg. Balance $1,000.00 $773.52 $453.15

1 2 3

$1,000 41.45% 3 $640.98 Interest $414.50 $320.62 $187.83

Principal $226.48 $320.36 $453.15

End Bal. $773.52 $453.15 $0.00

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Comprehension 36. 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 to the percentage that represents repayment of principal.

The proportions depend on the original life of the loan and the interest rate.

ANS: T This statement is true. The portion of the payment representing interest declines, while the portion representing principal repayment increases. The interest portion could be equal to, greater than, or less than the principal portion. We can work out some numbers to prove this point. Here's an example for a 3-year loan at a 10% and a 41.45% annual interest rate. The interest component is less than the principal at 10%, equal at about 41.45%, and greater at rates above 41.45%.

Original loan Rate Life Payment

1 2 3

Beg. Balance $1,000.00 $697.89 $365.56

Interest $100.00 $69.79 $36.56

Principal $302.11 $332.33 $365.56

$1,000 10% 3 $402.11

Original loan Rate Life Payment

End. Bal. $697.89 $365.56 $0.00

Beg. Balance $1,000.00 $773.52 $453.15

1 2 3

$1,000 41.45% 3 $640.98 Interest $414.50 $320.62 $187.83

Principal $226.48 $320.36 $453.15

End. Bal. $773.52 $453.15 $0.00

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Comprehension MULTIPLE CHOICE © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money LOC: TBA TOP: Time lines KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money LOC: TBA TOP: Time lines KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money LOC: TBA TOP: Time lines KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money LOC: TBA TOP: Time lines KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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 discount rate decreases. b. 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. c. The discount rate increases. d. The riskiness of the investment's cash flows decreases. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-3 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Effects of factors on PVs KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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? a. The discount rate increases. b. 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. c. The discount rate decreases. d. The riskiness of the investment's cash flows increases. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-3 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Effects of factors on PVs KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

43. Which of the following statements is CORRECT? a. 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. b. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. c. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. d. The cash flows for an annuity due must all occur at the ends of the periods. e. 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.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money LOC: TBA TOP: Annuities KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

44. Which of the following statements is CORRECT? a. 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. b. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. c. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. d. The cash flows for an annuity due must all occur at the beginning of the periods. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Time value of money LOC: TBA TOP: Annuities KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

45. Your bank account pays a 5% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT? a. The periodic rate of interest is 5% and the effective rate of interest is also 5%. b. The periodic rate of interest is 1.25% and the effective rate of interest is 2.5%. c. The periodic rate of interest is 5% and the effective rate of interest is greater than 5%. d. The periodic rate of interest is 1.25% and the effective rate of interest is greater than 5%. e. The periodic rate of interest is 2.5% and the effective rate of interest is 5%.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Quarterly compounding KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

question.

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 8% and the effective rate of interest is also 8%. b. The periodic rate of interest is 2% and the effective rate of interest is 4%. c. The periodic rate of interest is 8% and the effective rate of interest is greater than 8%. d. The periodic rate of interest is 4% and the effective rate of interest is less than 8%. e. The periodic rate of interest is 2% and the effective rate of interest is greater than 8%.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Quarterly compounding KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

47. A $250,000 loan is to be amortized over 8 years, with annual end-of-year payments. Which of these statements is CORRECT? a. The proportion of interest versus principal repayment would be the same for each of the 8 payments. b. The annual payments would be larger if the interest rate were lower. c. If the loan were amortized over 10 years rather than 8 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 8-year amortization plan. d. The proportion of each payment that represents interest as opposed to repayment of principal would be lower if the interest rate were lower. e. The last payment would have a higher proportion of interest than the first payment.

ANS: D a, b, and e can be ruled out as incorrect by simple reasoning. c is also incorrect because interest in the first year would be Loan amount  interest rate regardless of the life of the loan, so the interest payment would be identical for the first payment. Think about the situation where r = 0%, statement d is the "most logical guess." One could also set up an amortization schedule and change the numbers to confirm that only d is correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

48. A $150,000 loan is to be amortized over 6 years, with annual end-of-year payments. Which of these statements is CORRECT? a. The proportion of interest versus principal repayment would be the same for each of the 7 payments. b. The annual payments would be larger if the interest rate were lower. c. If the loan were amortized over 10 years rather than 6 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 6-year amortization plan. d. The proportion of each payment that represents interest as opposed to repayment of © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

principal would be higher if the interest rate were lower. e. The proportion of each payment that represents interest versus repayment of principal would be higher if the interest rate were higher.

ANS: E a, b, and d are obviously incorrect. c is also incorrect because interest in the first year would be Loan amount  interest rate regardless of the life of the loan. That makes e the "most logical guess." One could also set up an amortization schedule and change the numbers to confirm that only e is correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

49. Which of the following statements regarding a 20-year (240-month) $225,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) a. The outstanding balance declines at a slower rate in the later years of the loan's life. b. The remaining balance after three years will be $225,000 less one third of the interest paid during the first three years. c. Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant. d. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. e. 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.

ANS: C c is the correct answer. Thinking through the question, the other answers can all be eliminated. One could also set up an amortization schedule to prove that only statement c is correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

50. Which of the following statements regarding a 15-year (180-month) $225,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) a. The outstanding balance declines at a faster rate in the later years of the loan's life. b. The remaining balance after three years will be $125,000 less one third of the interest paid during the first three years. c. Because the outstanding balance declines over time, the monthly payments will also decline over time. d. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. e. 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.

ANS: A © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a is the correct answer. Thinking through the question, the other answers can all be eliminated. One could also set up an amortization schedule to prove that only statement a is correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

51. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 8% is CORRECT? a. Exactly 8% of the first monthly payment represents interest. b. The monthly payments will decline over time. c. A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal, than for the first monthly payment. d. The total dollar amount of principal being paid off each month gets smaller as the loan approaches maturity. e. The amount representing interest in the first payment would be higher if the nominal interest rate were 6% rather than 8%.

ANS: C c is correct. b is clearly wrong, as are d and e. It is not obvious whether a is correct or not, but we could set up an example to see: Loan Rate Periodic rate Payment Interest as % of total #360 payment: Principal as % of total #360 payment

100000 Term 8% Periods/Year 0.00666666667 Total periods −$733.76 Interest, Month 1 1% Interest, Month 360 99% Principal, Month 360

30 12 360 $666.67 $7.25 $726.51

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

52. Which of the following statements regarding a 20-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT? a. Exactly 10% of the first monthly payment represents interest. b. The monthly payments will increase over time. c. A larger proportion of the first monthly payment will be interest, and a smaller proportion will be principal, than for the last monthly payment. d. The total dollar amount of interest being paid off each month gets larger as the loan approaches maturity. e. The amount representing interest in the first payment would be higher if the nominal interest rate were 7% rather than 10%.

ANS: C © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c is correct. b is clearly wrong, as are d and e. It is not obvious whether a is correct or not, but we could set up an example to see: Loan Rate Periodic rate

100000 Term 10% Periods/Year 0.00833333 Total periods

Payment Interest as % of total payment:

20 12 240

$833.33 −$965.02 Interest Month 1 86%, which is much larger than 10%.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

53. At the end of 10 years, which of the following investments would have the highest future 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 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).

ANS: A A dominates B because it provides the same total amount, but it comes faster, hence it can earn more interest over the 10 years. A also dominates C and E for the same reason, and it dominates D because with D no interest whatever is earned. We could also do these calculations to answer the question: A B C D E

$4,382.79 $4,081.59 $4,280.81 $2,500.00 $3,984.36

Largest

EFF% NOM%

10.00% 9.76%

10

250 125 125 2500 250

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Time value concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

54. Of the following investments, which 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 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 beginning of every year for the next 10 years (a total of 10 payments).

ANS: D A is smaller than E and B is smaller than C because the money comes in later. A is smaller than B because a larger annuity is received later. So, now the choice comes down to either A or D. Since all of D is received at the end, this is the logical choice. We could also do these calculations to answer the question: A B C D E

$1,536.14 $1,573.63 $1,650.44 $963.86 $1,689.76

EFF% NOM% Smallest

10.00% 9.76%

10

250 125 125 2500 250

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Time value concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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 PV of the $1,000 lump sum has a higher present value than the PV of a 3-year, $333.33 ordinary annuity. b. The periodic interest rate is greater than 3%. c. The periodic rate is less than 3%. d. The present value would be greater if the lump sum were discounted back for more periods. e. The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Time value concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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 PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity. b. The periodic interest rate is greater than 3%. c. The periodic rate is less than 3%. d. The present value would be greater if the lump sum were discounted back for more periods. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Time value concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

57. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant? a. 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. b. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. c. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. d. A bank loan's nominal interest rate will always be equal to or less than its effective annual rate. e. If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Time value concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

58. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant? a. 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. b. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. c. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. d. A bank loan's nominal interest rate will always be equal to or greater than its effective annual rate. e. If an investment pays 10% interest, compounded quarterly, its effective annual rate will be greater than 10%.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Time value concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Time value concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

60. Which of the following statements is CORRECT? a. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%. b. The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due. c. If a loan has a nominal annual rate of 7%, then the effective rate will never be less than 7%. d. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. e. The proportion of the payment that goes toward interest on a fully amortized loan increases over time.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Time value concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

61. You are considering two equally risky annuities, each of which pays $15,000 per year for 20 years.

Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. e. The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD. ANS: E

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Annuities KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

62. You are considering two equally risky annuities, each of which pays $25,000 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. 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. b. A rational investor would be willing to pay more for DUE than for ORD, so their market prices should differ. c. 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. d. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. e. The present value of ORD exceeds the present value of DUE, while the future value of DUE exceeds the future value of ORD. ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Annuities KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

63. Which of the following statements is CORRECT? a. If CF0 is positive and all the other CFs are negative, then you cannot solve for I. b. 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 to equal the cash flow at Time 0. c. 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. d. 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. e. If you solve for I and get a negative number, then you must have made a mistake.

ANS: D PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-14 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Solving for I: uneven CFs KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

64. Which of the following statements is CORRECT? a. If CF0 is positive and all the other CFs are negative, then you can still solve for I. b. 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 to equal the cash flow at Time 0. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 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. d. 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. e. If you solve for I and get a negative number, then you must have made a mistake.

ANS: A PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-14 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Solving for I: uneven CFs KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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

ANS: A By inspection, we can see that a dominates b and c, and that d dominates e because, with the same interest rate, the account with the most frequent compounding has the highest EFF%. Thus, the correct answer must be either a or d. Moreover, we can see by inspection that since a and d have the same compounding frequency yet a has the higher nominal rate, a must have the higher EFF%. You could also prove that a is the correct choice by calculating the EFF%s: a. b. c. d. e.

8.328% = (1 + 0.08/365)365−1 8.300% = (1 + 0.08/12)12−1 8.000% = (1 + 0.08/1)1−1 7.250% = (1 + 0.07/365)365−1 7.229% = (1 + 0.07/12)12−1

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Effective annual rate KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 66. Which of the following bank accounts has the lowest effective annual return? a. An account that pays 8% nominal interest with daily (365-day) compounding. b. An account that pays 8% nominal interest with monthly compounding. c. An account that pays 8% nominal interest with annual compounding. d. An account that pays 7% nominal interest with daily (365-day) compounding. e. An account that pays 7% nominal interest with monthly compounding.

ANS: E By inspection, we can see that c must have a lower EFF% than either a or b because they all pay the same nominal rate but c is compounded least frequently. Similarly, d and e pay the same rate, but e is compounded less frequently, hence e must have the lower EFF%. So, the correct answer must be either c or e. It is not obvious which of these two has the lower EFF%, so we must do a quick calculation to determine the correct response. As the following calculations show, e is the correct answer. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

8.328% = (1 + 0.08/365)365−1 8.300% = (1 + 0.08/12)12−1 8.000% = (1 + 0.08/1)1−1 7.250% = (1 + 0.07/365)365−1 7.229% = (1 + 0.07/12)12−1

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Effective annual rate KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 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? 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.

ANS: E By inspection, we can see that e dominates b, c, and d because, with the same interest rate, the account with the most frequent compounding has the highest EFF%. Thus, the correct answer must be either a or e. However, we cannot tell by inspection whether a or e provides the higher EFF%. We know that with one compounding period an EFF% is 6.1%, so we can calculate e's EFF%. It is 6.183%, so e is the correct answer. a. e.

(1 + 0.061/12)12−1 = 6.100% (1 + 0.06/365)365−1 = 6.183%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Effective annual rate KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 68. Ellen now has $125. How much would she have after 8 years if she leaves it invested at 8.5% with annual compounding? a. $205.83 b. $216.67 c. $228.07 d. $240.08 e. $252.08 ANS: D N I/YR PV PMT FV

8 8.5% $125 $0 $240.08

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

69. How much would Roderick have after 6 years if he has $500 now and leaves it invested at 5.5% with annual compounding? a. $591.09 b. $622.20 c. $654.95 d. $689.42 e. $723.89 ANS: D N I/YR PV PMT FV

6 5.5% $500 $0 $689.42

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 70. JG Asset Services is recommending that you invest $1,500 in a 5-year certificate of deposit (CD) that pays 3.5% interest, compounded annually. How much will you have when the CD matures? a. $1,781.53 b. $1,870.61 c. $1,964.14 d. $2,062.34 e. $2,165.46 ANS: A N I/YR PV PMT FV

5 3.5% $1,500 $0 $1,781.53

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 71. Your bank offers a 10-year certificate of deposit (CD) that pays 6.5% interest, compounded annually.

If you invest $2,000 in the CD, how much will you have when it matures? a. $3,754.27 b. $3,941.99 c. $4,139.09 d. $4,346.04 e. $4,563.34 ANS: A N I/YR PV PMT

10 6.5% $2,000 $0

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

FV

$3,754.27

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 72. Cyberhost Corporation's sales were $225 million last year. If sales grow at 6% per year, how large (in millions) will they be 5 years later? a. $271.74 b. $286.05 c. $301.10 d. $316.16 e. $331.96 ANS: C N I/YR PV PMT FV

5 6.0% $225.00 $0.00 $301.10

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 73. Cochrane Associate's net sales last year were $525 million. If sales grow at 7.5% per year, how large (in millions) will they be 8 years later? a. $845.03 b. $889.51 c. $936.33 d. $983.14 e. $1,032.30 ANS: C N I/YR PV PMT FV

8 7.5% $525.00 $0.00 $936.33

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 74. How much would $1, growing at 3.5% per year, be worth after 75 years? a. $12.54 b. $13.20 c. $13.86 d. $14.55 e. $15.28 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: B N I/YR PV PMT FV

75 3.5% $1.00 $0.00 $13.20

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 75. How much would $100, growing at 5% per year, be worth after 75 years? a. $3,689.11 b. $3,883.27 c. $4,077.43 d. $4,281.30 e. $4,495.37 ANS: B N I/YR PV PMT FV

75 5.0% $100.00 $0.00 $3,883.27

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 76. Your bank offers a savings account that pays 3.5% interest, compounded annually. If you invest $1,000 in the account, then how much will it be worth at the end of 25 years? a. $2,245.08 b. $2,363.24 c. $2,481.41 d. $2,605.48 e. $2,735.75 ANS: B N I/YR PV PMT FV

25 3.5% $1,000 $0 $2,363.24

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 77. Your bank offers a savings account that pays 3.5% interest, compounded annually. How much will $500 invested today be worth at the end of 25 years? a. $1,122.54 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

$1,181.62 $1,240.70 $1,302.74 $1,367.88

ANS: B N I/YR PV PMT FV

25 3.5% $500 $0 $1,181.62

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-2 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 78. Suppose a State of North Carolina bond will pay $1,000 ten years from now. If the going interest rate on these 10-year bonds is 5.5%, how much is the bond worth today? a. $585.43 b. $614.70 c. $645.44 d. $677.71 e. $711.59 ANS: A N I/YR PMT FV PV

10 5.5% $0 $1,000.00 $585.43

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-3 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 79. Suppose a State of New Mexico bond will pay $1,000 eight years from now. If the going interest rate on these 8-year bonds is 5.5%, how much is the bond worth today? a. $651.60 b. $684.18 c. $718.39 d. $754.31 e. $792.02 ANS: A N I/YR PMT FV PV

8 5.5% $0 $1,000.00 $651.60

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-3 NAT: BUSPROG: Analytic STA: DISC: Time value of money © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: PV of a lump sum MSC: TYPE: Multiple Choice: Problem

KEY: Bloom’s: Application

80. How much would $20,000 due in 50 years be worth today if the discount rate were 7.5%? a. $438.03 b. $461.08 c. $485.35 d. $510.89 e. $537.78 ANS: E N I/YR PMT FV PV

50 7.5% $0 $20,000 $537.78

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-3 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 81. You expect to receive $5,000 in 25 years. How much is it worth today if the discount rate is 5.5%? a. $1,067.95 b. $1,124.16 c. $1,183.33 d. $1,245.61 e. $1,311.17 ANS: E N I/YR PMT FV PV

25 5.5% $0 $5,000 $1,311.17

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-3 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 82. The going rate of interest on a 5-year treasury bond is 4.25%. You have one that will pay $2,500 five years from now. How much is the bond worth today? a. $1,928.78 b. $2,030.30 c. $2,131.81 d. $2,238.40 e. $2,350.32 ANS: B N I/YR PMT FV

5 4.25% $0 $2,500.00

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PV

$2,030.30

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-3 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 83. Suppose a Google.com bond will pay $4,500 ten years from now. If the going interest rate on safe 10-year bonds is 4.25%, how much is the bond worth today? a. $2,819.52 b. $2,967.92 c. $3,116.31 d. $3,272.13 e. $3,435.74 ANS: B N I/YR PMT FV PV

10 4.25% $0 $4,500.00 $2,967.92

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-3 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of a lump sum KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 84. You have just purchased a U.S. Treasury bond for $747.25. 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 will you earn on this bond? a. 4.37% b. 4.86% c. 5.40% d. 6.00% e. 6.60% ANS: D N PV PMT FV I/YR

5 $747.25 $0 $1,000.00 6.00%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-4 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Finding I KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 85. You have purchased a U.S. Treasury bond for $3,000. No payments will be made until the bond matures 10 years from now, at which time it will be redeemed for $5,000. What interest rate will you earn on this bond? a. 3.82% b. 4.25% c. 4.72% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. 5.24% e. 5.77% ANS: D N PV PMT FV I/YR

10 $3,000.00 $0 $5,000.00 5.24%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-4 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Finding I KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 86. Ten years ago, Kronan Corporation earned $0.50 per share. Its earnings this year were $2.20. What was the growth rate in earnings per share (EPS) over the 10-year period? a. 15.17% b. 15.97% c. 16.77% d. 17.61% e. 18.49% ANS: B N PV PMT FV I/YR

10 $0.50 $0 $2.20 15.97%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-4 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Growth rate KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 87. Wildwoods, Inc. earned $1.50 per share five years ago. Its earnings this year were $3.20. What was the growth rate in earnings per share (EPS) over the 5-year period? a. 15.54% b. 16.36% c. 17.18% d. 18.04% e. 18.94% ANS: B N PV PMT FV I/YR

5 $1.50 $0 $3.20 16.36%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-4 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Growth rate KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

88. You have $5,000 invested in a bank that pays 3.8% annually. How long will it take for your funds to triple? a. 23.99 b. 25.26 c. 26.58 d. 27.98 e. 29.46 ANS: E I/YR PV PMT FV N

3.8% $5,000.00 $0 $15,000.00 29.46

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-5 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Finding N KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 89. Your bank pays 4% interest annually. You have $2,500 invested in the bank. How long will it take for your funds to double? a. 14.39 b. 15.15 c. 15.95 d. 16.79 e. 17.67 ANS: E I/YR PV PMT FV N

4.0% $2,500.00 $0 $5,000.00 17.67

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-5 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Finding N KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 90. Brockman Corporation's earnings per share were $3.50 last year, and its growth rate during the prior 5 years was 9.0% per year. If that growth rate were maintained, how many years would it take for Brockman's EPS to triple? a. 9.29 b. 10.33 c. 11.47 d. 12.75 e. 14.02 ANS: D I/YR PV PMT

9.0% $3.50 $0

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

FV N

$10.50 12.75

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-5 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Finding N KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 91. Your investment account pays 8.0%, compounded annually. If you invest $5,000 today, how many years will it take for your investment to grow to $9,140.20? a. 5.14 b. 5.71 c. 6.35 d. 7.05 e. 7.84 ANS: E I/YR PV PMT FV N

8.0% $5,000.00 $0 $9,140.20 7.84

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-5 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Finding N KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 92. Your investment advisor has recommended your 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 $30,000? a. 12.37 b. 13.74 c. 15.27 d. 16.97 e. 18.85 ANS: E I/YR PV PMT FV N

6.0% $10,000.00 $0 $30,000.00 18.85

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-5 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Finding N KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 93. You are hoping to buy a new boat 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. $11,973 b. $12,603 c. $13,267 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. $13,930 e. $14,626 ANS: C N I/YR PV PMT FV

3 5.2% $0.00 $4,200 $13,266.56

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-7 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of ordinary annuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 94. You want to buy new kitchen appliances 2 years from now, and you plan to save $8,200 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. $15,260 b. $16,063 c. $16,908 d. $17,754 e. $18,642 ANS: C N I/YR PV PMT FV

2 6.2% $0.00 $8,200 $16,908

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-7 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of ordinary annuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 95. You would like to travel in South America 5 years from now, and you can save $3,100 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. $18,369 b. $19,287 c. $20,251 d. $21,264 e. $22,327 ANS: A N I/YR PV PMT FV

5 8.5% $0.00 $3,100 $18,369

PTS: 1

DIF: Difficulty: Easy

OBJ: LO: 4-7

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of ordinary annuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 96. You want to purchase a motorcycle 4 years from now, and you plan to save $3,500 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. $16,112 b. $16,918 c. $17,763 d. $18,652 e. $19,584 ANS: A BEGIN Mode N I/YR PV PMT FV

4 5.7% $0.00 $3,500 $16,112

Alternative setup: 0 1 $3,500 $3,500

2 $3,500

3 $3,500

4 FV = $16,112

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-8 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of annuity due KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 97. You want to open a sushi bar 3 years from now, and you plan to save $7,000 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. $20,993 b. $22,098 c. $23,261 d. $24,424 e. $25,645 ANS: C BEGIN Mode N I/YR PV PMT FV

3 5.2% $0.00 $7,000 $23,261

Alternative setup: 0 1 $7,000 $7,000

PTS: 1

2 $7,000

DIF: Difficulty: Easy

3 $7,000 FV = $23,261 OBJ: LO: 4-8

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of annuity due KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 98. What is the PV of an ordinary annuity with 10 payments of $2,700 if the appropriate interest rate is 5.5%? a. $16,576 b. $17,449 c. $18,367 d. $19,334 e. $20,352 ANS: E N I/YR PMT FV PV

10 5.5% $2,700 $0.00 $20,352

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of ordinary annuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 99. What is the PV of an ordinary annuity with 5 payments of $4,700 if the appropriate interest rate is 4.5%? a. $16,806 b. $17,690 c. $18,621 d. $19,601 e. $20,633 ANS: E N I/YR PMT FV PV

5 4.5% $4,700 $0.00 $20,633

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of ordinary annuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 100. Your friend offers to pay you an annuity of $2,500 at the end of each year for 3 years in return for cash today. 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. $5,493.71 b. $5,782.85 c. $6,087.21 d. $6,407.59 e. $6,744.83 ANS: E © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

N I/YR PMT FV PV

3 5.5% $2,500 $0.00 $6,744.83

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of ordinary annuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 101. After receiving a reward for information leading to the arrest of a notorious criminal, you are considering investing it in an annuity that pays $5,000 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. $50,753 b. $53,424 c. $56,236 d. $59,195 e. $62,311 ANS: E N I/YR PMT FV PV

20 5.0% $5,000 $0.00 $62,311

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of ordinary annuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 102. An uncle of yours who is about to retire wants to sell some of his stock and buy an annuity that will provide him with income of $50,000 per year for 30 years, beginning a year from today. The going rate on such annuities is 7.25%. How much would it cost him to buy such an annuity today? a. $574,924 b. $605,183 c. $635,442 d. $667,214 e. $700,575 ANS: B N I/YR PMT FV PV

30 7.25% $50,000 $0.00 $605,183

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of ordinary annuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

103. What is the PV of an annuity due with 5 payments of $2,500 at an interest rate of 5.5%? a. $11,262.88 b. $11,826.02 c. $12,417.32 d. $13,038.19 e. $13,690.10 ANS: A BEGIN Mode N I/YR PMT FV PV

5 5.5% $2,500 $0.00 $11,262.88

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of annuity due KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 104. What's the present value of a perpetuity that pays $250 per year if the appropriate interest rate is 5%? a. $4,750 b. $5,000 c. $5,250 d. $5,513 e. $5,788 ANS: B I/YR PMT PV

5.0% $250 $5,000

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-11 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of a perpetuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 105. A perpetuity pays $85 per year and costs $950. What is the rate of return? a. 8.95% b. 9.39% c. 9.86% d. 10.36% e. 10.88% ANS: A Cost (PV) PMT I/YR

$950 $85 8.95%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 4-11 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Return on a perpetuity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

106. A new investment opportunity for you is an annuity that pays $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. $1,412.84 b. $1,487.20 c. $1,565.48 d. $1,643.75 e. $1,725.94 ANS: C BEGIN Mode N I/YR PMT FV PV

3 5.5% $550 $0.00 $1,565.48

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 107. Your father is considering purchasing an annuity that pays $5,000 at the beginning of each year for 5 years. He could earn 4.5% on his money in other investments with equal risk. What is the most he should pay for the annuity? a. 20,701 b. $21,791 c. $22,938 d. $24,085 e. $25,289 ANS: C BEGIN Mode N I/YR PMT FV PV

5 4.5% $5,000 $0.00 $22,938

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 108. Because your mother is about to retire, she wants to buy an annuity that will provide her with $75,000 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 her to buy the annuity today? a. $825,835 b. $869,300 c. $915,052 d. $963,213 e. $1,011,374 ANS: D © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

BEGIN Mode N I/YR PMT FV PV

20 5.25% $75,000 $0.00 $963,213

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 109. Now that your uncle has decided to retire, he wants to buy an annuity that will provide him with $85,000 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. $1,063,968 b. $1,119,966 c. $1,178,912 d. $1,240,960 e. $1,303,008 ANS: D BEGIN Mode N I/YR PMT FV PV

25 5.15% $85,000 $0.00 $1,240,960

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 110. A salt mine you inherited will pay you $25,000 per year for 25 years, with the first payment being made today. If you think a fair return on the mine is 7.5%, how much should you ask for it if you decide to sell it? a. $284,595 b. $299,574 c. $314,553 d. $330,281 e. $346,795 ANS: B BEGIN Mode N I/YR PMT FV PV

25 7.5% $25,000 $0.00 $299,574

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of annuity due KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 111. Geraldine was injured in a car accident, and the insurance company has offered her the choice of $25,000 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 her as well off financially as with the annuity? a. $225,367 b. $237,229 c. $249,090 d. $261,545 e. $274,622 ANS: B BEGIN Mode N I/YR PMT FV PV

15 7.5% $25,000 $0.00 $237,229

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 112. What's the present value of a 4-year ordinary annuity of $2,250 per year plus an additional $3,000 at the end of Year 4 if the interest rate is 5%? a. $8,509 b. $8,957 c. $9,428 d. $9,924 e. $10,446 ANS: E N I/YR PMT FV PV Alternative setup: 0

4 5.0% $2,250 $3,000 $10,446

1 $2,250

2 $2,250

3 $2,250

$2,250

$2,250

$2,250

4 $2,250 $3,000 $5,250

PV = $10,446.50 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-9 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of ord. ann. & end. pmt.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 113. Suppose you earned a $275,000 bonus this year and invested it at 8.25% per year. How much could you withdraw at the end of each of the next 20 years? a. $28,532 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

$29,959 $31,457 $33,030 $34,681

ANS: A N I/YR PV FV PMT

20 8.25% $275,000 $0.00 $28,532

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Payments on ord. annuity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 114. Your aunt wants to retire and has $375,000. She expects to live for another 25 years and to earn 7.5% on her invested funds. How much could she withdraw at the end of each of the next 25 years and end up with zero in the account? a. $28,843.38 b. $30,361.46 c. $31,959.43 d. $33,641.50 e. $35,323.58 ANS: D N I/YR PV FV PMT

25 7.5% $375,000 $0.00 $33,641.50

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Payments on ord. annuity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 115. Your aunt wants to retire and has $375,000. She expects to live for another 25 years, and she also expects to earn 7.5% on her invested funds. How much could she withdraw at the beginning of each of the next 25 years and end up with zero in the account? a. $28,243.21 b. $29,729.70 c. $31,294.42 d. $32,859.14 e. $34,502.10 ANS: C BEGIN Mode N I/YR PV FV PMT

25 7.5% $375,000 $0.00 $31,294.42

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Payments on annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 116. You were left $100,000 in a trust fund set up by your grandfather. The fund 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. $24,736 b. $26,038 c. $27,409 d. $28,779 e. $30,218 ANS: C BEGIN Mode N I/YR PV FV PMT

4 6.5% $100,000 $0.00 $27,409

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Payments on annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 117. Suppose you inherited $275,000 and invested it at 8.25% per year. How much could you withdraw at the beginning of each of the next 20 years? a. $22,598.63 b. $23,788.03 c. $25,040.03 d. $26,357.92 e. $27,675.82 ANS: D BEGIN Mode N I/YR PV FV PMT

20 8.25% $275,000 $0.00 $26,357.92

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Payments on annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

118. Your uncle just won the weekly lottery, receiving $375,000, which he invested at a 7.5% annual rate.

He now has decided to retire, and he wants to withdraw $35,000 at the end of each year, starting at the end of this year. What is the maximum number of whole payments that can be withdrawn before the account is exhausted, i.e., before the account balance would become negative? (Hint: Round down to the nearest whole number.) a. 22 b. 23 c. 24 d. 25 e. 26 ANS: A I/YR PV PMT FV N N rounded

7.5% −$375,000 $35,000 $0.00 22.50 22

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Years to deplete ord. ann.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 119. Your uncle has $300,000 invested at 7.5%, and he now wants to retire. He wants to withdraw $35,000 at the end of each year, beginning 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. What is the maximum number of $35,000 withdrawals that he can make and still have at least $25,000 left in the account? (Hint: If your solution for N is not an integer, round down to the nearest whole number.) a. 12 b. 13 c. 14 d. 15 e. 16 ANS: B I/YR PV PMT FV N N rounded

7.50% −$300,000 $35,000 $25,000 13.48 13

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Years to deplete ord. ann.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 120. Your Aunt Elsa has $500,000 invested at 6.5%, and she plans to retire. She wants to withdraw $40,000 at the beginning of each year, starting immediately. What is the maximum number of whole payments that can be withdrawn before the account is exhausted, i.e., before the account balance would become negative? (Hint: Round down to the nearest whole number.) a. 18 b. 19 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 20 d. 21 e. 22 ANS: E BEGIN Mode I/YR PV PMT FV N N rounded

6.5% −$500,000 $40,000 $0.00 22.86 22

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Years to deplete ann. due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 121. Your aunt has $500,000 invested at 5.5%, and she now wants to retire. She wants to withdraw $45,000 at the beginning of each year, beginning immediately. When she makes her last withdrawal (at the beginning of a year), she also wants to have enough left in the account so that you can make a final withdrawal of $50,000 at the end of that year (her last withdrawal is at the beginning of the year, your withdrawal is at the end of that same year). What is the maximum number of $45,000 withdrawals that she can make and still have enough in the account so that you can make a $50,000 withdrawal at the end of the year of her last withdrawal? (Hint: If your solution for N is not an integer, round down to the nearest whole number.) a. 13 b. 14 c. 15 d. 16 e. 17 ANS: C BEGIN Mode I/YR PV PMT FV N N rounded

5.5% −$500,000 $45,000 $50,000 15.05 15

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Years to deplete ann. due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 122. Suppose you just won the state lottery, and you have a choice between receiving $2,550,000 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. 7.12% b. 7.49% c. 7.87% d. 8.26% e. 8.67% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: B N PV PMT FV I/YR

20 $2,550,000 $250,000 $0.00 7.49%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Int. rate implicit: annuity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 123. Your girlfriend just won the Florida lottery. She has the choice of $15,000,000 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? a. 3.44% b. 3.79% c. 4.17% d. 4.58% e. 5.04% ANS: A N PV PMT FV I/YR

20 $15,000,000 $1,050,000 $0.00 3.44%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Int. rate implicit: annuity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 124. 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 open a new restaurant, and your uncle offers to give you $120,000 for the annuity. If you sell it, what rate of return would your uncle earn on his investment? a. 6.85% b. 7.21% c. 7.59% d. 7.99% e. 8.41% ANS: E BEGIN Mode N PV PMT FV I/YR

12 $120,000 $15,000 $0.00 8.41%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: Int. rate implicit: annuity due MSC: TYPE: Multiple Choice: Problem

KEY: Bloom’s: Analysis

125. What annual payment must you receive in order to earn a 6.5% rate of return on a perpetuity that has a cost of $1,250? a. $77.19 b. $81.25 c. $85.31 d. $89.58 e. $94.06 ANS: B Cost (PV) I/YR PMT

$1,250 6.5% $81.25 Multiply Cost by I/YR.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-11 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Payments on a perpetuity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 126. What is the present value of the following cash flow stream at a rate of 6.25%?

a. b. c. d. e.

$411.57 $433.23 $456.03 $480.03 $505.30

ANS: E I/YR = 6.25%

CFs: PV of CFs:

0 $0 $0

1 $75 $71

2 $225 $199

3 $0 $0

4 $300 $235

PV = $505.30 PV = $505.30 You can find the individual PVs and sum them. Alternately, you can automate the process using Excel or a calculator, by inputting the data into the cash flow register and pressing the NPV key.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-12 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of uneven cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 127. What is the present value of the following cash flow stream at a rate of 12.0%?

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

$9,699 $10,210 $10,747 $11,284 $11,849

ANS: C I/YR = 12.0%

CFs: PV of CFs: PV = $10,747 PV = $10,747 PV = $10,747

0 $0 $0

1 $1,500 $1,339

2 $3,000 $2,392

3 $4,500 $3,203

4 $6,000 $3,813

Found using the Excel NPV function.

Found by summing individual PVs. Found using the calculator NPV key.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-12 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of uneven cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 128. What is the present value of the following cash flow stream at a rate of 8.0%?

a. b. c. d. e.

$7,917 $8,333 $8,772 $9,233 $9,695

ANS: D I/YR = 8.0%

CFs: PV of CFs: PV = $9,233 PV = $9,233

0 $750

1 $2,450

2 $3,175

3 $4,400

$750 $2,269 $2,722 $3,493 Found by summing individual PVs. Found with a calculator or Excel to automate the process. With a calculator, input the cash flows and I into the cash flow register, then press the NPV key.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-12 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of uneven cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 129. You sold your motorcycle 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 6.0%?

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

$5,987 $6,286 $6,600 $6,930 $7,277

ANS: A I/YR = 6.0% 0 $0 $0

CFs: PV of CFs: PV = $5,987 PV = $5,987 PV = $5,987

1 $1,000 $943

2 $2,000 $1,780

3 $2,000 $1,679

4 $2,000 $1,584

Found using the Excel NPV function.

Found by summing individual PVs. Found using the calculator NPV key.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-12 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV of uneven cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 130. At a rate of 6.5%, what is the future value of the following cash flow stream?

a. b. c. d. e.

$526.01 $553.69 $582.83 $613.51 $645.80

ANS: E I/YR = 6.5%

CFs: FV of CFs:

0 $0 $0

1 $75 $91

2 $225 $255

3 $0 $0

4 $300 $300

FV = $645.80 FV = $645.80 FV = $645.80

Found by summing individual FVs. Found with the NFV key in some calculators.

Found with a calculator by first finding the PV of the stream, then finding the FV of that PV.

PV of the stream: FV of the PV:

$501.99 $645.80

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-13 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV of uneven cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

131. Your sister 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 $10,000 at the end of the 5th year. What is the expected rate of return on this investment? a. 6.77% b. 7.13% c. 7.50% d. 7.88% e. 8.27% ANS: C CFs:

I/YR

0 −$10,000

1 $750

2 $750

3 $750

4 $750

5 $750 $10,000 $10,750

−$10,000

$750

$750

$750

$750

7.50%

I is the discount rate that causes the PV of the inflows to equal the initial negative CF, and is found with Excel's IRR function or by inputting the CFs into a calculator and pressing the IRR key.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-14 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Rate in uneven cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 132. You are offered a chance to buy an asset for $7,250 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. 4.93% b. 5.19% c. 5.46% d. 5.75% e. 6.05% ANS: E 0 −$7,250

CFs: I/YR

6.05%

1 $750

2 $1,000

3 $850

4 $6,250

I is the discount rate that causes the PV of the positive inflows to equal the initial negative CF. I can be found using Excel's IRR function or by inputting the CFs into a calculator and pressing the IRR key.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-14 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Rate in uneven cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 133. What's the future value of $1,500 after 5 years if the appropriate interest rate is 6%, compounded semiannually? a. $1,819 b. $1,915 c. $2,016 d. $2,117 e. $2,223 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: C Years Periods/Yr Nom. I/YR

5 2 6.0%

N = Periods PMT I = I/Period PV FV =

10 $0 3.0% $1,500 Could be found using a calculator, an equation, or Excel. $2,016 Note that we must first convert to periods and rate per period.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV, semiannual compounding KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 134. What's the present value of $4,500 discounted back 5 years if the appropriate interest rate is 4.5%, compounded semiannually? a. $3,089 b. $3,251 c. $3,422 d. $3,602 e. $3,782 ANS: D Years Periods/Yr Nom. I/YR

5 2 4.5%

FV N = Periods PMT I = I/Period PV =

$4,500 10 $0 2.25% Could be found using a calculator, the equation, or Excel. $3,602 Note that we must first convert to periods and rate per period.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV, semiannual compounding KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 135. What's the future value of $1,200 after 5 years if the appropriate interest rate is 6%, compounded monthly? a. $1,537.69 b. $1,618.62 c. $1,699.55 d. $1,784.53 e. $1,873.76 ANS: B Years Periods/Yr Nom. I/YR

5 12 6.0%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

N = Periods PMT I/Period PV FV

60 $0 0.5% $1,200 Could be found using a calculator, the equation, or Excel. $1,618.62 Note that we must first convert to periods and rate per period.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV, monthly compounding KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 136. What's the present value of $1,525 discounted back 5 years if the appropriate interest rate is 6%, compounded monthly? a. $969 b. $1,020 c. $1,074 d. $1,131 e. $1,187 ANS: D Years Periods/Yr Nom. I/YR

5 12 6.0%

N = Periods 60 PMT $0 I/Period 0.5% FV $1,525 PV = $1,131 = FV/(1 + rPer)N PV = $1,131 Found using a calculator or Excel PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: PV, monthly compounding KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 137. American Express 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 18.00%, with interest paid monthly, what is the card's EFF%? a. 18.58% b. 19.56% c. 20.54% d. 21.57% e. 22.65% ANS: B APR = Nominal rate Periods/yr EFF% = (1 + (rNOM/N))N − 1 =

18.00% 12 19.56%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: APR vs. EFF% KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

138. Southwestern 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. Woodburn Bank also offers to lend you the $50,000, but it will charge an annual rate of 7.0%, with no interest due until the end of the year. How much higher or lower is the effective annual rate charged by Woodburn versus the rate charged by Southwestern? a. 0.52% b. 0.44% c. 0.36% d. 0.30% e. 0.24% ANS: D This problem can be worked using the interest conversion feature of a calculator or Excel. It could also be worked using the conversion formula. We used the conversion formula.

Nominal rate, Southwestern Nominal rate, Woodburn Periods/yr, Southwestern Periods/yr, Woodburn EFF% Southwestern = (1 + (rNOM/N))N − 1 = EFF% Woodburn Difference

6.5% 7.0% 12 1 6.70% 7.00% 0.30%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Comparing EFF% KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 139. Suppose United Bank offers to lend you $10,000 for one year at a nominal annual rate of 8.00%, 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. 8.24% b. 8.45% c. 8.66% d. 8.88% e. 9.10% ANS: A Nominal I/YR Periods/yr EFF% = (1 + (rNOM/N))N − 1 =

8.00% 4 8.24%

You could also find the EFF% as follows: Interest paid each quarter = Loan  rate/4 = Qtrly PMT = $200.00 Then find the IRR as a quarterly rate and convert to an annual rate. This procedure is obviously longer.

CFs:

0 10,000.00

1 −200.00

2 −200.00

3 −200.00

10,000.00

−200.00

−200.00

−200.00

4 −200.00 −10,000.00 −10,200.00

IRR (quarterly) = 2.00% Annual effective rate = 8.24% vs. nominal rate = 8.00% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Nominal rate vs. EFF% KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 140. Suppose People's bank offers to lend you $10,000 for 1 year on a loan contract that calls for you to make interest payments of $250.00 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. 8.46% b. 8.90% c. 9.37% d. 9.86% e. 10.38% ANS: E Interest payment: $250.00

CFs:

0 10,000

1 −250

2 −250

3 −250

10,000

−250

−250

−250

4 −250 −10,000 −10,250

IRR (quarterly) = 2.50% Annual effective rate = 10.38% vs. nominal rate = 10.00% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Nominal rate vs. EFF% KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 141. Pacific Bank pays a 4.50% nominal rate on deposits, with monthly compounding. What effective annual rate (EFF%) does the bank pay? a. 3.72% b. 4.13% c. 4.59% d. 5.05% e. 5.56% ANS: C Nominal I/YR Periods/yr Periodic rate EFF% = (1 + (rNOM/N))N − 1 =

4.50% 12 0.38% 4.59%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Nominal rate vs. EFF% KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 142. Suppose your credit card issuer states that it charges a 15.00% nominal annual rate, but you must make monthly payments, which amounts to monthly compounding. What is the effective annual rate? a. 15.27% b. 16.08% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 16.88% d. 17.72% e. 18.61% ANS: B Nominal I/YR = APR Periods/yr EFF% = (1 + (rNOM/N))N − 1 =

15.00% 12 16.08%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Nominal rate vs. EFF% KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 143. Billy Thornton borrowed $20,000 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 Billy have to pay in a 30-day month? a. $120.83 b. $126.88 c. $133.22 d. $139.88 e. $146.87 ANS: A Nominal I/YR Days/yr Amount borrowed Interest per month = Interest/day  30 =

7.25% Days in month 360 Daily rate $20,000 Interest per day $120.83

30 0.020139% $4.02778

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-16 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Simple interest KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 144. Suppose you deposited $5,000 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. $5,178.09 b. $5,436.99 c. $5,708.84 d. $5,994.28 e. $6,294.00 ANS: A Nominal I/YR Number of months Days in year Days in month Amount deposited Ending amount

5.25% Rate/day = rNOM/360 = 8 Days = Months  30 = 360 30 $5,000 $5,178.09

0.0146% 240

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-16 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Fractional time periods KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

145. Suppose you borrowed $12,000 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. $3,704.02 b. $3,889.23 c. $4,083.69 d. $4,287.87 e. $4,502.26 ANS: A Years = N I/YR FV Amount borrowed = PV Payments = PMT

4 9.0% $0 $12,000 $3,704.02 Found with a calculator, as the PMT.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: payment KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 146. Suppose you are buying your first home for $145,000, and you have $15,000 for your 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. $741.57 b. $780.60 c. $821.69 d. $862.77 e. $905.91 ANS: C Years Payments/year Nominal rate Purchase price Down payment

30 12 6.50% $145,000 $15,000

N Periodic rate PV FV PMT

360 0.54% $130,000 $0.00 $821.69

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: payment KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 147. Your cousin will sell you his coffee shop for $250,000, 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. $4,029.37 b. $4,241.44 c. $4,464.67 d. $4,699.66 e. $4,947.01 ANS: E © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Monthly annuity, so interest must be calculated on a monthly basis.

Years 4 Payments/year N 48 Nominal rate PV $250,000 I/period FV $50,000 PMT

12 6.0% 0.5% $4,947.01

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: payment KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 148. Suppose you borrowed $14,000 at a rate of 10.0% and must repay it in 5 equal installments at the end of each of the next 5 years. How much interest would you have to pay in the first year? a. $1,200.33 b. $1,263.50 c. $1,330.00 d. $1,400.00 e. $1,470.00 ANS: D I/YR Years Amount borrowed Interest in Year 1

10.0% 5 $14,000 $1,400.00 Simply multiply the rate times the amount borrowed.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: interest KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 149. You plan to borrow $35,000 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. $1,994.49 b. $2,099.46 c. $2,209.96 d. $2,326.27 e. $2,442.59 ANS: D Find the required payment: N 7 I 7.5% PV $35,000 FV $0 PMT $6,608.01 Found with a calculator or Excel.

Amortization schedule (first 2 years) Year Beg. Balance Payment 1 35,000.00 6,608.01 2 31,016.99 6,608.01

Interest 2,625.00 2,326.27

Principal 3,983.01 4,281.74

End. Balance 31,016.99 26,735.25

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: interest KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 150. Your bank offers to lend you $100,000 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. $7,531 b. $7,927 c. $8,323 d. $8,740 e. $9,177 ANS: B Find the required payment: N 10 I 8.5% PV $100,000 FV $0 PMT $15,241 Found with a calculator or Excel.

Amortization schedule (first 2 years) Year Beg. Balance Payment 1 100,000 15,241 2 93,259 15,241

Interest 8,500 7,927

Principal 6,741 7,314

End. Balance 93,259 85,945

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: interest KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 151. You are considering investing in a European 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 $250,000? Round fractional months up. a. 23 b. 27 c. 32 d. 38 e. 44 ANS: D BEGIN Mode I/YR I/MO PV PMT FV N

18.0% 1.5% Monthly annuity due, so interest must be calculated on monthly basis. rNOM/12. $0 $5,000 $250,000 37.16 Rounded up: 38

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-10 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: N, ann. due, monthly comp.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

152. 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 $150,000? a. 39.60 b. 44.00 c. 48.40 d. 53.24 e. 58.57 ANS: B I/YR I/MO PV PMT FV N

7.0% 0.583333% Monthly annuity, so interest must be calculated on monthly basis $0 $3,000 $150,000 44.0021

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-10 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: N, ann. due, monthly comp.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 153. The store where you bought new home furnishings offers you two alternative payment plans. The first plan requires a $4,000 immediate up-front 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. 12.31% b. 12.96% c. 13.64% d. 14.36% e. 15.08% ANS: D N 36 PV $4,000 PMT $137.41 FV $0 I/MO 1.20% Monthly annuity, so interest must be calculated on monthly basis I/YR = I/MO  12 = 14.36% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-10 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Rate, ord. ann., monthly comp.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 154. Your Green Investment Tips subscription 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 $850, 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. 7.48 b. 8.80 c. 10.35 d. 12.18 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. 14.33 ANS: E Find N for an annuity due with the indicated terms to determine how long you must live to make the lifetime subscription worthwhile.

BEGIN Mode Interest rate (I/YR) Annual cost (PMT) Lifetime subscription cost (PV) Number of payments made (N)

6.0% $85 $850 14.33

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 4-1 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: N, lifetime vs. yearly KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 155. You just deposited $2,500 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. $15,234.08 b. $16,035.88 c. $16,837.67 d. $17,679.55 e. $18,563.53 ANS: B Interest rate Periods/year Quarterly rate 1st deposit 2nd deposit 3rd deposit

4.0% 4 1.0% $2,500 $5,000 $7,500

Years on Deposit 3 2 1

Quarters on Deposit 12 8 4

Ending Amount $2,817.06 $5,414.28 $7,804.53

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Non-annual compounding KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 156. Partners Bank offers to lend you $50,000 at a nominal rate of 5.0%, simple interest, with interest paid quarterly. An offer to lend you the $50,000 also comes from Community Bank, 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. 1.56% b. 1.30% c. 1.09% d. 0.91% e. 0.72% ANS: D Students must understand that "simple interest with interest paid quarterly" means that the bank gets the interest at the end of each quarter, hence it can invest it, presumably at the same nominal rate. This results in the same effective rate as if it were stated as "6%, quarterly compounding." © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Nominal rate, Partners Periods/yr, Partners Nominal rate, Community Periods/yr, Community EFF% Partners EFF% Community Difference

5.0% 4 6.0% 1 5.09% 6.00% 0.91%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-15 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Comparing EFF% KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 157. Suppose you borrowed $15,000 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. $2,404.91 b. $2,531.49 c. $2,658.06 d. $2,790.96 e. $2,930.51 ANS: B Interest rate Years Amount borrowed Step 1: Step 2: Step 3:

8.5% 5 $15,000

Find the PMT Find the 1st year's interest Subtract the interest from the payment; this is repayment of principal

3,806.49 1,275.00 2,531.49

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: princ. repymt.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 158. Suppose you borrowed $15,000 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. $10,155.68 b. $10,690.19 c. $11,252.83 d. $11,845.09 e. $12,468.51 ANS: E Interest rate Years Amount borrowed Step 1: Step 2: Step 3:

8.5% 5 $15,000

Find the PMT Find the 1st year's interest Subtract the interest from the payment; this is repayment of

$3,806.49 $1,275.00 $2,531.49

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Step 4:

principal Subtract the repayment of principal from the beginning amount owed

$12,468.51

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: ending bal.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 159. Your older brother turned 35 today, and he is planning to save $7,000 per year for retirement, with the first deposit to be made one year from today. He will invest in a mutual fund that's expected to provide a return of 7.5% per year. He plans to retire 30 years from today, when he turns 65, and he expects to live for 25 years after retirement, to age 90. Under these assumptions, how much can he spend each year after he retires? His first withdrawal will be made at the end of his first retirement year. a. $58,601 b. $61,686 c. $64,932 d. $68,179 e. $71,588 ANS: C Interest rate Years to retirement Years in retirement Amount saved per year Step 1: Step 2:

7.5% 30 25 $7,000

Find the amount at age 65; use the FV function Find the PMT for a 25-year ordinary annuity using the FV you just found as the PV.

723,796 64,932

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-10 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Retirement planning KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 160. 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 $13,000 in your account. If the bank compounds interest monthly, what nominal annual interest rate will you be earning? a. 7.62% b. 8.00% c. 8.40% d. 8.82% e. 9.26% ANS: A BEGIN Mode N PV PMT FV I/MO I/YR

24 $0 $500 $13,000 0.63% 7.62%

PTS: 1

DIF: Difficulty: Challenging

OBJ: LO: 4-1

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Finding I in annuity due KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 161. Your business has just taken out a 1-year installment loan for $72,500 at a nominal rate of 11.0% but with equal end-of-month payments. What percentage of the 2nd monthly payment will go toward the repayment of principal? a. 73.67% b. 77.55% c. 81.63% d. 85.93% e. 90.45% ANS: E N rNOM Per. r PV PMT FV

12 11.0% 0.9167% $72,500 $6,407.67 $0 % prin. = Prin2/PMT = 90.45%

Amortization schedule (first 4 months) Month Beg. Balance Payment 1 72,500.00 6,407.67 2 66,756.91 6,407.67 3 60,961.18 6,407.67 4 55,112.32 6,407.67

Interest 664.58 611.94 558.81 505.20

Principal 5,743.09 5,795.73 5,848.86 5,902.47

Ending Balance 66,756.91 60,961.18 55,112.32 49,209.85

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 162. On January 1, 2012, your sister's pet supplies business obtained a 30-year amortized mortgage loan for $250,000 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 2012? a. $17,419.55 b. $17,593.75 c. $17,769.68 d. $17,947.38 e. $18,126.85 ANS: A Years Periods/yr N (12 mo.)

PV = Loan FV

30 12 360 $250,000 $0

Amortization schedule (first 3 months) Year Beg. Balance Payment 1 250,000.00 1,663.26 2 249,795.08 1,663.26 3 249,588.96 1,663.26

Nominal r I/period PMT Interest, 2009

Interest 1,458.33 1,457.14 1,455.94

7.00% 0.5833% $1,663.26 $17,419.55

Principal 204.92 206.12 207.32

End. Balance 249,795.08 249,588.96 249,381.64

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4 5 6 7 8 9 10 11 12

249,381.64 249,173.11 248,963.36 248,752.39 248,540.19 248,326.75 248,112.07 247,896.13 247,678.94

1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 19,959.07

1,454.73 1,453.51 1,452.29 1,451.06 1,449.82 1,448.57 1,447.32 1,446.06 1,444.79 17,419.55

208.53 209.75 210.97 212.20 213.44 214.68 215.94 217.20 218.46 2,539.52

249,173.11 248,963.36 248,752.39 248,540.19 248,326.75 248,112.07 247,896.13 247,678.94 247,460.48

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-17 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Amortization: interest KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 163. You borrowed $50,000 which you must repay in 10 years. You plan to make an initial deposit today, then make 9 more deposits at the beginning of each the next 9 years, but with the deposits increasing at the inflation rate. You expect to earn 5% on your funds, and you expect a 3% inflation rate. To the nearest dollar, how large must your initial deposit be to enable you to reach your $50,000 target? a. $3,008 b. $3,342 c. $3,676 d. $4,044 e. $4,448 ANS: B We can set up a table with an arbitrary initial deposit that grows at the inflation rate and is then compounded at the nominal rate for (N − t) years. The sum of the compounded amounts should total to $50,000. With an arbitrary initial amount the ending amount is not likely to be $50,000, so we use goal seek as shown in the completed dialog box to find the correct initial deposit.

Inputs: Years Amount Needed (FV) Nominal rate earned on account Inflation 1.

10 $50,000 5.00% 3.00%

Goal Seek approach: Use Goal Seek in the following table to determine the initial deposit. Start with $5,000 as the initial payment, but this will change to $3,341.94.

Period (t) 0 1 2 3 4 5 6 7 8 9

BOY Payment Initial(1 + I)t $3,341.94 $3,442.20 $3,545.47 $3,651.83 $3,761.39 $3,874.23 $3,990.45 $4,110.17 $4,233.47 $4,360.48

Computed Value $5,443.67 $5,339.98 $5,238.27 $5,138.49 $5,040.62 $4,944.61 $4,850.42 $4,758.03 $4,667.40 $4,578.50

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

N= 2.

10

$0.00

$50,000.00 = Sum of the 10 compounded values

Formula approach: Find the real rate 1.941748% = (1 + I1572)/(1 + I1573) −1 Find the PV of the required future amount, discounted at the inflation rate. This is our constant dollar future target. $37,204.70 = I1571/(1 + I1573)(I1570) Use a calculator or Excel to find the initial payment.

N = 10, I/YR = 1.941748, PV = 0, FV = −37204.70, and set to BEGIN mode.

This is consistent with the Goal Seek solution. $3,341.94 = PMT(H1593, I1570,0, −H1595,1)

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-18 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Growing annuity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 164. Your 75-year-old grandmother expects to live for another 15 years. She currently has $1,000,000 of savings, which is invested to earn a guaranteed 5% rate of return. If inflation averages 2% per year, how much can she withdraw (to the nearest dollar) at the beginning of each year and keep the withdrawals constant in real terms, i.e., growing at the same rate as inflation and thus enabling her to maintain a constant standard of living? a. $65,632 b. $72,925 c. $81,027 d. $89,130 e. $98,043 ANS: C Inputs: Number of years = Nominal interest rate, rNOM = Available to invest = Portfolio = Inflation rate =

15 5% $1,000,000 2%

Step 1.

Set up an "Amortization Table" to show exactly what's happening. We begin with $1 million. But we immediately make the first withdrawal, hence have less than $1 million to invest. We don't know how much we can withdraw initially, so we make a "guess" of $50,000. We subtract the $50,000 from the initial portfolio and get $950,000, which is invested at 5% and thus earns $47,500. The earnings are added to the beginning balance, less the withdrawal, to produce the ending balance, which is carried forward to create the next beginning balance. This process is continued for 15 years.

Step 2.

We want to end up with a $0.00 ending balance. With the $50,000 initial withdrawal, we see that we end with more than zero. Therefore, we should make a larger initial withdrawal. We could just go through a series of trials and errors until we found an initial withdrawal that produced the zero ending balance. The amount that does the trick is $81,027.42. Replace the $50,000 with 81027.42 to prove that this value "works" to within one penny.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Beginning Balance $1,000,000.00 $964,921.21 $926,386.90 $884,190.27 $838,113.49 $787,927.15 $733,389.64 $674,246.59 $610,230.13 $541,058.27 $466,434.15 $386,045.29 $299,562.77 $206,640.43 $106,913.96

BOY Amount Withdrawn $81,027.42 $82,647.97 $84,300.93 $85,986.95 $87,706.69 $89,460.82 $91,250.04 $93,075.04 $94,936.54 $96,835.27 $98,771.97 $100,747.41 $102,762.36 $104,817.61 $106,913.96

Investable Funds $918,972.58 $882,273.24 $842,085.97 $798,203.33 $750,406.81 $698,466.33 $642,139.61 $581,171.55 $515,293.59 $444,223.00 $367,662.18 $285,297.87 $196,800.41 $101,822.82 $0.00

Earnings $45,948.63 $44,113.66 $42,104.30 $39,910.17 $37,520.34 $34,923.32 $32,106.98 $29,058.58 $25,764.68 $22,211.15 $18,383.11 $14,264.89 $9,840.02 $5,091.14 $0.00

Ending Balance $964,921.21 $926,386.90 $884,190.27 $838,113.49 $787,927.15 $733,389.64 $674,246.59 $610,230.13 $541,058.27 $466,434.15 $386,045.29 $299,562.77 $206,640.43 $106,913.96 $0.00

Using Goal Seek: 1. Put the pointer on the cell for the Ending Balance after the 15th withdrawal.

2. Click Tools>Goal Seek to get a dialog box, which you then fill out as shown to the right.

3. You will be at the "Set cell" because you put the pointer there initially.

4. Go down to the "To value to" cell. You want to get 0 as the ending balance, so enter 0 here.

5. Now move down to the "By changing cell" box, then click on the cell with the Year 1 withdrawal and select it.

6. Now click OK, and the initial withdrawal will change to $81,027, and the final balance will go to $0.00. You could increase the decimals shown to see the extra digits Excel calculated.

Calculator solution: Step 1: Find the real rate of return, rr. rr = (1 + rNOM)/(1 + inflation) − 1 rr = (1.05)/(1.02) − 1 rr = 2.9412% Step 2:

Use the PMT function in Excel or a calculator to find the initial amount to be withdrawn. Be sure to set the calculator to BEGIN mode, and make a similar adjustment to the Excel function.

BEGIN N= 15 I = rr = 2.9411765% PV = −1,000,000 PMT = $81,027.42 This is consistent with the value found using Goal Seek.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-18 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Growing annuity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

165. Julian and Jonathan are twin brothers (and so were born on the same day). Today, both turned 25.

Their grandfather began putting $2,500 per year into a trust fund for Julian 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 $2,500 payments until a 46th and final payment is made on Julian's 65th birthday. The grandfather set things up this way because he wants Julian to work, not be a "trust fund baby," but he also wants to ensure that Julian is provided for in his old age.

Until now, the grandfather has been disappointed with Jonathan and so has not given him anything.

However, they recently reconciled, and the grandfather decided to make an equivalent provision for Jonathan. He will make the first payment to a trust for Jonathan today, and he has instructed his trustee to make 40 additional equal annual payments until Jonathan 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 Jonathan's trust today and each subsequent year to enable him to have the same retirement nest egg as Julian after the last payment is made on their 65th birthday? a. $3,726 b. $3,912 c. $4,107 d. $4,313 e. $4,528 ANS: A Julian's retirement account No. of payments thus far, including today's payment Number of remaining payments N = total payments I/YR PV PMT FV Julian's FV =

Jonathan's retirement account Payment today 6 40 46 8.0% $0 $2,500 $1,046,065

N I/YR PV FV = Jonathan's FV = PMT

1 40 41 8.0% $0 $1,046,065 $3,726

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-10 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Retirement planning KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 166. You plan to work for Strickland Corporation for 12 years after graduation and after that want to 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 grandmother just gave you a $25,000 graduation gift that 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. $238,176 b. $250,712 c. $263,907 d. $277,797 e. $291,687 ANS: D There are 3 cash flow streams: the gift and the two annuities. The gift will grow for 12 years. Then there is a 6-year annuity whose FV at the end of Year 6 will compound for an additional 6 years.

Finally, there is a second 6-year annuity. The sum of the compounded values of those three sets of cash flows is the final amount. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Interest rate 1st annuity 2nd annuity Gift Total years Annuity years

9.0% $7,500 $15,000 $25,000 12 6

Amount at end of Year 6

Amount at end of Year 12

$56,425 Compound @ 9% NA NA

$ 94,630 $112,850 $ 70,317

Final amt:

$277,797

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-8 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: FV comb. CF lump sum & ann.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 167. You are in negotiations to make a 7-year loan of $25,000 to DeVille Corporation. To repay you, DeVille 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. You are confident the payments will be made, since DeVille is essentially riskless.

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. $4,271.67 b. $4,496.49 c. $4,733.15 d. $4,969.81 e. $5,218.30 ANS: C This is a relatively difficult problem for an efficient calculator solution or classroom exam, but it is appropriate for a challenging take-home or online exam.

I/YR = 0 −$25,000

8% 1 $2,500

2 $5,000

3 $7,500

4 X

Calculator solution: Step 1.

Use the CF register to find the NPV of the 4 known cash flows, CF0 to CF3: Step 2.

Find the FV of this NPV at the end of period 3, i.e., compound the NPV you found for 3 years.

Step 3.

Now find the PMT for a 4-year annuity with this PV.

5 X

6 X

7 X

−$12,444.75 −$15,676.80 $4,733.15

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-10 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: CF for given return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

168. Scott and Linda have been saving to pay for their daughter Casie's college education. Casie 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, Scott and Linda have accumulated $15,000 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 Casie's anticipated college costs? a. $1,965.21 b. $2,068.64 c. $2,177.51 d. $2,292.12 e. $2,412.76 ANS: E This is a very difficult problem. It should only be used as a take-home assignment.

Current college cost/year College cost inflation Return on investment account Payments at t = 1, 2, 3, and 4 Account balance at t = 0 1.

Determine the cost of each year during college and its PV at t = 8, discounted at the return on investment.

Year 1 (t = 8) Year 2 (t = 9) Year 3 (t = 10) Year 4 (t = 11) Find PV (at t = 8) of all college costs 2.

$14,500 3.5% 9.0% $5,000 $15,000

= = = = =

Cost −19,093.73 −19,762.01 −20,453.68 −21,169.56

Current cost  (1 + infl)8 = Prior year  (1 + infl) = Prior year  (1 + infl) = Prior year  (1 + infl) = amount needed at t = 8:

PV at t = 8 −19,093.73 −18,130.29 −17,215.45 −16,346.79 −70,786.26

Create a time line with those cash flows, plus the known initial CFs, as shown below. Put X in for the unknown values for t = 5−7. We show the time line on two sets of rows. Ours now has the solution value, but it didn't originally.

0 1 Known values; X for $15,000.00 $5,000.00 unknown: Solution value for X: Cash flows: $15,000.00 $5,000.00 6 X $2,412.76

2

3

4

5

$5,000.00

$5,000.00

$5,000.00

X

$5,000.00

$5,000.00

$5,000.00

$2,412.76 $2,412.76

7 8 9 10 11 X −$19,093.73 −$19,762.01 −$20,453.68 −$21,169.56 $2,412.76

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash flows, continued: 3.

$2,412.76

$2,412.76 −$19,093.73 −$19,762.01 −$20,453.68 −$21,169.56

We found the PV of the college costs (t = 8−11) at t = 8 above.

Their sum is shown to the right.

0 1 2 3 4

−70,786.26

4.

Find the FV of t = 0 & 4 positive CFs at t = 8

$15,000.00 $5,000.00 $5,000.00 $5,000.00 $5,000.00

$29,888.44 $9,140.20 $8,385.50 $7,693.12 $7,057.91 $62,165.16

5.

Find the difference between the positive and negative t = 8 values:

−$8,621.09

6.

Find PMT for a 3-year annuity due whose FV is equal to this difference:

$2,412.76

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 4-18 NAT: BUSPROG: Analytic STA: DISC: Time value of money LOC: TBA TOP: Saving for college KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 5—BONDS, BOND VALUATION, AND INTEREST RATES TRUE/FALSE 1. If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

ANS: T OBJ: LO: 5-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Issuing bonds KEY: Bloom’s: Knowledge

2. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

ANS: F OBJ: LO: 5-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Call provision KEY: Bloom’s: Knowledge

3. Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value.

ANS: T OBJ: LO: 5-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Sinking funds KEY: Bloom’s: Knowledge

4. A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially) at par. These bonds provide compensation to investors in the form of capital appreciation.

ANS: F OBJ: LO: 5-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Zero coupon bond KEY: Bloom’s: Knowledge

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.

ANS: T OBJ: LO: 5-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Floating-rate debt KEY: Bloom’s: Knowledge

6. The market value of any real or financial asset, including stocks, bonds, or art work 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.

ANS: T OBJ: LO: 5-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Discounted cash flows KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures.

ANS: T OBJ: LO: 5-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Bond prices and interest rates KEY: Bloom’s: Knowledge

8. 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.

ANS: T OBJ: LO: 5-11 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Mortgage bond KEY: Bloom’s: Knowledge

9. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.

ANS: T OBJ: LO: 5-11 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Debt coupon rate KEY: Bloom’s: Knowledge

10. 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.

ANS: T OBJ: LO: 5-11 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Bond ratings and required returns KEY: Bloom’s: Knowledge

11. A bond that had a 20-year original maturity with 1 year left to maturity has more interest rate 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.)

ANS: F OBJ: LO: 5-13 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Interest rate risk KEY: Bloom’s: Knowledge

12. 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 interest rate price risk if you purchased a 30-day bond than if you bought a 30-year bond.

ANS: F OBJ: LO: 5-13 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Interest rate risk KEY: Bloom’s: Knowledge

13. 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.

ANS: T OBJ: LO: 5-15 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Junk bond KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. 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.

ANS: F The callable bond will be called if rates fall far enough below the coupon rate, but it will not be called otherwise. Thus, the call provision can only harm bondholders. Therefore, callable bonds sell at higher yields than noncallable bonds, regardless of the slope of the yield curve.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds LOC: TBA TOP: Callable bonds KEY: Bloom’s: Comprehension 15. 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.

ANS: F OBJ: LO: 5-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Income bond KEY: Bloom’s: Comprehension

16. You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investment-grade 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. ANS: F The sinking fund would give Bond SF a lower average maturity, and it would also lower its risk.

Therefore, Bond SF should have a lower, not a higher, yield.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds LOC: TBA TOP: Sinking funds KEY: Bloom’s: Comprehension 17. Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise.

Since floating-rate debt shifts interest rate risk to companies, it offers no advantages to issuers.

ANS: F Floating rates can benefit issuers if rates decline, so a company that thinks rates are likely to fall would want to issue such bonds.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds LOC: TBA TOP: Floating-rate debt KEY: Bloom’s: Comprehension 18. A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are below 10% and at a discount if interest rates are greater than 10%.

ANS: T

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 5-3 LOC: TBA

NAT: BUSPROG: Reflective Thinking TOP: Bond premiums and discounts

STA: DISC: Stocks and bonds KEY: Bloom’s: Comprehension

19. You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper 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%.

ANS: T The bonds expected return (YTM) is 13.81%, which exceeds the 12% required return, so buy the bond.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds LOC: TBA TOP: Bond value–annual payment KEY: Bloom’s: Comprehension 20. 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.)

ANS: T OBJ: LO: 5-4 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Bond value KEY: Bloom’s: Comprehension

21. "Restrictive covenants" are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures.

ANS: T OBJ: LO: 5-11 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Restrictive covenants KEY: Bloom’s: Comprehension

22. 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.

ANS: T The reason for this is that more of the cash flows of a low-coupon bond comes late in the bond's life (as the maturity payment), and later cash flows are impacted most heavily by changing market rates.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds LOC: TBA TOP: Prices and interest rates KEY: Bloom’s: Comprehension MULTIPLE CHOICE 23. Which of the following statements is CORRECT? a. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates. b. 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. c. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. 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. e. You hold two bonds. One is a 10-year, zero coupon, issue 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 larger percentage decline.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rates KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 24. Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds? a. Market interest rates rise sharply. b. Market interest rates decline sharply. c. The company's financial situation deteriorates significantly. d. Inflation increases significantly. e. The company's bonds are downgraded.

ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Callable bonds KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 25. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT? a. The bond is selling below its par value. b. The bond is selling at a discount. c. If the yield to maturity remains constant, the bond's price one year from now will be lower than its current price. d. The bond's current yield is greater than 9%. e. If the yield to maturity remains constant, the bond's price one year from now will be higher than its current price.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 26. Which of the following statements is CORRECT? a. An indenture is a bond that is less risky than a mortgage bond. b. The expected return on a corporate bond will generally exceed the bond's yield to maturity. c. If a bond's coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity. d. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated. e. All else equal, senior debt generally has a lower yield to maturity than subordinated debt.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-16 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bonds, default risk KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

27. Ranger Inc. would like to issue new 20-year bonds. Initially, the plan was to make the bonds non-callable. If the bonds were made callable after 5 years at a 5% call premium, how would this affect their required rate of return? a. There is no reason to expect a change in the required rate of return. b. The required rate of return would decline because the bond would then be less risky to a bondholder. c. The required rate of return would increase because the bond would then be more risky to a bondholder. d. It is impossible to say without more information. e. Because of the call premium, the required rate of return would decline.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-2 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Call provision KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 28. Under normal conditions, which of the following would be most likely to increase the coupon rate required to enable a bond to be issued at par? a. Adding a call provision. b. The rating agencies change the bond's rating from Baa to Aaa. c. Making the bond a first mortgage bond rather than a debenture. d. Adding a sinking fund. e. Adding additional restrictive covenants that limit management's actions.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-3 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond coupon rate KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 29. Which of the following bonds would have the greatest percentage increase in value if all interest rates fall by 1%? a. 20-year, 10% coupon bond. b. 20-year, 5% coupon bond. c. 1-year, 10% coupon bond. d. 20-year, zero coupon bond. e. 10-year, zero coupon bond.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 30. 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. A 1-year bond with a 15% coupon. b. A 3-year bond with a 10% coupon. c. A 10-year zero coupon bond. d. A 10-year bond with a 10% coupon. e. An 8-year bond with a 9% coupon.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

31. Which of the following bonds has the greatest interest rate price risk? a. A 10-year, $1,000 face value, zero coupon bond. b. A 10-year, $1,000 face value, 10% coupon bond with annual interest payments. c. All 10-year bonds have the same price risk since they have the same maturity. d. A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 32. 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 bond with an 8% coupon. b. A 10-year bond with an 8% coupon. c. A 10-year bond with a 12% coupon. d. A 10-year zero coupon bond. e. A 1-year zero coupon bond.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rate risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 33. Which of the following statements is CORRECT? a. Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature. b. A sinking fund provision makes a bond more risky to investors at the time of issuance. c. Sinking fund provisions never require companies to retire their debt; they only establish "targets" for the company to reduce its debt over time. d. If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price. e. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-2 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Sinking funds KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 34. Nicholas Industries can issue a 20-year bond with a 6% annual coupon. This bond is not convertible, is not callable, and has no sinking fund. Alternatively, Nicholas 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 Nicholas would have to pay on the convertible, callable bond? a. It could be less than, equal to, or greater than 6%. b. Greater than 6%. c. Exactly equal to 8%. d. Less than 6%. e. Exactly equal to 6%.

ANS: A OBJ: LO: 5-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds TOP: Convertible, callable bonds KEY: Bloom’s: Analysis

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 35. The YTMs of three $1,000 face value bonds that mature in 10 years and have the same level of risk are equal. Bond A has an 8% annual coupon, Bond B has a 10% annual coupon, and Bond C has a 12% annual coupon. Bond B sells at par. Assuming interest rates remain constant for the next 10 years, which of the following statements is CORRECT? a. 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. b. Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next year. c. Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year. d. Over the next year, Bond A's price is expected to decrease, Bond B's price is expected to stay the same, and Bond C's price is expected to increase. e. Bond A's current yield will increase each year.

ANS: C Note that Bond B sells at par, so the required return on all these bonds is 10%. B's price will remain constant; A will sell initially at a discount and will rise, and C will sell initially at a premium and will decline. Note too that since it has larger cash flows from its higher coupons, Bond C would be less sensitive to interest rate changes; i.e., it has less interest rate risk. Perhaps it has less default risk.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-3 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 36. 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 NOT CORRECT? a. The bond's yield to maturity is 9%. b. The bond's current yield is 9%. c. If the bond's yield to maturity remains constant, the bond will continue to sell at par. d. The bond's current yield exceeds its capital gains yield. e. The bond's expected capital gains yield is positive.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 37. Which of the following statements is CORRECT? a. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at par. b. All else equal, if a bond's yield to maturity increases, its price will fall. c. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at a premium over par. d. All else equal, if a bond's yield to maturity increases, its current yield will fall. e. A zero coupon bond's current yield is equal to its yield to maturity.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

38. Stephenson Co.'s 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 current yield exceeds its yield to maturity. b. The bond's yield to maturity is greater than its coupon rate. c. The bond's current yield is equal to its coupon rate. d. If the yield to maturity stays constant until the bond matures, the bond's price will remain at $850. e. The bond's coupon rate exceeds its current yield.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 39. 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. If the yield to maturity remains at 8%, then the bond's price will decline over the next year. b. The bond's coupon rate is less than 8%. c. If the yield to maturity increases, then the bond's price will increase. d. If the yield to maturity remains at 8%, then the bond's price will remain constant over the next year. e. The bond's current yield is less than 8%.

ANS: A Answers b, c, and d are clearly wrong, and answer a is clearly correct. Answer e is also wrong, but this is not obvious to most people. We can demonstrate that e is incorrect by using the following example.

Par YTM Maturity Price Payment Coupon rate Current yield

$1,000 8.00% 10 $1,100 $94.90 9.49% 8.63% The current yield is greater than 8%.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 40. Which of the following statements is CORRECT? a. 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. b. 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. c. If a coupon bond is selling at par, its current yield equals its yield to maturity. d. The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B. e. If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity.

ANS: C OBJ: LO: 5-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds TOP: Bond yields KEY: Bloom’s: Analysis

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 41. A 15-year bond has an annual coupon rate of 8%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 6%. Which of the following statements is CORRECT? a. The bond is currently selling at a price below its par value. b. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today. c. The bond should currently be selling at its par value. d. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today. e. If market interest rates decline, the price of the bond will also decline.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rates and bond prices KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 42. An 8-year Treasury bond has a 10% coupon, and a 10-year Treasury bond has an 8% coupon. Both bonds 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. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price. b. The prices of both bonds would increase by the same amount. c. One bond's price would increase, while the other bond's price would decrease. d. The prices of the two bonds would remain constant. e. The prices of both bonds will decrease by the same amount.

ANS: A We can tell by inspection that b, c, d, and e are all incorrect. That leaves answer a as the only possibly correct statement. Recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 10-year, 8% coupon bond should be more sensitive to a decline in rates. You could also do some calculations to confirm that a is correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rates and bond prices KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 43. 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 prices of both bonds will remain unchanged. b. The price of Bond A will decrease over time, but the price of Bond B will increase over time. c. The prices of both bonds will increase by 7% per year. d. The prices of both bonds will increase over time, but the price of Bond A will increase by more. e. The price of Bond B will decrease over time, but the price of Bond A will increase over time.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond yields and prices KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

44. Assume that interest rates on 15-year noncallable Treasury and corporate bonds with different ratings are as follows: T-bond = 7.72% AAA = 8.72%

A = 9.64% BBB = 10.18%

The differences in rates among these issues were most probably caused primarily by: a. Tax effects. b. Default risk differences. c. Maturity risk differences. d. Inflation differences. e. Real risk-free rate differences.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-7 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rates KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 45. Which of the following statements is CORRECT? a. All else equal, long-term bonds have less interest rate price risk than short-term bonds. b. All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds. c. All else equal, short-term bonds have less reinvestment rate risk than long-term bonds. d. All else equal, long-term bonds have less reinvestment rate risk than short-term bonds. e. All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest vs. reinvestment rate risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 46. Which of the following statements is CORRECT? a. Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds. b. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk. c. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk. d. Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest vs. reinvestment rate risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 47. Which of the following statements is CORRECT? a. Liquidity premiums are generally higher on Treasury than corporate bonds. b. 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. c. Default risk premiums are generally lower on corporate than on Treasury bonds. d. Reinvestment rate risk is lower, other things held constant, on long-term than on © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

short-term bonds. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Term structure of interest rates KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 48. Which of the following statements is CORRECT? a. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity. b. 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. c. If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium. d. If a coupon bond is selling at a premium, its current yield equals its yield to maturity. e. If a coupon bond is selling at par, its current yield equals its yield to maturity.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 49. 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 has a current yield greater than 8%. b. The bond sells at a discount. c. The bond's required rate of return is less than 7.5%. d. If the yield to maturity remains constant, the price of the bond will decline over time. e. The bond sells at a price below par.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 50. Bonds A and B are 15-year, $1,000 face value 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%, which is expected to remain constant for the next 15 years. Which of the following statements is CORRECT? a. One year from now, Bond A's price will be higher than it is today. b. Bond A's current yield is greater than 8%. c. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. d. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature. e. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

51. Which of the following statements is NOT CORRECT? a. All else equal, bonds with longer maturities have more interest rate (price) risk than bonds with shorter maturities. b. If a bond is selling at its par value, its current yield equals its yield to maturity. c. If a bond is selling at a premium, its current yield will be greater than its yield to maturity. d. All else equal, bonds with larger coupons have greater interest rate (price) risk than bonds with smaller coupons. e. If a bond is selling at a discount to par, its current yield will be less than its yield to maturity.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 52. Which of the following statements is CORRECT? a. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value. b. Other things held constant, a corporation would rather issue noncallable bonds than callable bonds. c. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond. d. Reinvestment rate risk is worse from an investor's standpoint than interest rate price risk if the investor has a short investment time horizon. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 53. Which of the following statements is CORRECT? a. The total yield on a bond is derived from dividends plus changes in the price of the bond. b. Bonds are riskier than common stocks and therefore have higher required returns. c. Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies. d. The market value of a bond will always approach its par value as its maturity date approaches, provided the bond's required return remains constant. e. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 54. Which of the following statements is CORRECT? a. If rates fall after its issue, a zero coupon bond could trade at a price above its par value. b. If rates fall rapidly, a zero coupon bond's expected appreciation could become negative. c. If a firm moves from a position of strength toward financial distress, its bonds' yield to maturity would probably decline. d. If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

rate. e. If a coupon bond is selling at par, its current yield equals its yield to maturity.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 55. You are considering three different bonds for your portfolio. Each bond has a 10-year maturity and a yield to maturity of 10%. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Which of the following statements is CORRECT? a. Bond X has the greatest reinvestment rate risk. b. If market interest rates decline, all of the bonds will have an increase in price, and Bond Z will have the largest percentage increase in price. c. If market interest rates remain at 10%, Bond Z's price will be 10% higher one year from today. d. 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. e. If the bonds' market interest rates remain at 10%, Bond Z's price will be lower one year from now than it is today.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 56. Bonds A, B, and C all have a maturity of 15 years and a yield to maturity of 9%. 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.

Which of the following statements is CORRECT? a. Bond A has the most interest rate risk. b. 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. c. If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline. d. Bond C sells at a premium over its par value. e. If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its price.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 57. Which of the following statements is CORRECT? a. A 10-year, 10% coupon bond has less reinvestment rate risk than a 10-year, 5% coupon bond (assuming all else equal). b. The total 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. c. 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. d. A $1,000 bond with $100 annual interest payments that has 5 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%. e. 10-year, zero coupon bonds have higher reinvestment rate risk than 10-year, 10% coupon © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

bonds.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 58. Which of the following statements is CORRECT? a. 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. b. Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is based on market prices. c. The yield to maturity on a coupon bond that sells at its par value consists entirely of a current interest yield; it has a zero expected capital gains yield. d. 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. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 59. Which of the following statements is CORRECT? a. If a coupon bond is selling at a discount, then the bond's expected capital gains yield is negative. b. 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. c. 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. d. If a coupon bond is selling at par, its current yield equals its yield to maturity. e. If a coupon bond is selling at a premium, then the bond's current yield is zero.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond yields KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 60. Which of the following statements is CORRECT? a. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. b. 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. c. If the maturity risk premium (MRP) equals zero, the yield curve must be flat. d. The yield curve can never be downward sloping. e. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the yield curve will have an upward slope.

ANS: E The slope of the yield curve depends primarily on expected inflation and the MRP. The greater the expected increase in inflation, and the higher the MRP, the steeper the slope of the yield curve. If inflation is expected to decline, then even if the MRP is positive, the curve could still have a downward slope. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yield curve KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 61. Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that a. The economy is not in a recession. b. Long-term bonds are a better buy than short-term bonds. c. Maturity risk premiums could help to explain the yield curve's upward slope. d. Long-term interest rates are more volatile than short-term rates. e. Inflation is expected to decline in the future.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yield curve KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 62. Which of the following statements is CORRECT? a. The most likely explanation for an inverted yield curve is that investors expect inflation to increase. b. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. c. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. d. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted. e. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yield curve KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 63. Bonds for two companies were just issued: Short Corp.'s bonds will mature in 5 years, and Long Corp.'s bonds will mature in 15 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 expectations about future inflation, i.e., that the maturity risk premium is zero for T-bonds. Under these conditions, which of the following statements is correct? a. If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield. 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 the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds. d. If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal. e. 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 the lower yield.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-14 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Corporate yield curve KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

64. 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, and an 8% yield to maturity. Which of the following statements is CORRECT? a. Bond A trades at a discount, whereas Bond B trades at a premium. b. 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. c. If the yield to maturity for both bonds immediately decreases to 6%, Bond A's bond will have a larger percentage increase in value. d. Bond A's current yield is greater than that of Bond B. e. Bond A's capital gains yield is greater than Bond B's capital gains yield.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond rates and prices KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 65. Which of the following statements is CORRECT? a. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond. b. 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. c. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate. d. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond. e. 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.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Callable bonds KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 66. Cornwall Corporation is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT? a. 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. b. If two tiers of debt are used (with one senior and one subordinated debt class), the subordinated debt will carry a lower interest rate. c. 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. d. 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. e. 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.

ANS: A © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

On statement a, note that if only $500,000 of 1st mortgage bonds were secured by $1 million of property, each of those bonds would be less risky than if there were $1 million of bonds backed by the $1 million of property. Note too that the cost of the total $1 million of debt would be an average of the cost of the mortgage bonds and the debentures, and that cost could be higher, lower, or the same as if only mortgage bonds or debentures were used.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-11 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Costs of types of debt KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 67. Which of the following statements is CORRECT? a. Subordinated debt has less default risk than senior debt. b. Convertible bonds have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains. c. Junk bonds typically provide a lower yield to maturity than investment-grade bonds. d. A debenture is a secured bond that is backed by some or all of the firm's fixed assets. e. Junior debt is debt that has been more recently issued, and in bankruptcy it is paid off after senior debt because the senior debt was issued first.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-15 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Types of debt KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 68. Which of the following statements is CORRECT? a. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond. b. Once a firm declares bankruptcy, it must then be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and lawyer fees. c. 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. d. A firm with a sinking fund that gave 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. e. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the debt until the bonds mature.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-16 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Miscellaneous concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 69. Which of the following statements is CORRECT? a. 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%. b. The price of a discount bond will increase over time, assuming that the bond's yield to maturity remains constant. c. For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds. d. When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized. e. The total return on a bond during a given year consists only of the coupon interest © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

payments received.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-16 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Miscellaneous concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 70. Which of the following statements is NOT CORRECT? a. The expected return on a corporate bond must be less than its promised return if the probability of default is greater than zero. b. All else equal, senior debt has less default risk than subordinated debt. c. A company's bond rating is affected by its financial ratios and provisions in its indenture. d. Under Chapter 11 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 its debt according to the seniority of the debt as spelled out in the Act. e. All else equal, secured debt is less risky than unsecured debt.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-16 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Default and bankruptcy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 71. Which of the following statements is CORRECT? a. A bond is likely to be called if its market price is below its par value. b. 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. c. A bond is likely to be called if its market price is equal to its par value. d. A bond is likely to be called if it sells at a discount below par. e. A bond is likely to be called if its coupon rate is below its YTM. ANS: B A bond would not be called unless the current rate was below the YTM. The investor would get the funds, then reinvest at the new market rate. Thus, the investor would end up earning less than the YTM, even after receiving the call premium.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Call provision KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 72. Which of the following statements is CORRECT? a. 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. b. If a bond sells at par, then its current yield will be less than its yield to maturity. c. If a bond sells for less than par, then its yield to maturity is less than its coupon rate. d. A discount bond's price declines each year until it matures, when its value equals its par value. e. 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.

ANS: A Answer b is incorrect because a bond selling at par must have a current yield equal to its YTM. Answer c is incorrect because a bond selling at below par must have a YTM > the coupon rate.

Answer d is incorrect because a discount bond's price must rise over time. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Answer e is incorrect because a premium bond must have a negative capital gains yield.

That leaves Answer a as the only possibly correct answer. Note that YTM = Cur Yld +/− Cap gains Yld., so Cur Yld = YTM +/− Cap gain yld. The cap gains yld will be positive or negative depending on whether the coupon rate is above or below the YTM. That means that the Cur yld must either equal the YTM or be between the YTM and the coupon rate. a's correctness is also demonstrated below:

Par Maturity Coup rate YTM Ann coup Price Cur Yield

Par bond 1000 10 10% 10.00% $100.00 $1,000.00 10.00%

Premium 1000 10 11% 10.00% $110.00 $1,061.45 10.36%

Cap gain

0.00%

−0.36%

Discount 1000 10 9% 10.00% $90.00 $938.55 9.59% Equal to or between YTM and coupon rate.

0.41%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Current yield and yield to maturity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 73. Assume that a 10-year Treasury bond has a 12% annual coupon, while a 15-year T-bond has an 8% 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 will increase, but the 10-year bond would have a larger percentage increase in price. b. The 10-year bond would sell at a discount, while the 15-year bond would sell at a premium. c. The 10-year bond would sell at a premium, while the 15-year bond would sell at par. d. 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. e. If interest rates decline, the prices of both bonds will increase, but the 15-year bond would have a larger percentage increase in price.

ANS: E We can tell by inspection that b, c, and d are all incorrect. That leaves answers a and e as the only possibly correct statements. Also, recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 15-year, 8% coupon bond should be more sensitive to a decline in rates. Finally, we can do some calculations to confirm that e is the correct answer:

Par Maturity Coup rate YTM Ann coup Price % Gain PTS: 1

Current situation 10-year 15-year 1000 1000 10 15 12% 8% 10.00% 10.00% 120 80 $1,122.89 $847.88

DIF: Difficulty: Challenging

Rates decline 10-year 15-year 1000 1000 10 15 12% 8% 9.00% 9.00% 120 80 $1,192.53 $919.39 6.2% 8.4% OBJ: LO: 5-4

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Effect of interest rate on bond prices KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 74. 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.

2.

3.

4.

5.

6.

Fixed assets are used as security for a bond.

A given bond is subordinated to other classes of debt.

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

The bond has a sinking fund.

The bond has a call provision.

The indenture contains covenants that prevent the use of additional debt.

a. b. c. d. e.

1, 4, 6 1, 2, 3, 4, 6 1, 2, 3, 4, 5, 6 1, 3, 4, 5, 6 1, 3, 4, 6

ANS: E PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-11 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond indenture KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 75. Suppose International Digital Technologies decides to raise a total of $200 million, with $100 million as long-term debt and $100 million as common equity. 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. 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 debentures. b. In this situation, we cannot tell for sure how, or 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 of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two. c. 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. d. 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. e. 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.

ANS: B

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The higher the percentage of mortgage bonds, the less the collateral backing each bond, so the bonds' risk and thus required return would be higher. Also, the higher the percentage of mortgage bonds, the less free assets would be backing the debentures, so their risk and required return would also be higher.

However, mortgage bonds are less risky than debentures, so mortgage bond rates are lower than rates on debentures. We end up with a situation where the greater the percentage of mortgage bonds, the higher the rate on both types of bonds, but the average cost to the company could be higher, lower, or constant. Note that we could draw a graph of the situation, with % mortgage on the horizontal axis and rates on the vertical axis, then the graph would look like the WACC graph in the cost of capital chapter.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-11 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Types of debt and their relative costs KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 76. Which of the following statements is CORRECT? a. If their maturities and other characteristics were the same, a 5% coupon bond would have more interest rate price risk than a 10% coupon bond. b. A 10-year coupon bond would have more reinvestment rate risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of reinvestment rate risk. c. A 10-year coupon bond would have more interest rate price risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of interest rate price risk. d. If their maturities and other characteristics were the same, a 5% coupon bond would have less interest rate price risk than a 10% coupon bond. e. A zero coupon bond of any maturity will have more interest rate price risk than any coupon bond, even a perpetuity.

ANS: A PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Interest rate and reinvestment rate risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 77. Which of the following statements is CORRECT? a. All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds. b. 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. c. If a bond's yield to maturity exceeds its coupon rate, the bond's price must be less than its maturity value. d. If a bond's yield to maturity exceeds its coupon rate, the bond's current yield must be less than its coupon rate. e. 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 the bond's coupon rates.

ANS: C PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond yields and prices KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 78. Assuming all else is constant, which of the following statements is CORRECT? a. 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. b. From a corporate borrower's point of view, interest paid on bonds is not tax-deductible. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 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. d. 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. e. A 20-year zero coupon bond has more reinvestment rate risk than a 20-year coupon bond.

ANS: D It is relatively easy to eliminate b, c, and e. When choosing between a and d, think about the graph that shows the relationship between a bond's price and the going interest rate. This curve is concave, indicating that at any interest rate, the decline in price from an increase in rates is less than the gain in price from a similar interest rate decline. It would be easy to confirm this statement with an example.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-13 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 79. Kessen Inc.'s bonds mature in 7 years, have a par value of $1,000, and make an annual coupon payment of $70. The market interest rate for the bonds is 8.5%. What is the bond's price? a. $923.22 b. $946.30 c. $969.96 d. $994.21 e. $1,019.06 ANS: A N I/YR PMT FV PV

7 8.5% $70 $1,000 $923.22

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-3 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond valuation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 80. Noncallable bonds that mature in 10 years were recently issued by Sternglass Inc. They have a par value of $1,000 and an annual coupon of 5.5%. If the current market interest rate is 7.0%, at what price should the bonds sell? a. $829.21 b. $850.47 c. $872.28 d. $894.65 e. $917.01 ANS: D Coupon rate PMT N I/YR FV PV

5.5% $55 10 7.0% $1,000 $894.65

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-3 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond valuation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 81. Curtis Corporation's noncallable bonds currently sell for $1,165. They have a 15-year maturity, an annual coupon of $95, and a par value of $1,000. What is their yield to maturity? a. 6.20% b. 6.53% c. 6.87% d. 7.24% e. 7.62% ANS: E N PV PMT FV I/YR

15 $1,165 $95 $1,000 7.62%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yield to maturity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 82. Sommers Co.'s bonds currently sell for $1,080 and have a par value of $1,000. They pay a $100 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,125. What is their yield to maturity (YTM)? a. 8.56% b. 9.01% c. 9.46% d. 9.93% e. 10.43% ANS: B N PV PMT FV I/YR

15 $1,080 $10 $1,000 9.01% = YTM

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yield to maturity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 83. Sentry Corp. bonds have an annual coupon payment of 7.25%. The bonds have a par value of $1,000, a current price of $1,125, and they will mature in 13 years. What is the yield to maturity on these bonds? a. 5.56% b. 5.85% c. 6.14% d. 6.45% e. 6.77% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: B Coupon rate N PV = Price PMT FV = Par I/YR

7.25% 13 $1,125 $72.50 $1,000 5.85% = YTM

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yield to maturity KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 84. Meacham Enterprises' bonds currently sell for $1,280 and have a par value of $1,000. They pay a $135 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,050. What is their yield to call (YTC)? a. 6.39% b. 6.72% c. 7.08% d. 7.45% e. 7.82% ANS: D N PV PMT FV I/YR = YTC

5 $1,280 $135 $1,050 7.45%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yield to call KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 85. Perry Inc.'s bonds currently sell for $1,150. They have a 6-year maturity, an annual coupon of $85, and a par value of $1,000. What is their current yield? a. 7.39% b. 7.76% c. 8.15% d. 8.56% e. 8.98% ANS: A N PV PMT FV Current yield =

6 $1,150 $85 $1,000 7.39%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Current yield KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

86. Rogoff Co.'s 15-year bonds have an annual coupon rate of 9.5%. Each bond has face value of $1,000 and makes semiannual interest payments. If you require an 11.0% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. $891.00 b. $913.27 c. $936.10 d. $959.51 e. $983.49 ANS: A Par value Coupon rate Periods/year Yrs to maturity N = periods Annual rate Periodic rate PMT/period FV PV

$1,000 9.5% 2 15 30 11.0% 5.50% $47.50 $1,000 $891.00

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond valuation: semiannual coupons KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 87. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-year 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. 1.90% b. 2.09% c. 2.30% d. 2.53% e. 2.78% ANS: A T-bond yield Corporate yield MRP LP DRP

Included in both bonds Included in corporate

6.20% 8.50% 1.30% 0.40% 1.90%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 5-11 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Default risk premium (DRP) KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 88. One year ago Lerner and Luckmann Co. issued 15-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 14 years to maturity? a. $1,077.01 b. $1,104.62 c. $1,132.95 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. $1,162.00 e. $1,191.79 ANS: E Par value Coupon rate N I/YR PMT FV PV

$1,000 7.5% 14 5.5% $75 $1,000 $1,191.79

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-3 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond valuation: annual coupons KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 89. Currently, Bruner Inc.'s bonds sell for $1,250. They pay a $120 annual coupon, have a 15-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.) a. 2.11% b. 2.32% c. 2.55% d. 2.80% e. 3.09% ANS: A If held to maturity: N = Maturity PV PMT FV = Par I/YR = YTM

15 $1,250 $120 $1,000 8.91%

Difference:

2.11%

If called in 5 years: N = Call PV PMT FV = Call Price I/YR = YTC

5 $1,250 $120 $1,050 6.81%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yields to maturity and call KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 90. Gilligan Co.'s bonds currently sell for $1,150. They have a 6.75% annual coupon rate and a 15-year maturity, and are callable in 6 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 on into the future. Under these conditions, what rate of return should an investor expect to earn if he or she purchases these bonds, the YTC or the YTM? a. 3.92% b. 4.12% c. 4.34% d. 4.57% e. 4.81% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: E If the coupon rate exceeds the YTM, then it is likely that the bonds will be called and replaced with new, lower coupon bonds. In that case, the YTC will be earned. Otherwise, one should expect to earn the YTM. If held to maturity Par value Coupon N PV PMT FV I/YR

$1,000 6.75% 15 $1,150.00 $67.50 $1,000.00 5.28% YTM

Expected rate of return:

If called Par value Coupon N PV PMT FV I/YR

$1,000 6.75% 6 $1,150.00 $67.50 $1,067.50 4.81% YTC

4.81% YTC

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yields to maturity and call KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 91. Haswell Enterprises' bonds have a 10-year maturity, a 6.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 4.75%, based on semiannual compounding. What is the bond's price? a. 1,063.09 b. 1,090.35 c. 1,118.31 d. 1,146.27 e. 1,174.93 ANS: C Par value Coupon rate Periods/year Yrs to maturity N = periods Annual rate Periodic rate PMT/period FV PV

$1,000 6.25% 2 10 20 4.75% 2.38% $31.25 $1,000 $1,118.31

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond valuation: semiannual coupons KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 92. CMS Corporation's balance sheet as of today is as follows: Long-term debt (bonds, at par) Preferred stock Common stock ($10 par) Retained earnings

$10,000,000 2,000,000 10,000,000 4,000,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Total debt and equity

$26,000,000

The bonds have a 4.0% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 12%, so the bonds now sell below par. What is the current market value of the firm's debt? a. $5,276,731 b. $5,412,032 c. $5,547,332 d. $7,706,000 e. $7,898,650 ANS: B Calculate the price of each bond: Coupon rate 4.0% Par value $1,000 Maturity (Yrs) 10 Periods/Yr. 2 YTM 12.0% N I/YR PMT FV PV

20 6.0% $20.00 $1,000 $541.20

Determine the number of bonds: Book value on balance sheet Par value Number of bonds = Book value/Par value

$10,000,000 $1,000 10,000

Calculate the market value of bonds: Mkt value = PV  Number of bonds =

$5,412,032

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Market value of semiannual bonds KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 93. 5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year bonds is 0.4%. What is the real risk-free rate, r*? a. 2.59% b. 2.88% c. 3.20% d. 3.52% e. 3.87% ANS: C rT-bond IP MRP r*

Included in both bonds Included in both bonds

5.50% 1.90% 0.40% 3.20%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-8 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

KEY: Bloom’s: Analysis

LOC: TBA TOP: Real risk-free rate MSC: TYPE: Multiple Choice: Problem

94. The Gergen Group's 5-year bonds yield 6.85%, and 5-year T-bonds yield 4.75%. The real risk-free rate is r* = 2.80%, the default risk premium for Gergen's bonds is DRP = 0.85% versus zero for T-bonds, the liquidity premium on Gergen's bonds is LP = 1.25%, 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 5-year bonds? a. 1.40% b. 1.55% c. 1.71% d. 1.88% e. 2.06% ANS: B Maturity rKrockett rT-bond r* LP DRP MRP IP

Included in both bonds Included in corp. only Included in corp. only Included in both bonds

5 6.85% 4.75% 2.80% 1.25% 0.85% 0.40% 1.55%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-9 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Inflation premium (IP) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 95. Chandler Co.'s 5-year bonds yield 7.00%, 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 Chandler'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 Chandler's bonds? a. 0.99% b. 1.10% c. 1.21% d. 1.33% e. 1.46% ANS: B Maturity rKeys' rT-bond r* IP LP MRP DRP

Included in both bonds Included in both bonds Included in corp. only Included in both bonds

5 7.00% 5.15% 3.00% 1.75% 0.75% 0.40% 1.10%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-11 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Default risk premium (DRP) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

96. Squire Inc.'s 5-year bonds yield 6.75%, 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 Squire'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 Squire's bonds? a. 0.49% b. 0.55% c. 0.61% d. 0.68% e. 0.75% ANS: E Maturity rNie rT-bond r* IP DRP MRP LP

Included in both bonds Included in both bonds Included in corp. only Included in both bonds

5 6.75% 4.80% 2.75% 1.65% 1.20% 0.40% 0.75%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 5-12 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Liquidity premium (LP) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 97. Field Industries' outstanding bonds have a 25-year maturity and $1,000 par value. Their nominal yield to maturity is 9.25%, they pay interest semiannually, and they sell at a price of $850. What is the bond's nominal (annual) coupon interest rate? a. 6.27% b. 6.60% c. 6.95% d. 7.32% e. 7.70% ANS: E First, use the data provided to find the dollar coupon payment per 6 months, then multiply by 2 to get the annual coupon, and then divide by the par value to find the coupon rate. One could use the indicated data and solve for the price. It would be $850, which confirms the rate.

Par value Maturity Periods/year N YTM Periodic rate PV PMT Coupon rate =

$1,000 25 2 50 9.25% 4.63% $850.00 $38.50 7.70%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Determining the coupon rate KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 98. Jerome Corporation's bonds have 15 years to maturity, an 8.75% coupon paid semiannually, 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 $1,050. What is the bond's nominal yield to call? a. 5.01% b. 5.27% c. 5.54% d. 5.81% e. 6.10% ANS: B First, use the given data to find the bond's current price. Then use that price to find the YTC. Coupon rate YTM Maturity Par value Periods/year Determine the bond's price PMT/period N I/YR FV PV = Price

8.75% Yrs to call 6.50% Call price 15 $1,000 2 Determine the bond's YTC N $43.75 PV 30 PMT 3.25% FV $1,000.00 I/YR $1,213.55 Nom. YTC

6 $1,050.00

12 $1,213.55 $43.75 $1,050.00 2.64% 5.27%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Yields to maturity and call KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 99. A 25-year, $1,000 par value bond has an 8.5% annual coupon. The bond currently sells for $875. If the yield to maturity remains at its current rate, what will the price be 5 years from now? a. $839.31 b. $860.83 c. $882.90 d. $904.97 e. $927.60 ANS: C First find the YTM at this time, then use the YTM with the other data to find the bond's price 5 years hence.

Par value Coupon rate N PV PMT FV I/YR

$1,000 8.50% 25 $875 $85 $1,000 9.86%

Value in 5 years N I/YR PMT FV PV

20 9.86% $85 $1,000 $882.90

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-4 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond value in future time periods KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 100. McCurdy Co.'s Class Q bonds have a 12-year maturity, $1,000 par value, and a 5.75% coupon paid semiannually (2.875% each 6 months), and those bonds sell at their par value. McCurdy's Class P bonds have the same risk, maturity, and par value, but the P bonds pay a 5.75% annual coupon.

Neither bond is callable. At what price should the annual payment bond sell? a. $943.98 b. $968.18 c. $993.01 d. $1,017.83 e. $1,043.28 ANS: C These two bonds should provide the same EFF%. Therefore, we can find the EFF% for the semiannual bond and then use it as the YTM for the annual payment bond. At the calculated price, the two bonds will have YTMs with the same EFF%. Note too that the semiannual payment bond must have a higher price than the annual bond because then it receives the same cash flow, but faster. Therefore Bond A must sell at a price below the $1,000 par value at which S sells.

Semiannual bond Par value Coupon rate = Nominal rate Payment per period Years to maturity Periods/year Total periods EFF% Price

$1,000 5.75% $28.75 12 2 24 5.833% $1,000.00

Annual bond Par value Coupon rate Pmt/Period Yrs to maturity Periods/year Total periods EFF% = YTM Price

$1,000 5.75% $57.50 12 1 12 5.833% $993.01

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond valuation: effective rates KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 101. Reinegar Corporation is planning two new issues of 25-year bonds. Bond Par will be sold at its $1,000 par value, and it will have a 10% semiannual coupon. Bond OID will be an Original Issue Discount bond, and it will also have a 25-year maturity and a $1,000 par value, but its semiannual coupon will be only 6.25%. If both bonds are to provide investors with the same effective yield, how many of the OID bonds must Reinegar issue to raise $3,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds. a. 4,228 b. 4,337 c. 4,448 d. 4,562 e. 4,676 ANS: D The par bond has a coupon rate of 10% and a periodic rate of 5%, and it sells at par. Therefore, the going nominal rate must be 10%. The OID bond must provide the same EFF%, because it is equally risky. Therefore, it must be evaluated with the parameters shown below to find its price, which is then used to find the number of bonds issued.

Bond A: Issued at par Par value

Bond B: Issued at a discount (OID bonds) $1,000 Par value $1,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Coupon rate Maturity yrs Periods/year N Periodic rate PMT PV = Price

10.00% 25 2 50 5.00% $50.00 $1,000.00

Funds needed Number of bonds Rounded up

$3,000,000 4,561.34 4,562

Coupon rate Maturity yrs Periods/year N Periodic rate PMT PV = Price

6.25% 25 2 50 5.00% $31.25 $657.70

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 5-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Bond valuation: original issue discount bonds KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 6—RISK AND RETURN TRUE/FALSE 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.

ANS: F OBJ: LO: 6-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Standard deviation KEY: Bloom’s: Knowledge

2. Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

ANS: T OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Risk aversion KEY: Bloom’s: Knowledge

3. 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.

ANS: T OBJ: LO: 6-5 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Portfolio risk KEY: Bloom’s: Knowledge

4. Diversification will normally reduce the riskiness of a portfolio of stocks.

ANS: T OBJ: LO: 6-5 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Portfolio risk KEY: Bloom’s: Knowledge

5. 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.

ANS: T OBJ: LO: 6-5 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Portfolio risk KEY: Bloom’s: Knowledge

6. The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

ANS: F OBJ: LO: 6-5 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Portfolio return KEY: Bloom’s: Knowledge

7. 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.

ANS: T OBJ: LO: 6-6

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA

TOP: Market risk

KEY: Bloom’s: Knowledge

8. 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.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Market risk KEY: Bloom’s: Knowledge

9. 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.

ANS: F OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Risk and expected returns KEY: Bloom’s: Knowledge

10. 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. ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: CAPM and risk KEY: Bloom’s: Knowledge

11. 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 well-diversified portfolio.

ANS: T OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: CAPM and risk KEY: Bloom’s: Knowledge

12. If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

ANS: F OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: SML and risk aversion KEY: Bloom’s: Knowledge

13. If a stock's expected return as seen by the marginal investor exceeds this investor's 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.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Stock market equilibrium KEY: Bloom’s: Knowledge

14. 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.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Stock market equilibrium KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. 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 this investor's required return.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Stock market equilibrium KEY: Bloom’s: Knowledge

16. Two conditions are used to determine whether or not 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 this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.

ANS: F If one condition holds, then the other must also hold.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds LOC: TBA TOP: Stock market equilibrium KEY: Bloom’s: Knowledge 17. 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, its standard deviation.

ANS: T OBJ: LO: 6-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Variance KEY: Bloom’s: Comprehension

18. "Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

ANS: T OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Risk aversion KEY: Bloom’s: Comprehension

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 low standard deviation.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Risk aversion KEY: Bloom’s: Comprehension

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.

ANS: T OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Risk prem. and risk aversion KEY: Bloom’s: Comprehension

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Beta coefficients KEY: Bloom’s: Comprehension

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.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Beta coefficients KEY: Bloom’s: Comprehension

23. If the returns of two firms are negatively correlated, then one of them must have a negative beta.

ANS: T OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Beta coefficients KEY: Bloom’s: Comprehension

24. A stock with a beta equal to −1.0 has zero systematic (or market) risk.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Beta coefficients KEY: Bloom’s: Comprehension

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.

ANS: T OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Beta coefficients KEY: Bloom’s: Comprehension

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.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Portfolio risk KEY: Bloom’s: Comprehension

27. Portfolio A has but 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.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Portfolio risk KEY: Bloom’s: Comprehension

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.

ANS: F

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 6-6 LOC: TBA

NAT: BUSPROG: Reflective Thinking TOP: Portfolio risk

STA: DISC: Risk and return KEY: Bloom’s: Comprehension

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 30% 10% −5%

BB −10% 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. ANS: F The stocks have the same expected returns, but BB does badly in booms and well in recessions.

Therefore, it would do more to reduce risk.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Comprehension 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 2-asset portfolio will have less risk than either security held alone.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Cor. coefficient and risk KEY: Bloom’s: Comprehension

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.

ANS: T OBJ: LO: 6-5 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Company-specific risk KEY: Bloom’s: Comprehension

32. We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Portfolio beta KEY: Bloom’s: Comprehension

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.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Portfolio beta KEY: Bloom’s: Comprehension

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

34. If an investor buys enough stocks, he or she 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.

ANS: F OBJ: LO: 6-5 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Diversification effects KEY: Bloom’s: Comprehension

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. ANS: F OBJ: LO: 6-11 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: CAPM KEY: Bloom’s: Comprehension

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.

ANS: F OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Required return KEY: Bloom’s: Comprehension

37. A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Changes in beta KEY: Bloom’s: Comprehension

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.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Changes in beta KEY: Bloom’s: Comprehension

39. The slope of the SML is determined by the value of beta.

ANS: F OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: SML KEY: Bloom’s: Comprehension

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. ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: SML KEY: Bloom’s: Comprehension

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 well-diversified investor, assuming that the observed relationship is expected to continue in the future.

ANS: T OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: SML KEY: Bloom’s: Comprehension

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 risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.

ANS: F OBJ: LO: 6-6 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: SML KEY: Bloom’s: Comprehension

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.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: SML KEY: Bloom’s: Comprehension

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.

ANS: F The slope and intercept of the SML are determined by the market, generally not the actions of a single firm. However, managers can influence their firms' beta, and thus their firms' required returns.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Comprehension 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.

ANS: F OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: SML KEY: Bloom’s: Comprehension

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.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: CAPM and inflation KEY: Bloom’s: Comprehension

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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.

ANS: T OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Market risk premium KEY: Bloom’s: Comprehension

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.

ANS: T Both portfolios would be twice as risky as a portfolio of average stocks. Their risks would decline if they added b = 1.0 stocks, as those stocks would move the portfolios' betas toward 1.0.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return LOC: TBA TOP: Beta coefficients KEY: Bloom’s: Comprehension 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.

ANS: F The CAPM is a single-period model, and it does not take account of securities' maturities.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return LOC: TBA TOP: CAPM KEY: Bloom’s: Comprehension MULTIPLE CHOICE 50. If markets are in equilibrium, which of the following conditions will exist? a. Each stock's expected return should equal its required return as seen by the marginal investor. b. All stocks should have the same expected return as seen by the marginal investor. c. The expected and required returns on stocks and bonds should be equal. d. All stocks should have the same realized return during the coming year. e. Each stock's expected return should equal its realized return as seen by the marginal investor.

ANS: A Statement a is true, because if the expected return does not equal the required return, then markets are not in equilibrium.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Market equilibrium KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

51. You are considering investing in one of the these three stocks: Stock A B C

Standard Deviation 20% 10% 12%

Beta 0.59 0.61 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; B. b. B; A. c. C; A. d. C; B. e. A; A. ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Risk aversion KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 52. Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. She is highly risk averse and has asked for your advice. 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 his or her portfolio, or does the choice not matter? a. Stock A. b. Stock B. c. Neither A nor B, as neither has a return sufficient to compensate for risk. d. Add A, since its beta must be lower. e. Either A or B, i.e., the investor should be indifferent between the two.

ANS: B With only 4 stocks in the portfolio, unsystematic risk matters, and B has less.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Standard deviation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 53. Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE? a. 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. b. The beta of an "average stock," or "the market," can change over time, sometimes drastically. c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. d. All of the statements above are true. e. The fact that a security or project may not have a past history that can be used as the basis for calculating beta.

ANS: B

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 6-6 NAT: BUSPROG: Analytic LOC: TBA TOP: Beta coefficients MSC: TYPE: Multiple Choice: Conceptual

STA: DISC: Risk and return KEY: Bloom’s: Analysis

54. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true about these securities? (Assume market equilibrium.) a. Stock B must be a more desirable addition to a portfolio than A. b. Stock A must be a more desirable addition to a portfolio than B. c. The expected return on Stock A should be greater than that on B. d. The expected return on Stock B should be greater than that on A. e. When held in isolation, Stock A has more risk than Stock B. ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Beta coefficients KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 55. Which of the following statements is CORRECT? a. 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. b. 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. c. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks. d. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF. e. The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Beta coefficients KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 56. Which of the following statements is CORRECT? a. 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 5 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 5-year period. b. 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. c. 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. d. If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline. e. Paid-in-Full Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Paid-in-Full's revenues, profits, and stock price tend to rise during recessions. This suggests that Paid-in-Full Inc.'s beta should be quite high, say 2.0, © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

because it does so much better than most other companies when the economy is weak.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Beta coefficients KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 57. Which of the following statements is CORRECT? a. 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. b. The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically. c. 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. d. 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. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Beta coefficients KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 58. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct. a. In equilibrium, the expected return on Stock B will be greater than that on Stock A. b. When held in isolation, Stock A has more risk than Stock B. c. Stock B would be a more desirable addition to a portfolio than A. d. In equilibrium, the expected return on Stock A will be greater than that on B. e. Stock A would be a more desirable addition to a portfolio then Stock B. ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Beta coefficients KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 59. Stock X has a beta of 0.7 and Stock Y has a beta of 1.7. Which of the following statements must be true, according to the CAPM? a. Stock Y's realized return during the coming year will be higher than Stock X's return. b. 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. c. Stock Y's return has a higher standard deviation than Stock X. d. If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y. e. If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.

ANS: B OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Risk and return TOP: Beta coefficients KEY: Bloom’s: Analysis

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 60. Consider the following average annual returns for Stocks A and B and the Market. Which of the possible answers best describes the historical betas for A and B? Years 1 2 3 4 5 a. b. c. d. e.

Market 0.03 −0.05 0.01 −0.10 0.06

Stock A 0.16 0.20 0.18 0.25 0.14

Stock B 0.05 0.05 0.05 0.05 0.05

bA > +1; bB = 0. bA = 0; bB = −1. bA < 0; bB = 0. bA < −1; bB = 1. bA > 0; bB = 1.

ANS: C First, note that B's beta must be zero, so either a or c must be correct. Second, note that A's returns are highest when the market's returns are negative and lowest when the market's returns are positive. This indicates that A's beta is negative. Thus, c must be correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Beta coefficients KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 61. a. b. c. d. e.

Which of the following statements is CORRECT? The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.

An investor can eliminate almost all risk if he or she holds a very large and well diversified portfolio of stocks.

Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.

An investor can eliminate almost all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

An investor can eliminate almost all market risk if he or she holds a very large and well diversified portfolio of stocks.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-5 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 62. Which of the following statements is CORRECT? a. 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. b. 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 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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. c. Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless. d. A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate. e. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-5 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 63. Recession, inflation, and high interest rates are economic events that are best characterized as being a. company-specific risk factors that can be diversified away. b. among the factors that are responsible for market risk. c. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. d. irrelevant except to governmental authorities like the Federal Reserve. e. systematic risk factors that can be diversified away.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-5 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Market risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 64. Which of the following statements is CORRECT? a. If an investor buys enough stocks, he or she 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. b. 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. c. Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. d. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Risk and port. divers.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 65. Which of the following statements is CORRECT? a. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk. b. A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0. c. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8. d. If you add enough randomly selected stocks to a portfolio, you can completely eliminate © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

all of the market risk from the portfolio. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Risk and port. divers.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 66. Which of the following statements is CORRECT? a. A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations. b. A two-stock portfolio will always have a lower beta than a one-stock portfolio. c. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. d. A stock with an above-average standard deviation must also have an above-average beta. e. A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-5 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Port. risk, return, and beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 67. 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.

Stock A B C

Expected Return 10% 10% 12%

Standard Deviation 20% 10% 12%

Beta 1.0 1.0 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's coefficient of variation is greater than 2.0. b. Portfolio AB's required return is greater than the required return on Stock A. c. Portfolio ABC's expected return is 10.66667%. d. Portfolio ABC has a standard deviation of 20%. e. Portfolio AB has a standard deviation of 20%.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 68. Which of the following statements is CORRECT? a. 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. b. If a stock has a negative beta, its expected return must be negative. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 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. d. According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Port. return, CAPM, and beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 69. Which of the following is most likely to be true for a portfolio of 40 randomly selected stocks? a. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. b. The beta of the portfolio is less than the average of the betas of the individual stocks. c. The beta of the portfolio is equal to the average of the betas of the individual stocks. d. The beta of the portfolio is larger than the average of the betas of the individual stocks. e. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 70. If you randomly select stocks and add them to your portfolio, which of the following statements best describes what you should expect? a. Adding more such stocks will increase the portfolio's expected rate of return. b. Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk. c. Adding more such stocks will have no effect on the portfolio's risk. d. Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk. e. Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 71. Charlie and Lucinda each have $50,000 invested in stock portfolios. Charlie's has a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Lucinda's 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 Charlie's and Lucinda's portfolios is zero. If Charlie and Lucinda marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio? a. 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%. b. 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%. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%. d. The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%. e. 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%.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 72. The two stocks in your portfolio, X and Y, have independent returns, so the correlation between them, rXY is zero. 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%. Which of the following statements best describes the characteristics of your 2-stock portfolio? a. Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6. b. Your portfolio has a beta equal to 1.6, and its expected return is 15%. c. Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%. d. Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6. e. Your portfolio has a standard deviation of 30%, and its expected return is 15%.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 73. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks? a. The expected return of your portfolio is likely to decline. b. The diversifiable risk will remain the same, but the market risk will likely decline. c. Both the diversifiable risk and the market risk of your portfolio are likely to decline. d. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline. e. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 74. Ann has a portfolio of 20 average stocks, and Tom has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. The required return on Ann's portfolio will be lower than that on Tom's portfolio because Ann's portfolio will have less total risk. b. Tom's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Ann's portfolio, but the required (and expected) returns will be the same on both portfolios. c. If the two portfolios have the same beta, their required returns will be the same, but Ann's portfolio will have less market risk than Tom's. d. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified. e. Ann's portfolio will have less diversifiable risk and also less market risk than Tom's portfolio. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 75. Stocks A and B are quite similar: Each has 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 standard deviation that is greater than 25%. b. Portfolio P has an expected return that is less than 12%. c. Portfolio P has a standard deviation that is less than 25%. d. Portfolio P has a beta that is less than 1.2. e. Portfolio P has a beta that is greater than 1.2.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 76. Stocks A, B, and C are similar in some respects: Each has 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 zero. 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 greater than 25%. b. Portfolio AB has a standard deviation that is greater than 25%. c. Portfolio AB has a standard deviation that is equal to 25%. d. Portfolio AC has a standard deviation that is less than 25%. e. Portfolio AC has an expected return that is less than 10%.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 77. 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. Your portfolio consists of 50% A and 50% B. Which of the following statements is CORRECT? a. The portfolio's expected return is 15%. b. The portfolio's standard deviation is greater than 20%. c. The portfolio's beta is greater than 1.2. d. The portfolio's standard deviation is 20%. e. The portfolio's beta is less than 1.2.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 78. 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 1/3 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? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

Portfolio P's expected return is equal to the expected return on Stock A. Portfolio P's expected return is less than the expected return on Stock B. Portfolio P's expected return is equal to the expected return on Stock B. Portfolio P's expected return is greater than the expected return on Stock C. Portfolio P's expected return is greater than the expected return on Stock B.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 79. In a portfolio of three randomly selected stocks, which of the following could NOT be true; i.e., which statement is false? a. The standard deviation of the portfolio is greater than the standard deviation of one or two of the stocks. b. The beta of the portfolio is lower than the lowest of the three betas. c. The beta of the portfolio is equal to one of the three stock's betas. d. The beta of the portfolio is equal to 1. e. The standard deviation of the portfolio is less than the standard deviation of each of the stocks if they were held in isolation.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk and return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 80. Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT? a. 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. b. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2. c. 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. d. 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. e. Stock B's required return is double that of Stock A's.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Port. risk & ret. relationships KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 81. 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 $300,000 invested in Stock A and $100,000 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. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. c. Portfolio AB's expected return is 11.0%. d. Portfolio AB's beta is less than 1.2. e. Portfolio AB's standard deviation is 17.5%.

ANS: A

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 6-7 NAT: BUSPROG: Analytic LOC: TBA TOP: Port. risk & ret. relationships MSC: TYPE: Multiple Choice: Conceptual

STA: DISC: Risk and return KEY: Bloom’s: Analysis

82. You have a portfolio P that consists of 50% Stock X and 50% Stock Y. 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. Given this information, which of the following statements is CORRECT? a. The required return on Portfolio P is equal to the market risk premium (rM − rRF). b. Portfolio P has a beta of 0.7. c. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF. d. Portfolio P has the same required return as the market (rM). e. Portfolio P has a standard deviation of 20%.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Port. risk & ret. relationships KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 83. Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.) a. The effect of a change in the market risk premium depends on the slope of the yield curve. b. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. c. 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. d. The effect of a change in the market risk premium depends on the level of the risk-free rate. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Market risk premium KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 84. In historical data, we see 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. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds. b. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. c. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks. d. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. e. Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills.

ANS: B OBJ: LO: 6-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Risk and return TOP: Risk & ret. relationships KEY: Bloom’s: Analysis

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 85. Suppose that during the coming year, the risk free rate, rRF, is expected to remain the same, while the market risk premium (rM − rRF), is expected to fall. Given this forecast, which of the following statements is CORRECT? a. The required return on all stocks will remain unchanged. b. The required return will fall for all stocks, but it will fall more for stocks with higher betas. c. The required return for all stocks will fall by the same amount. d. The required return will fall for all stocks, but it will fall less for stocks with higher betas. e. 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.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Required return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 86. 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. Stock B's required rate of return is twice that of Stock A. b. If Stock A's required return is 11%, then the market risk premium is 5%. c. If Stock B's required return is 11%, then the market risk premium is 5%. d. 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. e. 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.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 87. 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 fall has been greater for stocks with higher betas. b. 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. c. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. d. The required returns on all stocks have fallen by the same amount. e. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM and required return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 88. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? a. If a stock's beta doubled, its required return under the CAPM would also double. b. If a stock's beta doubled, its required return under the CAPM would more than double. c. If a stock's beta were 1.0, its required return under the CAPM would be 5%. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%. e. If a stock has a negative beta, its required return under the CAPM would be less than 5%.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM and required return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 89. Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT? a. 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. b. If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks will increase by the same amount. c. Since the market is in equilibrium, the required returns of the two stocks should be the same. d. 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. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM and required return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 90. Portfolio P has equal amounts invested in each of the three stocks, A, B, and C. 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. 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 on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium. b. 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. c. The required returns on all three stocks will increase by the amount of the increase in the market risk premium. d. 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. e. The required return of all stocks will remain unchanged since there was no change in their betas.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM and required return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 91. Which of the following statements is CORRECT? a. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. If a company's beta were cut in half, then its required rate of return would also be halved. c. 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. d. 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. e. If a company's beta doubles, then its required rate of return will also double.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM and required return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 92. 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. If a stock has a negative beta, its required return must also be negative. b. An index fund with beta = 1.0 should have a required return less than 11%. c. If a stock's beta doubles, its required return must also double. d. An index fund with beta = 1.0 should have a required return greater than 11%. e. An index fund with beta = 1.0 should have a required return of 11%.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM, beta, and req. return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 93. Which of the following statements is CORRECT? a. Lower beta stocks have higher required returns. b. A stock's beta indicates its diversifiable risk. c. Diversifiable risk cannot be completely diversified away. d. Two securities with the same stand-alone risk must have the same betas. e. The slope of the security market line is equal to the market risk premium.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 94. Which of the following statements is CORRECT? a. If the risk-free rate rises, then the market risk premium must also rise. b. If a company's beta is halved, then its required return will also be halved. c. If a company's beta doubles, then its required return will also double. d. The slope of the security market line is equal to the market risk premium, (rM − rRF). e. Beta is measured by the slope of the security market line.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 95. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. 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%. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.) a. Stock B has a higher required rate of return than Stock A. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

Portfolio P has a standard deviation of 22.5%.

More information is needed to determine the portfolio's beta.

Portfolio P has a beta of 1.0.

Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 96. Dixon Food's stock has a beta of 1.4, while Clark Café's 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 market risk premium increases but the risk-free rate remains unchanged, Dixon's required return will increase because it has a beta greater than 1.0 but Clark's required return will decline because it has a beta less than 1.0. b. Since Dixon's beta is twice that of Clark's, its required rate of return will also be twice that of Clark's. c. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase. d. If the market risk premium decreases but the risk-free rate remains unchanged, Dixon's required return will decrease because it has a beta greater than 1.0 and Clark's will also decrease, but by more than Dixon's because it has a beta less than 1.0. e. 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 Dixon since it has a higher beta.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 97. 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. Stock Y must have a higher expected return and a higher standard deviation than Stock X. b. If expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount. c. 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. d. 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. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 98. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur? a. The required return would decrease by the same amount for both Stock A and Stock B. b. The required return would increase for Stock A but decrease for Stock B. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. The required return on Portfolio P would remain unchanged. d. The required return would increase for Stock B but decrease for Stock A. e. The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A. ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 99. 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 both stocks would increase by 1%. b. The required return on Portfolio P would remain unchanged. c. The required return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%. d. The required return for Stock A would fall, but the required return for Stock B would increase. e. The required return on Portfolio P would increase by 1%.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 100. 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 increase. b. The return on "the market" will remain constant. c. The return on "the market" will increase. d. The required return on a stock with beta < 1.0 will decline. e. The required return on a stock with beta = 1.0 will not change.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 101. Which of the following statements is CORRECT? a. 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. b. 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. c. If investors become less risk averse, the slope of the Security Market Line will increase. d. If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock. e. The slope of the SML is determined by the value of beta.

ANS: B OBJ: LO: 6-7

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Risk and return

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 102. How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse? a. The x-axis intercept would decline, and the slope would increase. b. The y-axis intercept would increase, and the slope would decline. c. The SML would be affected only if betas changed. d. Both the y-axis intercept and the slope would increase, leading to higher required returns. e. The y-axis intercept would decline, and the slope would increase.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 103. 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 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. b. Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. c. 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. d. The required return of all stocks will fall by the amount of the decline in the market risk premium. e. The required return of all stocks will increase by the amount of the increase in the risk-free rate.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 104. Suppose that Federal Reserve actions have caused an increase in the risk-free rate, rRF. Meanwhile, investors are afraid of a recession, so the market risk premium, (rM − rRF), has increased. 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, but the increase would be greatest for stocks with betas of less than 1.0. b. Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices. c. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks. d. The prices of all stocks would increase, but the increase would be greatest for high-beta stocks. e. The required return on all stocks would increase by the same amount.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 105. Which of the following statements is CORRECT? a. The slope of the Security Market Line is beta. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive. c. If a stock's beta doubles, its required rate of return must also double. d. If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative. e. If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML, CAPM, and beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 106. 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 will decline for stocks whose betas are less than 1.0. b. The required rate of return on the market, rM, will not change as a result of these changes. c. 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 d. The required rate of return on a riskless bond will decline. e. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML and risk aversion KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 107. Which of the following statements is CORRECT? a. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt. b. If two "normal" or "typical" stocks were combined to form a 2-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. c. 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. d. 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. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML, CAPM, and port. risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 108. 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 past realized rate of return must be equal to the expected future rate of return; that is, . b. The required rate of return must equal the past realized rate of return; that is, r = . © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. The expected rate of return must be equal to the required rate of return; that is, = r. d. All of the above statements must hold for equilibrium to exist; that is = r = . e. None of the above statements is correct.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Market equilibrium KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 109. Which of the following statements is CORRECT? a. Portfolio diversification reduces the variability of returns on an individual stock. b. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events. c. 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. d. A stock with a beta of −1.0 has zero market risk if held in a 1-stock portfolio. e. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Risk concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 110. 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.

Given this information, which of the following statements is CORRECT? a. Company X has a lower coefficient of variation than Company Y. b. Company X has less market risk than Company Y. c. Company X's returns will be negative when Y's returns are positive. d. Company X's stock is a better buy than Company Y's stock. e. Company X has more diversifiable risk than Company Y. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Risk measures KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 111. 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. 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. b. Portfolio P has more market risk than Stock A but less market risk than B. c. Stock A should have a higher expected return than Stock B as viewed by the marginal investor. d. Portfolio P has a coefficient of variation equal to 2.5. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. Portfolio P has a standard deviation of 25% and a beta of 1.0.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 112. For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then a. the past realized return must be equal to the expected return during the same period. b. the required return must equal the realized return in all periods. c. the expected return must be equal to both the required future return and the past realized return. d. the expected future returns must be equal to the required return. e. the expected future return must be less than the most recent past realized return.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Market equilibrium KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

113. Which of the following are the factors for the Fama-French model? a. The excess market return, a debt factor, and a book-to-market factor. b. The excess market return, a size factor, and a debt. c. A debt factor, a size factor, and a book-to-market factor. d. The excess market return, an industrial production factor, and a book-to-market factor. e. The excess market return, a size factor, and a book-to-market factor.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-8 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Fama-French model KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 114. Gretta's 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. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT? a. The required return on the market is 10%. b. The portfolio's required return is less than 11%. c. If the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's required return will increase by more than 2%. d. If the market risk premium remains unchanged but expected inflation increases by 2%, Gretta's portfolio's required return will increase by more than 2%. e. If the stock market is efficient, Gretta's portfolio's expected return should equal the expected return on the market, which is 11%.

ANS: C c is correct. The portfolio's beta is 1.08. Therefore, if the market risk premium increases by 2.0% the portfolio's required return will increase by 2.16%.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Port. risk & ret. relationships KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

115. Assume that the market is in equilibrium and that Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. 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%. 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. Since the two stocks have zero correlation, Portfolio AB is riskless. b. Stock B's beta is 1.0000. c. Portfolio AB's required return is 11%. d. Portfolio AB's standard deviation is 25%. e. Stock A's beta is 0.8333.

ANS: E e is correct. Stock A's required return is 10% = 5% + b(6%), so b = 5%/6% = 0.83333.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Port. risk & ret. relationships KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 116. Portfolio AB was created by investing in a combination of Stocks A and B. 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%. 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 Stock B but less stand-alone risk. b. Portfolio AB has more money invested in Stock A than in Stock B. c. Portfolio AB has the same amount of money invested in each of the two stocks. d. Portfolio AB has more money invested in Stock B than in Stock A. e. Stock A has more market risk than Portfolio AB. ANS: B b is correct. Beta P = %A(1.2) + %B(1.4) = 1.25. If 50% is in each stock, then we would have Beta P = 0.5(1.2) + 0.5(1.4) = 1.3. But beta P < 1.3, so more money must be invested in the low beta stock, A. PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Port. risk & ret. relationships KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 117. Which of the following statements is CORRECT? a. 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 average-risk stock will not change. b. 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 1-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. c. There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML. d. 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. e. If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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.

ANS: D PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: SML KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 118. Freedman Flowers' stock has a 50% chance of producing a 25% 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? a. 9.41% b. 9.65% c. 9.90% d. 10.15% e. 10.40% ANS: C Conditions Good Average Poor

Prob.

0.50 0.30 0.20 1.00

Return 25.0% 10.0% −28.0%

Prob  Return 12.50% 3.00% −5.60% 9.90%

= Expected return

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-2 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Expected return KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 119. Bloome Co.'s stock has a 25% chance of producing a 30% 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? a. 7.72% b. 8.12% c. 8.55% d. 9.00% e. 9.50% ANS: D Conditions Good Average Poor

Prob.

0.25 0.50 0.25 1.00

Return 30.0% 12.0% −18.0%

Prob.  Return 7.50% 6.00% −4.50% 9.00%

= Expected return

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-2 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Expected return KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 120. Donald Gilmore has $100,000 invested in a 2-stock portfolio. $35,000 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? a. 0.65 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

0.72 0.80 0.89 0.98

ANS: E Company X Y

Investment $ 35,000 $ 65,000 $100,000

Weight 0.35 0.65 1.00

Beta 1.50 0.70

Weight  beta 0.53 0.46 0.98

= Portfolio beta

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 121. Shirley Paul's 2-stock portfolio has a total value of $100,000. $37,500 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 her portfolio's beta? a. 1.17 b. 1.23 c. 1.29 d. 1.35 e. 1.42 ANS: A Company Stock A Stock B

Investment $ 37,500 $ 62,500 $100,000

Port. weight 0.375 0.625 1.00

Beta 0.75 1.42

Weight  beta 0.28 0.89 1.17

= Portfolio beta

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 122. Ivan Knobel holds a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20.

He is in the process of buying 1,000 shares of Syngine Corp at $10 a share and adding it to his portfolio. Syngine has an expected return of 13.0% and a beta of 1.50. The total value of Ivan's current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Syngine stock? a. 10.64%; 1.17 b. 11.20%; 1.23 c. 11.76%; 1.29 d. 12.35%; 1.36 e. 12.97%; 1.42 ANS: B Old portfolio return Old portfolio beta New stock return New stock beta % of portfolio in new stock = $ in New/($ in Old + $ in New) =

11.0% 1.20 13.0% 1.50

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

$10,000/$100,000 = New expected portfolio return = rp = 0.1  13% + 0.9  11% = New expected portfolio beta = bp = 0.1  1.50 + 0.9  1.20 =

10% 11.20% 1.23

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 123. Calculate the required rate of return for Everest Expeditions 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 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. a. 10.29% b. 10.83% c. 11.40% d. 12.00% e. 12.60% ANS: D Real rate (r*): IP: RPM: Beta: Required return = rRF + b(RPM) = r* + IP + b(RPM) =

3.00% 4.00% 5.00% 1.00 12.00%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 124. Zacher Co.'s stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return? a. 11.36% b. 11.65% c. 11.95% d. 12.25% e. 12.55% ANS: C Beta Risk-free rate Market risk premium Required return

1.40 4.25% 5.50% 11.95%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 125. Nystrand Corporation's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium? a. 5.80% b. 5.95% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 6.09% d. 6.25% e. 6.40% ANS: A Use the SML to determine the market risk premium with the given data. rs 12.25% 7.25% 5.80%

= rRF + bStock  RPM = 5.00% + 1.25  RPM = RPM  1.25 = RPM

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Market risk premium KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 126. Martin Ortner 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 0.95 0.80 1.00 1.20

What is the portfolio's beta? a. 0.938 b. 0.988 c. 1.037 d. 1.089 e. 1.143 ANS: B Stock A B C D Total

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

Percentage 25.00% 25.00% 25.00% 25.00% 100.00%

Beta 0.95 0.80 1.00 1.20

Product 0.238 0.200 0.250 0.300 0.988

= Portfolio beta

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 127. Sherrie Hymes holds a $200,000 portfolio consisting of the following stocks. The portfolio's beta is 0.875.

Stock A B C D

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

Beta 0.50 0.80 1.00 1.20

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Total

$200,000

If Sherrie replaces Stock A with another stock, E, which has a beta of 1.50, what will the portfolio's new beta be? a. 1.07 b. 1.13 c. 1.18 d. 1.24 e. 1.30 ANS: B Stock A B C D E Total

Stock A B C D E Total

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

Original Portfolio Percentage Beta Product 25.00% 0.50 0.125 25.00% 0.80 0.200 25.00% 1.00 0.250 25.00% 1.20 0.300

$200,000

100.00%

0.875

New Portfolio Percentage Beta Product 25.00% 0.80 25.00% 1.00 25.00% 1.20 25.00% 1.50 New Portfolio beta =

0.200 0.250 0.300 0.375 1.125

Alternative solution: (bE − bA)(%A) + bOld = 1.125 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 128. Megan Ross 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

What is the portfolio's beta? a. 1.06 b. 1.17 c. 1.29 d. 1.42 e. 1.56 ANS: B Stock

Investment

Percentage

Beta

Product

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A B C D Total

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

40.00% 13.33% 26.67% 20.00% 100.00%

1.40 0.80 1.00 1.20

0.56 0.11 0.27 0.24 1.17

= Portfolio beta

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 129. Paul McLaren 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

Paul plans to sell Stock A and replace it with Stock E, which has a beta of 0.75. By how much will the portfolio beta change? a. −0.190 b. −0.211 c. −0.234 d. −0.260 e. −0.286 ANS: D Stock A B C D Total

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

Original Percentage Beta 40.00% 1.400 13.33% 0.800 26.67% 1.000 20.00% 1.200 100.00% Old b =

Product 0.560 0.107 0.267 0.240 1.173

Beta 0.750 0.800 1.000 1.200 New b =

New Product 0.300 0.107 0.267 0.240 0.913

Change in beta = New − Old = −0.260 Alternative solution: (bE − bA)  %A = −0.260 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 130. Jenna holds a diversified $100,000 portfolio consisting of 20 stocks with $5,000 invested in each. The portfolio's beta is 1.12. Jenna plans to sell a stock with b = 0.90 and use the proceeds to buy a new stock with b = 1.80. What will the portfolio's new beta be? a. 1.286 b. 1.255 c. 1.224 d. 1.194 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. 1.165 ANS: E % in each stock: Old stock's beta: New stock's beta: Old port. beta:

5% 0.90 1.80 1.12

New beta = (bNew − bOld)  %A + bOld = 1.165 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 131. Porter Plumbing's stock had a required return of 11.75% last year, when the risk-free rate was 5.50% 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.) a. 14.38% b. 14.74% c. 15.11% d. 15.49% e. 15.87% ANS: A Risk-free rate Old market risk premium Old required return b = (Old return − rRF)/Old RPM New market risk premium New required return = rRF + b(RPM) =

5.50% 4.75% 11.75% 1.32 6.75% 14.38%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 132. Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. 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.) a. 2.75% b. 2.89% c. 3.05% d. 3.21% e. 3.38% ANS: E Beta: A Beta: B Market return Risk-free rate Market risk premium Required return A = rRF + bA(RPM) =

0.70 1.20 11.00% 4.25% 6.75% 8.98%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Required return B = rRF + bB(RPM) = Difference

12.35% 3.38%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 133. Stock A's stock has a beta of 1.30, and its required return is 12.00%. Stock B's beta is 0.80. If the risk-free rate is 4.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.) a. 8.76% b. 8.98% c. 9.21% d. 9.44% e. 9.68% ANS: C Beta: A Beta: B A's required return Risk-free rate RPM = (A's return − rRF)/betaA = B's required return = rRF + b(RPM) =

1.30 0.80 12.00% 4.75% 5.58% 9.21%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 134. Barker Corp. has a beta of 1.10, 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 Barker's required rate of return? a. 9.43% b. 9.67% c. 9.92% d. 10.17% e. 10.42% ANS: D Real risk-free rate, r* Expected inflation, IP Market risk premium, RPM Beta, b Risk-free rate = r* + IP = Required return = rRF + b(RPM) =

2.00% 3.00% 4.70% 1.10 5.00% 10.17%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 135. Brodkey Shoes 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 13.00%. Based on the SML, what is the firm's required return? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

13.51% 13.86% 14.21% 14.58% 14.95%

ANS: E Use SML to determine the market risk premium. Note that rRF is based on T-bonds, not short-term T-bills. rs = rRF + RPM 13.00% = 6.50% + RPM 6.50% = RPM Use the SML to determine the firm's required return using the RPM calculated above. rs = rRF + RPM  b = 6.50% + 6.50%  1.30 = 14.95% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 136. Gardner Electric 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 12.50%.

Using the SML, what is the firm's required rate of return? a. 11.34% b. 11.63% c. 11.92% d. 12.22% e. 12.52% ANS: B Use SML to determine the market risk premium. Note that rRF is based on T-bonds, not short-term T-bills. Also, note that the dividend growth rate is not needed. rs = rRF + RPM 12.50% = 5.25% + RPM RPM = 7.25% Use SML to determine the firm's required return using RPM calculated above. rs = rRF + RPM  b = 5.25% + 7.25%  0.88 = 11.63% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

137. Consider the following information and then calculate the required rate of return for the Universal Investment Fund, which holds 4 stocks. The market's required rate of return is 13.25%, the risk-free rate is 7.00%, and the Fund's assets are as follows: Stock A B C D a. b. c. d. e.

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

Beta 1.50 −0.50 1.25 0.75

9.58% 10.09% 10.62% 11.18% 11.77%

ANS: E rM 13.25% rRF 7.00% Find portfolio beta: $ 200,000 $ 300,000 $ 500,000 $1,000,000 $2,000,000

Weight 0.100 0.150 0.250 0.500 1.000

Beta 1.50 −0.50 1.25 0.75

Product 0.1500 −0.0750 0.3125 0.3750 0.7625

= portfolio beta

Find RPM = rM − rRF = 6.25% rs = rRF + b(RPM) = 11.77% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 138. Data for Atwill Corporation is shown below. Now Atwill acquires some risky assets that cause its beta to increase by 30%. In addition, expected inflation increases by 2.00%. What is the stock's new required rate of return?

Initial beta Initial required return (rs) Market risk premium, RPM Percentage increase in beta Increase in inflation premium, IP a. b. c. d. e.

1.00 10.20% 6.00% 30.00% 2.00%

14.00% 14.70% 15.44% 16.21% 17.02%

ANS: A Old beta

1.00

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Old rs = rRF + b(RPM) RPM Percentage increase in beta Increase in IP Find new beta after increase = Find old rRF: Old rs = rRF+ b(RPM): 10.2% = rRF + 1.0(6.0%): rRF = 10.2% − 6.0% = Find new rRF: Old rRF + increase in IP = Find new rs = new rRF + new beta(RPM)

10.20% 6.00% 30.00% 2.00% 1.30 4.20% 4.20% 6.20% 14.00%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 139. Fiske Roofing Supplies' stock has a beta of 1.23, its required return is 11.75%, and the risk-free rate is 4.30%. What is the required rate of return on the market? (Hint: First find the market risk premium.) a. 10.36% b. 10.62% c. 10.88% d. 11.15% e. 11.43% ANS: A Beta Risk-free rate Required return on stock RPM = (rStock − rRF)/beta Required return on market = rRF + RPM =

1.23 4.30% 11.75% 6.06% 10.36%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Return on the market KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 140. Suppose Stan holds a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose Stan decided to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be? a. 1.17 b. 1.23 c. 1.29 d. 1.36 e. 1.43 ANS: C Number of stocks Percent in each stock = 1/number of stocks = Portfolio beta Stock that's sold Stock that's bought Change in portfolio's beta = 0.125  (b2 − b1) = New portfolio beta

8 12.500% 1.25 1.00 1.35 0.0438 1.29

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 141. Returns for the Alcoff 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.)

Year 2010 2009 2008 a. b. c. d. e.

Return 21.00% −12.50% 25.00%

20.08% 20.59% 21.11% 21.64% 22.18%

ANS: B This is a relatively technical problem. It should be used only if calculations are emphasized in class or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions.

Year 2010 2009 2008 Expected return SQRT =  = 20.59%

Return 21.00% −12.50% 25.00% 11.17%

Deviation from Mean 9.83% −23.67% 13.83%

Squared Deviation 0.97% 5.60% 1.91% 8.48% 4.24% 20.59% with Excel

Sum sqd deviations Sum/(N − 1)

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-4 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Std. dev., historical returns KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 142. Stuart Company'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.)

Economic Conditions Strong Normal Weak a. b. c. d.

Prob.

30% 40% 30%

Return 32.0% 10.0% −16.0%

17.69% 18.62% 19.55% 20.52%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. 21.55% ANS: B This is a relatively technical problem. It should be used only if calculations are emphasized in class, or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions.

Economic Conditions Strong Normal Weak  = Sqrt of variance

Prob.

30% 40% 30% 100%

Return This state 32.0% 10.0% −16.0% 8.8% 18.62%

Dev. from Mean 23.20% 1.20% −24.80%

Squared Dev. 10.24% 0.01% 6.15% Variance 18.62% by Excel

Sqd. dev.  Prob 3.07% 0.01% 1.85% 4.92%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-2 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Std. dev., prob. data KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 143. Assume that your cousin holds just one stock, Eastman Chemical Bonding (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 Wilder's Creations and Buildings (WCB). Both companies 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 cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.)

Year 2007 2008 2009 2010 2011 Average return = Standard deviation = a. b. c. d. e.

ECB 40.00% −10.00% 35.00% −5.00% 15.00%

WCB 40.00% 15.00% −5.00% −10.00% 35.00%

15.00% 22.64%

15.00% 22.64%

3.29% 3.46% 3.65% 3.84% 4.03%

ANS: D This is a relatively technical problem. It should be used only if calculations are emphasized in class or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions. % ECB: 60%

Year 2007 2008 2009 2010

ECB 40.00% −10.00% 35.00% −5.00%

WCB 40.00% 15.00% −5.00% −10.00%

Portfolio ECB/WCB 40.00% 0.00% 19.00% −7.00%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2011 Average return = Standard deviation = Reduction in the SD vs. ECB's SD:

15.00%

35.00%

23.00%

15.00% 22.64%

15.00% 22.64%

15.00% 18.80%

3.84%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-4 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio risk reduction KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 144. The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50% required return. The risk-free rate is 4.20%. Henry now receives another $5.00 million, which he invests in stocks with an average beta of 0.65. What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then find the new portfolio beta.) a. 8.83% b. 9.05% c. 9.27% d. 9.51% e. 9.74% ANS: A

Old funds (millions) New funds (millions) Total portfolio Req'd return, old stocks Risk-free rate Market risk premium: rP = rRF + b(RPM) >> 9.5% = 4.2% + 1.05(RPM) RPM = (9.5% − 4.2%)/1.05 = 5.05% New portfolio: Old portfolio's beta New stocks' beta New portfolio beta New portfolio required return = rRF + New beta(RPM) =

$10.00 $5.00 $15.00 9.50% 4.20%

% of New Port.

66.67% 33.33% 100.00%

5.30%

1.05 0.65 0.9167 8.8270%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 145. Hazel Morrison, a mutual fund manager, has a $40 million portfolio with a beta of 1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%. Hazel expects to receive an additional $60 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? a. 1.68 b. 1.76 c. 1.85 d. 1.94 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. 2.04 ANS: B Old funds (millions) New funds (millions) Total new funds

$ 40.00 $ 60.00 $100.00

Beta on existing portfolio Risk-free rate Market risk premium Desired required return Required new bp Required beta, new stocks

40.00% 60.00% 100.00%

1.00 4.25% 6.00% 13.00% 13% = rRF + b(RPM); b = (13% − rRF)/RPM 1.4583 beta = (Return − Risk-free)/RPM 1.76 Req. b = (Old$/Total$)  Old b + (New$/Total$)  New b

Beta on new stocks = (Req. b − (Old$/Total$)  Old b)/(New$/Total$) PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Portfolio beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 146. Joel Foster is 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 5.00%.

What rate of return should investors expect (and require) on this fund?

Stock A B C D

a. b. c. d. e.

Amount $1,075,000 675,000 750,000 500,000 $3,000,000

Beta 1.20 0.50 1.40 0.75

10.56% 10.83% 11.11% 11.38% 11.67%

ANS: C Company Stock A Stock B Stock C Stock D

Amount $1,075,000 675,000 750,000 500,000 $3,000,000

Weight 0.358 0.225 0.250 0.167 1.000

Beta 1.20 0.50 1.40 0.75 bPortfolio =

Required market return Risk free rate Market risk premium = rMarket − rRF =

11.00% 5.00% 6.00%

Portfolio's required return = rRF + b(RPM) =

11.11%

PTS: 1

DIF: Difficulty: Challenging

Wt  beta 0.43 0.11 0.35 0.13 1.02

Intermediate step

OBJ: LO: 6-7

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Port. beta and req. ret. KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 147. DHF Company 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 30.0% (not percentage points). Neither betas nor the risk-free rate change.

What would DHF's new required return be? a. 14.89% b. 15.68% c. 16.50% d. 17.33% e. 18.19% ANS: C This problem requires some algebra: CCC's beta CCC's initial required return Percentage increase in required market return Initial required return on the market New required return on the market

1.50 12.00% 30.0% 10.00% 13.00%

Now for the algebra: rStock = rRF + b(RPM) = rRF + 1.5(RPM) rMarket = rRF + b(RPM) = rRF + 1.0(RPM) Now insert known data and transpose: 12% = rRF + 1.5(RPM) >> 12% − rRF = 1.5(RPM) 10% = rRF + (RPM) >> 10% − rRF = 1.0(RPM) Now subtract the second equation from the first. rRF and one of the RPMs cancel, leaving: 2% = 0.5(RPM) Now solve for RPM: RPM = 2%/0.5 4.00% 6.00% Now find the risk-free rate: rRF = Initial rMarket − RPM = 10% − 4% = 7.00% New RPM = New required return on the market − rRF Now find the new return on CCC = rRF + b(new RPM) = 16.50% PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 6-7 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: CAPM: required rate of return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 7—VALUATION OF STOCKS AND CORPORATIONS 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.

ANS: T OBJ: LO: 7-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Proxy KEY: Bloom’s: Knowledge

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.

ANS: T OBJ: LO: 7-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Preemptive right KEY: Bloom’s: Knowledge

3. If a firm's stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight.

ANS: F OBJ: LO: 7-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Preemptive right KEY: Bloom’s: Knowledge

4. Classified stock differentiates various classes of common stock, and using it 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.

ANS: T OBJ: LO: 7-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Classified stock KEY: Bloom’s: Knowledge

5. Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock.

ANS: T OBJ: LO: 7-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Founders' shares KEY: Bloom’s: Knowledge

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.

ANS: F OBJ: LO: 7-4 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Total stock returns KEY: Bloom’s: Knowledge

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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T OBJ: LO: 7-4 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Common stock cash flows KEY: Bloom’s: Knowledge

8. According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock.

ANS: F OBJ: LO: 7-4 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Value: investment horizon KEY: Bloom’s: Knowledge

9. When a new issue of stock is brought to market, it is the marginal investor who determines the price at which the stock will trade.

ANS: T OBJ: LO: 7-4 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Marginal investor and price KEY: Bloom’s: Knowledge

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.

ANS: T OBJ: LO: 7-5 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Constant growth model KEY: Bloom’s: Knowledge

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.

ANS: T OBJ: LO: 7-6 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Nonconstant growth model KEY: Bloom’s: Knowledge

12. Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

ANS: T OBJ: LO: 7-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Free cash flows and valuation KEY: Bloom’s: Knowledge

13. The corporate valuation model cannot be used unless a company doesn't pay dividends.

ANS: F OBJ: LO: 7-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Corporate valuation model KEY: Bloom’s: Knowledge

14. Free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

ANS: T OBJ: LO: 7-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Free cash flows and valuation KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Preferred stock is a hybrid⎯a sort of 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.

ANS: F Preferred dividends don't normally grow, and they are not guaranteed.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds LOC: TBA TOP: Preferred stock KEY: Bloom’s: Knowledge 16. From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer's standpoint, these risk relationships are reversed: Bonds are the most risky for the firm, preferred is next, and common is least risky.

ANS: T OBJ: LO: 7-9 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Stocks and bonds TOP: Preferred stock KEY: Bloom’s: Knowledge

MULTIPLE CHOICE 17. Which of the following statements is CORRECT? a. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. b. 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. c. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. d. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time. e. 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.

ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth model KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

18. If a firm's expected growth rate increased then its required rate of return would a. decrease. b. fluctuate less than before. c. fluctuate more than before. d. possibly increase, possibly decrease, or possibly remain constant. e. increase.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Required return KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that you think a. the stock should be sold. b. the stock is a good buy. c. management is probably not trying to maximize the price per share. d. dividends are not likely to be declared. e. the stock is experiencing supernormal growth.

ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Required return KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

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

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-1 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Preemptive right KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

21. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks, regardless of class, must have the same voting rights. b. All firms have several classes of common stock. c. All common stock, regardless of class, must pay the same dividend. d. Some class or classes of common stock are entitled to more votes per share than other classes. e. All common stocks fall into one of three classes: A, B, and C. ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-2 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Classified stock KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

22. Which of the following statements is CORRECT? a. Two firms with the same expected dividend and growth rates must also have the same stock price. b. 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. c. 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%, this implies that the stock's dividend yield is also 5%. 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 takes into consideration the capital gains investors expect to earn on a stock. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: E Statement e is true, because the expected growth rate is also the expected capital gains yield. All the other statements are false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth model KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

23. 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%, which of the following statements is CORRECT? a. The company's dividend yield 5 years from now is expected to be 10%. b. The constant growth model cannot be used because the growth rate is negative. c. The company's expected capital gains yield is 5%. d. The company's expected stock price at the beginning of next year is $9.50. e. The company's current stock price is $20.

ANS: D Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so P1 must be $10(0.95) = $9.50. Therefore, answer d is correct, while the others are all false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Declining constant growth KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

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

ANS: D Statement d is true, because the stock price is expected to grow at the dividend growth rate.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth stock KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

25. 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%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

These two stocks must have the same dividend yield.

These two stocks should have the same expected return.

These two stocks must have the same expected capital gains yield.

These two stocks must have the same expected year-end dividend.

These two stocks should have the same price.

ANS: A The following calculations show that answer a is correct. The others are all wrong.

Expected return Expected growth Dividend yield

A 10% 7% 3%

B 12% 9% 3%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected and required returns KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

26. 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. b. c. d. e.

A $25 7% 10%

B $40 9% 12%

The two stocks could not be in equilibrium with the numbers given in the question.

A's expected dividend is $0.50.

B's expected dividend is $0.75.

A's expected dividend is $0.75 and B's expected dividend is $1.20.

The two stocks should have the same expected dividend.

ANS: D The following calculations show that answer d is correct. The others are all wrong.

Price Expected growth Expected return

A $25 7% 10%

B $40 9% 12%

A = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $0.75 B = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $1.20 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected and required returns KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

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? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Price Expected growth (constant) Required return

A $25 10% 15%

B $25 5% 15%

a. Stock A has a higher dividend yield than Stock B. b. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. c. 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. d. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist. e. Stock A's expected dividend at t = 1 is only half that of Stock B. ANS: E Statement e is correct, because if both stocks have the same price and the same required return, and A's growth rate is twice that of B, then A's dividend and dividend yield must be half that of B. This point is illustrated with the following example.

Price g r Div. Yield = r − g = D1 = P(Div Yield) =

A $25 10% 15% 5% $1.25

B $25 5% 15% 10% $2.50

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected and required returns KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

28. 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?

Price Expected growth (constant) Required return a. b. c. d. e.

X $30 6% 12%

Y $30 4% 10%

Stock Y has a higher dividend yield than Stock X. One year from now, Stock X's price is expected to be higher than Stock Y's price.

Stock X has the higher expected year-end dividend.

Stock Y has a higher capital gains yield.

Stock X has a higher dividend yield than Stock Y.

ANS: B The correct answer is statement b. Both prices are currently the same, but X's price should grow at 6% vs. 4% for Y, so X's price should be higher a year from now.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected and required returns KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NOT: Question may require calculations to find the correct answer.

29. 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 a. b. c. d. e.

$3.00 $50 6.0%

The stock's expected dividend yield and growth rate are equal.

The stock's expected dividend yield is 5%.

The stock's expected capital gains yield is 5%.

The stock's expected price 10 years from now is $100.00.

The stock's required return is 10%.

ANS: A The correct answer choice is a. One could quickly calculate the dividend yield and see that it equals the growth rate, but here are some numbers that provide more information.

D1 P0 g

$3.00 D1/P0 $50.00 rX 6.0%

6.0% 12.0%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected and required returns KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

30. 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?

Price Expected dividend yield Required return a. b. c. d. e.

X $25 5% 12%

Y $25 3% 10%

Stock X pays a higher dividend per share than Stock Y. One year from now, Stock X should have the higher price.

Stock Y has a lower expected growth rate than Stock X. Stock Y has the higher expected capital gains yield.

Stock Y pays a higher dividend per share than Stock X.

ANS: A Dividend = Yield  Price:

X dividend = $1.25

Y dividend = $0.75

Stock X has a dividend yield of 5% versus a yield of 3% for Y. Since they both have the same stock price, X must pay a higher dividend.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected and required returns KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

31. Merrell Enterprises' stock has an expected return of 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 8%. b. The current dividend per share is $4.00. c. The stock price is expected to be $54 a share one year from now. d. The stock price is expected to be $57 a share one year from now. e. The stock's dividend yield is 7%.

ANS: C P1 = P0(1 + g) = $54. Therefore, c is correct. All the other answers are false. P1 = $54.00.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected and required returns KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

32. 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. Stock B must have a higher dividend yield than Stock A. b. Stock A must have a higher dividend yield than Stock B. c. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B's. d. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. e. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's.

ANS: E Statement e is true, because if the required return for Stock A is higher than that of Stock B, and if the dividend yield for Stock A is lower than Stock B's, the growth rate for Stock A must be higher to offset this.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Dividend yield and g KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

33. 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. If one stock has a higher dividend yield, it must also have a lower dividend growth rate. b. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. c. The two stocks must have the same dividend growth rate. d. The two stocks must have the same dividend yield. e. The two stocks must have the same dividend per share.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Dividend yield and g KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Dividend yield and g KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

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

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 36. Which of the following statements is CORRECT? a. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock. b. Corporations cannot buy the preferred stocks of other corporations. c. Preferred dividends are not generally cumulative. d. A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing corporation. e. Preferred stockholders have a priority over bondholders in the event of bankruptcy to the income, but not to the proceeds in a liquidation.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-9 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Preferred stock concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

37. Which of the following statements is CORRECT? a. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm's common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock. b. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free. d. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer. e. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-9 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Preferred stock concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

38. Which of the following statements is CORRECT? a. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. b. 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. c. The stock valuation model, P0 = D1/(rs − g), cannot be used for firms that have negative growth rates. d. The stock valuation model, P0 = D1/(rs − g), can be used only for firms whose growth rates exceed their required returns. e. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights.

ANS: B Statement a is simply false. Statement b is true. Statements c and d are false, because the constant growth model can be used anytime as long as the constant growth rate is less than the required return (even if the growth rate is negative). Statement e is false⎯a number of companies have different classes of stock with different voting rights.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Common stock concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

39. The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is CORRECT? a. 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. b. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price. c. The stocks must sell for the same price. d. Stock Y must have a higher dividend yield than Stock X. e. 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.

ANS: E Since X has the lower required return, if Y has a lower dividend yield it must have a higher expected growth rate. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Common stock concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

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? A 1.10 7.00%

Beta Constant growth rate a. b. c. d. e.

B 0.90 7.00%

Stock A must have a higher dividend yield than Stock B. Stock B's dividend yield equals its expected dividend growth rate.

Stock B must have the higher required return.

Stock B could have the higher expected return.

Stock A must have a higher stock price than Stock B.

ANS: A Statement a is true, because Stock A has a higher required return but the stocks have the same growth rate, so Stock A must have the higher dividend yield. Here are some calculations to demonstrate the point.

A B

rRF 6.40% 6.40%

A B

Div. Yld. D1/P0 D1/P0

+ +

beta 1.10 0.90

+ +

g 7.00% 7.00%

 

RPM 6.00% 6.00%

rStock 13.00% 11.80%

= =

= =

rStock 13.00% 11.80%

D1/P0 = r − g = 6.00% D1/P0 = r − g = 4.80%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth model: CAPM KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual NOT: Question may require calculations to find the correct answer.

41. 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 = 6.4%. What is the stock's current price? a. $17.39 b. $17.84 c. $18.29 d. $18.75 e. $19.22 ANS: C D1 rs g P0 = D1/(rs − g)

$0.75 10.5% 6.4% $18.29

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth valuation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 42. A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth rate is g = 4.0%. What is the current stock price? a. $23.11 b. $23.70 c. $24.31 d. $24.93 e. $25.57 ANS: E D0 rs g D1 = D0(1 + g) = P0 = D1/(rs − g)

$1.50 10.1% 4.0% $1.56 $25.57

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth valuation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 43. A share of Lash Inc.'s 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 11.4%, what is the stock price? a. $16.28 b. $16.70 c. $17.13 d. $17.57 e. $18.01 ANS: D Last dividend (D0) Long-run growth rate Required return D1 = D0(1 + g) = P0 = D1/(rs − g)

$1.00 5.4% 11.4% $1.054 $17.57

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth valuation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 44. Franklin Corporation is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $32.50 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. 6.01% b. 6.17% c. 6.33% d. 6.49% e. 6.65% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: E Expected dividend (D1) Stock price Required return Dividend yield Growth rate = rs − D1/P0 =

$1.25 $32.50 10.5% 3.85% 6.65%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth rate KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 45. $35.50 per share is the current price for Foster Farms' stock. The dividend is projected to increase at a constant rate 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. $37.86 b. $38.83 c. $39.83 d. $40.85 e. $41.69 ANS: E Stock price Growth rate Years in the future P3 = P0(1 + g)3 =

$35.50 5.50% 3 $41.69

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth: future price KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 46. Kelly Enterprises' stock currently sells for $35.25 per share. The dividend is projected to increase at a constant rate of 4.75% 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. $40.17 b. $41.20 c. $42.26 d. $43.34 e. $44.46 ANS: E Growth rate Years in the future Stock price P5 = P0(1 + g)5 =

4.75% 5 $35.25 $44.46

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth: future price KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 47. If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $26.00, what is the stock's expected dividend yield for the coming year? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

4.12% 4.34% 4.57% 4.81% 5.05%

ANS: D D1 g P0 Dividend yield = D1/P0 =

$1.25 4.7% $26.00 4.81%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected dividend yield KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 48. If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the stock's expected dividend yield for the coming year? a. 4.42% b. 4.66% c. 4.89% d. 5.13% e. 5.39% ANS: B D0 g P0 D1 = D0(1 + g) = Dividend yield = D1/P0 =

$2.25 3.5% $50.00 $2.329 4.66%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected dividend yield KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 49. If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock's expected capital gains yield for the coming year? a. 6.50% b. 6.83% c. 7.17% d. 7.52% e. 7.90% ANS: A D1 g P0 Capital gains yield = g =

$1.50 6.5% $56.00 6.50%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected cap. gains yield KEY: Bloom’s: Application © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 50. If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock's expected total return for the coming year? a. 7.54% b. 7.73% c. 7.93% d. 8.13% e. 8.34% ANS: E D1 g P0 Total return = rs = D1/P0 + g

$1.25 5.5% $44.00 8.34%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected total return KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 51. If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the stock's expected total return for the coming year? a. 8.37% b. 8.59% c. 8.81% d. 9.03% e. 9.27% ANS: E D0 g P0 D1 = D0(1 + g) = Total return = rs = D1/P0 + g

$1.75 3.6% $32.00 $1.81 9.27%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Expected total return KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 52. Barnette Inc.'s free cash flows are expected to be unstable during the next few years while the company undergoes restructuring. However, FCF is expected to be $50 million in Year 5, i.e., FCF at t = 5 equals $50 million, and the FCF growth rate is expected to be constant at 6% beyond that point. If the weighted average cost of capital is 12%, what is the horizon value (in millions) at t = 5? a. $719 b. $757 c. $797 d. $839 e. $883 ANS: E FCF5: g:

$50 6%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

WACC: HV5

12%

= FCF6/(WACC − g) = FCF5(1 + g)/(WACC − g) = $50(1 + 0.06)/(0.12 − 0.06) = $53/0.06 = $883

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model, horizon value KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 53. Gere Furniture forecasts a free cash flow of $40 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5% thereafter. If the weighted average cost of capital is 10% and the cost of equity is 15%, what is the horizon value, in millions at t = 3? a. $840 b. $882 c. $926 d. $972 e. $1,021 ANS: A FCF3: g: WACC: HV3

$40 5% 10%

= FCF4/(WACC − g) = FCF3(1 + g)/(WACC − g) = $40(1 + 0.05)/(0.10 − 0.05) = $42/0.05 = $840

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model, horizon value KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 54. Young & Liu Inc.'s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm's value of operations, in millions? a. $948 b. $998 c. $1,050 d. $1,103 e. $1,158 ANS: C FCF0: g: WACC: Value Ops

$100 5% 15% = FCF1/(WACC − g) = FCF0(1 + g)/(WACC − g) = $100(1 + 0.05)/(0.15 − 0.05) = $105/0.1 = $1,050

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: Corporate valuation model, value of operations KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 55. The projected cash flow for the next year for Minesuah Inc. is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company's weighted average cost of capital is 11%, what is the value of its operations? a. $1,714,750 b. $1,805,000 c. $1,900,000 d. $2,000,000 e. $2,100,000 ANS: D FCF1: g: WACC: Value Ops

$100,000 6% 11% = FCF1/(WACC − g) = FCF0(1 + g)/(WACC − g) = $100,000/(0.11 − 0.06) = $100,000/0.05 = $2,000,000

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model, value of operations KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 56. Carby Hardware 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%, at what price should the preferred stock sell? a. $104.27 b. $106.95 c. $109.69 d. $112.50 e. $115.38 ANS: E Preferred dividend Required return Preferred price = DP/rP =

$7.50 6.5% $115.38

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 7-9 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Preferred stock valuation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 57. Dyer Furniture 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 1.15, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is Dyer's current stock price? a. $28.90 b. $29.62 c. $30.36 d. $31.12 e. $31.90 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: A D1 b rRF RPM g rs = rRF + b(RPM) = P0 = D1/(rs − g)

$1.25 1.15 4.00% 5.50% 6.00% 10.33% $28.90

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant g value: CAPM KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 58. The Jameson 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 1.15, the market risk premium is 5.00%, and the risk-free rate is 4.00%. What is Jameson's current stock price, P0? a. $18.62 b. $19.08 c. $19.56 d. $20.05 e. $20.55 ANS: A D0 b rRF RPM g D1 = D0(1 + g) = rs = rRF + b(RPM) = P0 = D1/(rs − g)

$0.75 1.15 4.0% 5.0% 5.5% $0.7913 9.75% $18.62

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant g value: CAPM KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 59. National Advertising 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 1.25, 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? a. $14.52 b. $14.89 c. $15.26 d. $15.64 e. $16.03 ANS: A D0 b rRF rM g

$0.75 1.25 4.5% 10.5% 6.5%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

D1 = D0(1 + g) = rs = rRF + b(rM − RRF) = P0 = D1/(rs − g)

$0.7988 12.0% $14.52

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant g value: CAPM KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 60. Kellner Motor Co.'s stock has a required rate of return of 11.50%, and it sells for $25.00 per share.

Kellner's dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D0? a. $0.95 b. $1.05 c. $1.16 d. $1.27 e. $1.40 ANS: B Stock price Required return Growth rate P0 = D1/(rs − g), so D1 = P0(rs − g) = Last dividend = D0 = D1/(1 + g)

$25.00 11.50% 7.00% $1.1250 $1.05

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth dividend KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 61. Hirshfeld Corporation's stock has a required rate of return of 10.25%, and it sells for $57.50 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. $2.20 b. $2.44 c. $2.69 d. $2.96 e. $3.25 ANS: B Stock price Required return Growth rate P0 = D1/(rs − g), so D1 = P0(rs − g) Expected dividend = D1 = P0(rs − g) =

$57.50 10.25% 6.00% $2.44

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth dividend KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 62. Connolly Co.'s expected year-end dividend is D1 = $1.60, 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 Connolly's expected stock price in 7 years, i.e., what is ? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

$37.52 $39.40 $41.37 $43.44 $45.61

ANS: A Next expected dividend = D1 = Required return Dividend yield = D1/P0 = Find the growth rate: g = rs − yield = Find P0 = D1/(rs − g) = Years in the future = P0(1 + g)7

$1.60 11.0% 6.0% 5.0% $26.67 7 $37.52

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-5 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Constant growth: future price KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 63. Alcott's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return? a. 8.03% b. 8.24% c. 8.45% d. 8.67% e. 8.89% ANS: E Pref. quarterly dividend Annual dividend = Qtrly dividend  4 = Preferred stock price Nom. required return = Annual dividend/Price =

$1.00 $4.00 $45.00 8.89%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-9 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Preferred required return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 64. Connor Publishing's preferred stock pays a dividend of $1.00 per quarter, and it sells for $55.00 per share. What is its effective annual (not nominal) rate of return? a. 6.62% b. 6.82% c. 7.03% d. 7.25% e. 7.47% ANS: E Periods per year = Pref. quarterly dividend Preferred stock price Eff % required return = (1+ (Qt Div/P))N − 1 = PTS: 1

DIF: Difficulty: Moderate

4 $1.00 $55.00 7.47% OBJ: LO: 7-9

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Preferred required return KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 65. Burke Tires just paid a dividend of D0 = $1.32. 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? a. $41.59 b. $42.65 c. $43.75 d. $44.87 e. $45.99 ANS: D rs = 9.0% Year Growth rates: Dividend Terminal value = D3/(rs − g3) = Total CFs PV of CFs

0 $1.32

1 30.0% $1.716 $1.716 $1.574

2 10.0% $1.888 49.550 $51.437 $43.294

3 5.0% $1.982

Stock price = $44.87 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Nonconstant growth valuation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 66. Kinkead Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be −$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14%, what is the firm's value of operations, in millions? a. $158 b. $167 c. $175 d. $184 e. $193 ANS: B FCF1: FCF2: g: WACC:

−$10 $20 4% 14%

First, find the horizon, or terminal, value: HV2 = FCF2(1 + g)/(WACC − g) = $20(1.04)/(0.14 − 0.04) = $20.8/0.10 = $208.00 Then find the PV of the free cash flows and the horizon value: Value of operations = −$10/(1.14)1 + ($20 + $208)/(1.14)2 = −$8.772 + $175.439 = $167 PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic

OBJ: LO: 7-7

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model, value of operations KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 67. The free cash flows (in millions) shown below are forecast by Parker & Sons. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments).

Year: Free cash flow: a. b. c. d. e.

1 −$50

2 $100

$1,456 $1,529 $1,606 $1,686 $1,770

ANS: A FCF1: FCF2: g: WACC:

−$50 $100 5% 11%

First, find the horizon, or terminal, value: HV2 = FCF2(1 + g)/(WACC − g) = $100(1.05)/(0.11 − 0.05) = $1,750.00 Then find the PV of the free cash flows and the horizon value: Value of operations = −$50/(1.11) + ($100 + $1,750)/(1.11)2 = $1,456 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model, value of operations KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 68. Heath and Logan Inc. forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13%, and the FCFs are expected to continue growing at a 5% rate after Year 3.

Assuming that the ROIC is expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions?

Year: Free cash flow: a. b. c. d. e.

1 −$15

2 $10

3 $40

$315 $331 $348 $367 $386

ANS: E Year: FCF:

1 −$15

2 $10

3 $40

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

g: WACC:

5% 13%

First, find the horizon, or terminal, value: HV4 = FCF3(1 + g)/(WACC − g) = $40(1.05)/(0.13 − 0.05) = $525 Then find the PV of the free cash flows and the horizon value: Value of operations = −$15/(1.13) + $10/(1.13)2 + ($40 + $525)/(1.13)3 = $386 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model, value of operations KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 69. Reynolds Construction's value of operations is $750 million based on the corporate valuation model.

Its balance sheet shows $50 million of short-term investments that are unrelated to operations, $100 million of accounts payable, $100 million of notes payable, $200 million of long-term debt, $40 million of common stock (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. $429 b. $451 c. $475 d. $500 e. $525 ANS: D Value of operations: Short-term investments: Notes payable: Long-term debt:

$750 $50 $100 $200

Assuming that the book value of debt is close to its market value, the total market value of the company is: Total market value = Value of operations + Value of non-operating assets = $750 + $50 = $800.

Value of Equity

= Total MV − Long- and Short-term debt = $500.

The book value of equity figures are irrelevant for this problem. Also, the accounts payable are not relevant because they were netted out when the FCF was calculated.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model, value of equity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

70. Based on the corporate valuation model, the value of Weidner Co.'s operations is $1,200 million. The company's balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180 million in retained earnings, and $800 million in total common equity.

If Weidner has 30 million shares of stock outstanding, what is the best estimate of the stock's price per share? a. $24.90 b. $27.67 c. $30.43 d. $33.48 e. $36.82 ANS: B Value of operations: Short-term investments: Notes payable: Long-term debt: Preferred stock Shares outstanding:

$1,200 $100 $120 $300 $50 30

Assuming that the book value of debt is close to its market value, the total market value of the company is: Total market value = Value of operations + Value of non-operating assets = $1,200 + $100 = $1,300.

Value of Equity Stock price

= Total MV − Long- and Short-term debt and preferred = $830 = Value of Equity/Shares outstanding = $27.67

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 71. The value of Broadway-Brooks Inc.'s operations is $900 million, based on the corporate valuation model. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stock's price per share? a. $23.00 b. $25.56 c. $28.40 d. $31.24 e. $34.36 ANS: C Value of operations: Short-term investments: Notes payable:

$900 $30 $110

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Long-term debt: Preferred stock Shares outstanding:

$90 $20 25

Assuming that the book value of debt is close to its market value, the total market value of the company is: Total market value = Value of operations + Value of non-operating assets = $900 + $30 = $930.

Value of Equity Stock price

= Total MV − Long- and Short-term debt and preferred = $710 = Value of Equity/Shares outstanding = $28.40

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 72. Based on the corporate valuation model, Bizzaro Co.'s value of operations is $300 million. The balance sheet shows $20 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. Bizzaro has 10 million shares of stock outstanding. What is the best estimate of the stock's price per share? a. $13.72 b. $14.44 c. $15.20 d. $16.00 e. $16.80 ANS: D Value of operations: Short-term investments: Notes payable: Long-term debt: Preferred stock Shares outstanding:

$300 $20 $90 $30 $40 10

Assuming that the book value of debt is close to its market value, the total market value of the company is: Total market value = Value of operations + Value of non-operating assets = $300 + $20 = $320.

Value of Equity Stock price

= Total MV − Long- and Short-term debt and preferred = $160 = Value of Equity/Shares outstanding = $16.00

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

KEY: Bloom’s: Analysis

LOC: TBA TOP: Corporate valuation model MSC: TYPE: Multiple Choice: Problem

73. McGaha Enterprises expects earnings and dividends to grow at a rate of 25% for the next 4 years, after the growth rate in earnings and dividends will fall 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? a. $26.77 b. $27.89 c. $29.05 d. $30.21 e. $31.42 ANS: C Last dividend (D0) Short-run growth rate Long-run growth rate Beta Market risk premium Risk-free rate Required return = rs = rRF + b(RPM) = Year

0

Dividend $1.2500 Terminal value = D5/(rs − g5) = Total CFs PV of the CFs

$1.25 25% 0% 1.20 5.50% 3.00% 9.60%

1 25% $1.5625

2 25% $1.9531

3 25% $2.4414

$1.5625 $1.4256

$1.9531 $1.6260

$2.4414 $1.8544

4 25% $3.0518 31.7891 $34.8409 $24.1461

5 0% $3.0518

Price = Sum of PVs = $29.05 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 7-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Nonconstant growth valuation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 74. Orwell Building Supplies' last dividend was $1.75. Its dividend growth rate is expected to be constant at 25% 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? a. $41.58 b. $42.64 c. $43.71 d. $44.80 e. $45.92 ANS: B Last dividend (D0) Short-run growth rate Long-run growth rate Required return Year Dividend

$1.75 25% 6% 12% 0 $1.7500

1 25.00% $2.1875

2 25.00% $2.7344

3 6.00% $2.8984

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Terminal value = D3/(rs − g3) = Total CFs PV of CFs

$2.1875 $1.9531

48.3073 $51.0417 $40.6901

Price = Sum of PVs = $42.64 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 7-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Nonconstant growth valuation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 75. The last dividend paid by Wilden Corporation was $1.55. 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? a. $37.05 b. $38.16 c. $39.30 d. $40.48 e. $41.70 ANS: A Last dividend (D0) Short-run growth rate Long-run growth rate Required return

$1.55 1.50% 8.00% 12.00%

Year

0

Dividend Terminal value = D3/(rs − g3) = Total CFs PV of CFs

$1.5500

1 1.50% $1.5733 $1.5733 $1.4047

2 1.50% $1.5968 43.1149 $44.7118 $35.6439

3 8.00% $1.7246

Price = Sum of PVs = $37.05 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 7-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Nonconstant growth valuation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 76. The last dividend paid by Coppard Inc. was $1.25. The dividend growth rate is expected to be constant at 15% 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? a. $30.57 b. $31.52 c. $32.49 d. $33.50 e. $34.50 ANS: D Required return Short-run growth rate Long-run growth rate Last dividend (D0)

11.0% 15.0% 6.0% $1.25

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Year 0 Dividend $1.2500 Terminal value = P3 = D4/(rs − g4) = Total CFs PV of CFs

1 $1.4375

2 $1.6531

$1.4375 $1.2950

$1.6531 $1.3417

3 $1.9011 40.3032 $42.2043 $30.8594

4 $2.0152

Price = Sum of PVs = $33.50 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 7-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Nonconstant growth valuation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 77. Sawchuck Consulting has been profitable for the last 5 years, but it 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?

Year Growth rate Dividends a. b. c. d. e.

0 NA $0.000

1 NA $0.000

2 NA $0.000

3 NA $0.250

4 50.00% $0.375

5 25.00% $0.469

6 8.00% $0.506

1

2

3

$0.000

$0.250

4 50.00% $0.375

6 8.00% $0.506

$0.000 $0.000

$0.250 $0.183

$0.375 $0.247

5 25.00% $0.469 16.875 $17.344 $10.293

$9.94 $10.19 $10.45 $10.72 $10.99

ANS: D Required return = 11% Year 0

Dividend $0.000 $0.000 Terminal value = P5 = D6/(rs − g6) = Total CFs $0.000 PV of CFs $0.000 Price = $10.72

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 7-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Nonconstant growth valuation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 78. The free cash flows (in millions) shown below are forecast by Simmons Inc. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions?

Year: Free cash flow:

1 −$20

2 $42

3 $45

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a. b. c. d. e.

$586 $617 $648 $680 $714

ANS: B Year: Free cash flow:

1 −$20

2 $42

3 $45

WACC: 13% First, find the growth rate: g = $45/$42 − 1.0 = 7.14% Second, find the horizon, or terminal, value, at Year 2: HV2 = FCF3/(WACC − g) = $45/(0.13 − 0.0714) = $768 Now find the PV of the FCFs and the horizon value: Value of operations = −$20/(1.13) + ($42 + $768)/(1.13)2 = $617 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 7-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate valuation model, value of operations KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 79. The required return for Williamson Heating's stock is 12%, and the stock sells for $40 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% 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? a. 5.17% b. 5.44% c. 5.72% d. 6.02% e. 6.34% ANS: E Stock price Paid dividend (D0) Short-run growth rate Required return Forecasted LR growth rate, X Year

0

1 30.0% Dividend $1.0000 $1.3000 Terminal value = P4 = D5/(rs − g5): Total CFs $1.3000 PV of CFs $1.1607

$40.00 $1.00 30.0% 12.0% 6.34% Arbitrarily set at 5% initially.

2 30.0% $1.6900

3 30.0% $2.1970

$1.6900 $1.3473

$2.1970 $1.5638

4 30.0% $2.8561 53.6777 $56.5338 $35.9282

5 6.34% $3.0372

Stock price = $40.00. Must equal $40. Change the forecasted growth rate till reach $40.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

We must solve for the long-run growth rate. We can forecast the dividends in Years 1-4, so they are inserted in the time line. We need a growth rate to find D5 and the TV. We begin with a guess of say 5.0%, which we insert in the forecast cell. We then find the PV of the forecasted CFs and sum them. If the sum equals the given price, then our growth rate would be correct. If not, we need to substitute in different g's until we find the one that works. We used Excel's Goal Seek function to simplify the process, but one could use trial and error.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 7-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Nonconstant growth rate–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 80. Julia Saunders is your boss and the treasurer of Foster Carter Enterprises (FCE). She 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 $15.00 per share. Julia 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. Julia 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:

Julia 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 TV. 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 one. She notes, though, that this trial-and-error process would be 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. 11.84% b. 12.21% c. 12.58% d. 12.97% e. 13.36% ANS: D Finding the discount rate when we know the dividends and the actual stock price is complicated if the growth rate is not constant, and an iterative solution is required.

Estimated rs = Actual Market Price, P0: Year

12.97% $15.00 0

1

Rapid Growth 2

3

Normal Growth 4 5

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Dividend growth rate 10% Dividends (D0 has been paid) $1.00 $1.100 TV3 = P3 = D4/(rs − g4). Use Estimated rs.

Total CFs $1.100 PVs of CFs discounted at Estimated rs $0.974

10% $1.210 $1.210 $0.948

10% $1.331 $17.527 $18.858 $13.078

5% $1.398

5%

Calculated Price = P0 = Sum of PVs = $15.00

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 7-6 NAT: BUSPROG: Analytic STA: DISC: Stocks and bonds LOC: TBA TOP: Nonconstant value: Excel–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 8—FINANCIAL OPTIONS AND APPLICATIONS IN CORPORATE FINANCE TRUE/FALSE 1. An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period of time.

ANS: T OBJ: LO: 8-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives TOP: Options KEY: Bloom’s: Knowledge

2. The strike price is the price that must be paid for a share of common stock when it is bought by exercising a warrant.

ANS: T OBJ: LO: 8-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives TOP: Strike price KEY: Bloom’s: Knowledge

3. The exercise value is the positive difference between the current price of the stock and the strike price.

The exercise value is zero if the stock's price is below the strike price.

ANS: T OBJ: LO: 8-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives TOP: Exercise value KEY: Bloom’s: Knowledge

4. The exercise value is also called the strike price, but this term is generally used when discussing convertibles rather than financial options.

ANS: F OBJ: LO: 8-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives TOP: Exercise value KEY: Bloom’s: Knowledge

5. As the price of a stock rises above the strike price, the value investors are willing to pay for a call option increases because both (1) the immediate capital gain that can be realized by exercising the option and (2) the likely exercise value of the option when it expires have both increased.

ANS: T OBJ: LO: 8-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives TOP: Option time value KEY: Bloom’s: Knowledge

6. If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value.

ANS: F OBJ: LO: 8-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives TOP: Option pricing KEY: Bloom’s: Knowledge

7. If the market is in equilibrium, then an option must sell at a price that is exactly equal to the difference between the stock's current price and the option's strike price.

ANS: F

PTS: 1

DIF: Difficulty: Easy

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 8-1 LOC: TBA

NAT: BUSPROG: Reflective Thinking TOP: Option pricing

STA: DISC: Derivatives KEY: Bloom’s: Knowledge

8. Since investors tend to dislike risk and like certainty, the more volatile a stock, the less valuable will be an option to purchase the stock, other things held constant.

ANS: F OBJ: LO: 8-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives TOP: Option pricing KEY: Bloom’s: Knowledge

9. Because of the time value of money, the longer before an option expires, the less valuable the option will be, other things held constant.

ANS: F OBJ: LO: 8-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives TOP: Option pricing KEY: Bloom’s: Knowledge

10. If we define the "premium" on an option to be the difference between the price at which an option sells and the exercise value (or the difference between the stock's current market price and the strike price), then we would expect the premium to increase as the stock price increases, other things held constant.

ANS: F See Figure 8−1, which shows that the premium becomes smaller and smaller as the price of the stock increases. One factor that produces this result is the fact that the amount of leverage inherent in the option diminishes as the stock price increases.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives LOC: TBA TOP: Option pricing KEY: Bloom’s: Knowledge 11. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock, provided the strike prices for the put and call are the same.

ANS: F Recognize that if a stock is selling far above the strike price, the call option will be quite valuable, but the put option will be worth very little because the probability is low that the stock's market price will fall below the put's strike price.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives LOC: TBA TOP: Put-call parity KEY: Bloom’s: Knowledge 12. If a company announces a change in its dividend policy from a zero target payout ratio to a 100% payout policy, this action could be expected to increase the value of long-term options (say 5-year options) on the firm's stock.

ANS: F Dividends do not enter into the OPM pricing formula. We would expect the stock of a firm that retains all of its earnings to grow over time due to the reinvestment of its earnings, whereas a firm that retains zero earnings should not grow much if any. Therefore, the value of the firm's long-term options should decline if it announces a change from a zero to a 100% payout policy.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives LOC: TBA TOP: Put-call parity KEY: Bloom’s: Comprehension MULTIPLE CHOICE 13. An option that gives the holder the right to sell a stock at a specified price at some future time is a. a put option. b. an out-of-the-money option. c. a naked option. d. a covered option. e. a call option.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Option terms KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 14. Other things held constant, the value of an option depends on the stock's price, the risk-free rate, and the a. Variability of the stock price. b. Option's time to maturity. c. Strike price. d. All of the above. e. None of the above.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Option value KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 15. Which of the following statements is most correct, holding other things constant, for XYZ Corporation's traded call options? a. The higher the strike price on XYZ's options, the higher the option's price will be. b. Assuming the same strike price, an XYZ call option that expires in one month will sell at a higher price than one that expires in three months. c. If XYZ's stock price stabilizes (becomes less volatile), then the price of its options will increase. d. If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the option will be reduced by the amount of the dividend. e. The price of these call options is likely to rise if XYZ's stock price rises.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Option concepts KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 16. BLW Corporation is considering the terms to be set on the options it plans to issue to its executives.

Which of the following actions would decrease the value of the options, other things held constant? a. The exercise price of the option is increased. b. The life of the option is increased, i.e., the time until it expires is lengthened. c. The Federal Reserve takes actions that increase the risk-free rate. d. BLW's stock price becomes more risky (higher variance). e. BLW's stock price suddenly increases. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Option concepts KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 17. Which of the following statements is CORRECT? a. Call options give investors the right to sell a stock at a certain strike price before a specified date. b. Options typically sell for less than their exercise value. c. LEAPS are very short-term options that were created relatively recently and now trade in the market. d. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend. e. Put options give investors the right to buy a stock at a certain strike price before a specified date.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Miscellaneous option concepts KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 18. An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of options? a. Put b. Naked c. Covered d. Out-of-the-money e. In-the-money ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Options KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 19. Cazden Motors' stock is trading at $30 a share. Call options on the company's stock are also available, some with a strike price of $25 and some with a strike price of $35. Both options expire in three months. Which of the following best describes the value of these options? a. The options with the $25 strike price will sell for less than the options with the $35 strike price. b. The options with the $25 strike price have an exercise value greater than $5. c. The options with the $35 strike price have an exercise value greater than $0. d. If Cazden's stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5. e. The options with the $25 strike price will sell for $5.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Option value KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 20. Braddock Construction Co.'s stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $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 more than $2. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%. c. The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%. d. The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%. e. The price of the call option will increase by $2.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Option value KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 21. Which of the following statements is CORRECT? a. Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be. b. Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be. c. Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be. d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock. e. If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-6 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Miscellaneous option concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 22. Which of the following statements is CORRECT? a. Call options generally sell at a price less than their exercise value. b. If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value. c. Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be. d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock. e. If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as soon as the stock's price exceeds the strike price by about 10%, because this permits the option holder to lock in an immediate profit.

ANS: C Answer c is correct. See Figure 8−1 and the related discussion.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-6 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Miscellaneous option concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 23. Which of the following statements is CORRECT? a. As the stock's price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. Issuing options provides companies with a low cost method of raising capital. c. The market value of an option depends in part on the option's time to maturity and also on the variability of the underlying stock's price. d. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger. e. An option's value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can't sell for more than its exercise value.

ANS: C PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Options KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 24. Suppose you believe that Basso Inc.'s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $3.10 you can buy a 5-month call option giving you the right to buy 1 share at a price of $25 per share. If you buy this option for $3.10 and Basso's stock price actually rises to $45, what would your pre-tax net profit be? a. −$3.10 b. $16.90 c. $17.75 d. $22.50 e. $25.60 ANS: B The call option will be exercised only if the final price is above the strike price. If the final price is below the strike price, there will simply be a loss equal to the cost of the option.

Strike price: $25.00 Final price: $45.00

No. of options: 1 Option cost: $3.10

Profit per share = Final price − Strike price = $45 − $25 or zero: $20.00 Total profit = Profit/option  No. of options − Cost of options = $16.90 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Call options KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 25. Suppose you believe that Florio Company's stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $5.10 you could buy a 5-month put option giving you the right to sell 1 share at a price of $85 per share. If you bought this option for $5.10 and Florio's stock price actually dropped to $60, what would your pre-tax net profit be? a. −$5.10 b. $19.90 c. $20.90 d. $22.50 e. $27.60 ANS: B The put option will be exercised only if the final price is below the strike price. If the final price exceeds the strike price, there will simply be a loss equal to the cost of the option.

Strike price: $85.00

No. of options: 1

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Final price: $60.00

Option cost: $5.10

Profit per share = Strike price − Final price = $85 − $60 or zero: $25.00 Total profit = Profit/option  No. of options − Cost of options = $19.90 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Put options KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 26. The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binomial model, what is the option's value? (Hint: Use daily compounding.) a. $2.43 b. $2.70 c. $2.99 d. $3.29 e. $3.62 ANS: C Current price Exercise price rRF

$22.00 $22.00 6.00%

Price at end of year: High $27.00 Low $17.00

Step 1.

Payoff range, stock:

$27.00 − $17.00 =

$10.00

Step 2.

Payoff range, option: If stock is high: If stock is low: Option range:

Price − Exercise = 27 − 22 = (Price − Exercise) or $0 = $5 − $0 =

$5.00 0.00 $5.00

Step 3.

Equalize the ranges to find the number of shares of stock: Option range/Stock range = $5/$10 = shares of stock =

0.5

Step 4.

The payoff from 0.5 shares of stock will be either: $13.50 or $8.50 The payoff from the option will be either: 5.00 or 0.00 The portfolio's payoff will be either: $ 8.50 or $8.50 So the portfolio's payoff is riskless, $8.50 regardless of which choice materializes.

Step 5.

The present value of $8.50 at the daily compounded risk-free rate is: PV = $8.50/(1 + (0.06/365))365 = $8.005.

Step 6.

The option price is the cost of the stock purchased for the portfolio minus the PV of the payoff: V = 0.5($22) −$8.01 = $2.99

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-2 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Option price based on binomial model KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

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27. The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option? a. $7.33 b. $7.71 c. $8.12 d. $8.55 e. $9.00 ANS: E Stock price: Strike price: Call option price: Risk-free rate: Value of put

$50.00 $55.00 $7.20 6.0%

= Value of call − Stock price + (Exercise price  e−rt) = $7.20 − $50.00 + $55  e−rt = $7.20 − $50.00 + $51.80 = $9.00

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-6 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Put-call parity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 28. An analyst wants to use the Black-Scholes model to value call options on the stock of Heath Corporation based on the following data: • • • • •

The price of the stock is $40.

The strike price of the option is $40.

The option matures in 3 months (t = 0.25).

The standard deviation of the stock's returns is 0.40, and the variance is 0.16.

The risk-free rate is 6%.

Given this information, the analyst then calculated the following necessary components of the Black-Scholes model: • • • •

d1 = 0.175 d2 = −0.025 N(d1) = 0.56946 N(d2) = 0.49003

N(d1) and N(d2) represent areas under a standard normal distribution function. Using the Black-Scholes model, what is the value of the call option? a. $2.81 b. $3.12 c. $3.47 d. $3.82 e. $4.20 ANS: C Stock price: Strike price:

$40.00 N(d1) = 0.56946 $40.00 N(d2) = 0.49003

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Option maturity: Variance of stock returns: Risk-free rate:

0.25 0.16 6.0%

The Black-Scholes model calculates the value of the call option as: V = P[N(d1)] − Xe−rt[N(d2)] = $40(0.56946) − $40e−rt(0.49003) = $22.78 − $19.31 = $3.47 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 8-5 NAT: BUSPROG: Analytic STA: DISC: Derivatives LOC: TBA TOP: Black-Scholes model KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 9—THE COST OF CAPITAL TRUE/FALSE 1. "Capital" is sometimes defined as funds supplied to a firm by investors.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital KEY: Bloom’s: Knowledge 2. The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of capital KEY: Bloom’s: Knowledge 3. The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Component capital costs KEY: Bloom’s: Knowledge 4. 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Specific capital cost KEY: Bloom’s: Knowledge 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. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of debt KEY: Bloom’s: Knowledge 6. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of debt KEY: Bloom’s: Knowledge © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of debt KEY: Bloom’s: Knowledge 8. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of preferred stock KEY: Bloom’s: Knowledge 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, is not deductible by the issuing firm.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of preferred stock KEY: Bloom’s: Knowledge 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common stock KEY: Bloom’s: Knowledge 11. For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to the firm.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common stock KEY: Bloom’s: Knowledge 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common stock KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common stock KEY: Bloom’s: Knowledge 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of new common stock KEY: Bloom’s: Knowledge 15. 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 reinvested earnings, whose cost is the average return on the assets that are acquired.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Flotation and capital KEY: Bloom’s: Knowledge 16. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Knowledge 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.

ANS: F In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then "project financing" may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the "in general" case.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Specific capital cost KEY: Bloom’s: Comprehension 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: After-tax cost of debt KEY: Bloom’s: Comprehension 19. The reason why reinvested 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 distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Reinvested earnings KEY: Bloom’s: Comprehension 20. 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.

ANS: T Unfortunately, this is true.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity: CAPM KEY: Bloom’s: Comprehension 21. 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.

ANS: T Unfortunately, this is true.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity: DCF KEY: Bloom’s: Comprehension 22. 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.

ANS: T Unfortunately, this is true.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity: BY + RP KEY: Bloom’s: Comprehension 23. The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r s), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)." © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: F This statement is true only if the expected growth rate is zero. Here are some illustrative numbers that show that the statement is true if g = 0 but false otherwise.

Price Dividend Growth Flotation rs = D1/P0 + g re = D1/P0(1 − F) + g rs/(1 − F)

Positive g $10.00 $0.50 6.00% 5.00% 11.00% 11.263% 11.579%

Zero g $10.00 $0.50 0.00% 5.00% 5.00% 5.263% Equal only if g = zero.

5.263%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of new common equity KEY: Bloom’s: Comprehension 24. 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.

ANS: T This statement is true. Here are some illustrative numbers to demonstrate this point.

Price Dividend Growth Flotation rs = D1/P0 + g re = D1/P0(1 − F) + g rs/(1 − F)

Positive g $10.00 $0.50 6.00% 5.00% 11.00% 11.263% 11.579%

Zero g $10.00 $0.50 0.00% 5.00% 5.00% 5.263% Equal only if g = zero.

5.263%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of new common equity KEY: Bloom’s: Comprehension 25. Suppose the debt ratio (D/TA) 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 decrease the weighted average cost of capital (WACC).

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Factors affecting WACC KEY: Bloom’s: Comprehension 26. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Adjusting cap. costs for risk KEY: Bloom’s: Comprehension 27. 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.

ANS: T True, but data on comparable publicly owned firms can often be obtained and used as proxies for private firms.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-10 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity: private cos.

KEY: Bloom’s: Comprehension 28. 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).

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Comprehension 29. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Taxes, cost of debt, and WACC KEY: Bloom’s: Comprehension 30. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity estimates KEY: Bloom’s: Comprehension 31. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): 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.

ANS: F None of the methods always provides accurate and reliable estimates. With the CAPM, we don't know the beta that investors are using, we are not totally sure of what rRF to use, and we don't know if the CAPM is truly correct. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity estimates KEY: Bloom’s: Comprehension 32. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): 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. ANS: T Unfortunately, this is true.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity estimates KEY: Bloom’s: Comprehension 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).

ANS: F The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer; hence, this statement is not true. It actually is just nonsense anyway!

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity KEY: Bloom’s: Comprehension 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.

ANS: F Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Inflation and cap. costs KEY: Bloom’s: Comprehension 35. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. 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.

ANS: T OBJ: LO: 9-6

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Inflation and cap. costs KEY: Bloom’s: Comprehension MULTIPLE CHOICE 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. Accounts payable. b. Common stock “raised” by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital components KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 37. With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the percentage of debt in the target capital structure. b. Increase the proposed capital budget. c. Reduce the amount of short-term bank debt in order to increase the current ratio. d. Reduce the percentage of debt in the target capital structure. e. Increase the dividend payout ratio for the upcoming year.

ANS: A Statement a is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Factors affecting WACC KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 38. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The flotation costs associated with issuing new common stock increase. b. The company's beta increases. c. Expected inflation increases. d. The flotation costs associated with issuing preferred stock increase. e. The market risk premium declines.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Factors affecting WACC KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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. re > rs > WACC > rd. b. WACC > re > rs > rd. c. rd > re > rs > WACC. d. WACC > rd > rs > re. e. rs > re > rd > WACC. ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital components KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 40. When working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient, bi, of a relatively safe stock. b. The most appropriate risk-free rate, rRF. c. The expected rate of return on the market, rM. d. The beta coefficient of "the market," which is the same as the beta of an average stock. e. The market risk premium (RPM).

ANS: D By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-6 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity: CAPM KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 41. Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept? a. A Division Y project with a 12% return. b. A Division X project with an 11% return. c. A Division X project with a 9% return. d. A Division Y project with an 11% return. e. A Division Y project with a 13% return.

ANS: B The correct answer is statement b. Division X should accept only projects with returns greater than 10%, while Division Y should accept only projects with returns greater than 14%. Only statement b meets this criterion.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Divisional risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 42. Taylor 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? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

Project C, which is of above-average risk and has a return of 11%.

Project A, which is of average risk and has a return of 9%.

None of the projects should be accepted.

All of the projects should be accepted.

Project B, which is of below-average risk and has a return of 8.5%.

ANS: E Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk and projects KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 43. Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and 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 an 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 rejected because its expected return (before risk adjustment) is less than its required return. b. 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. c. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. d. 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. e. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

ANS: C Statement c is correct. Here is the proof: rs = 5% + 4%(2.0) = 5% + 8% = 13%.

Required return for risky projects = 13% + 3% = 16%.

Project return = 14% < adjusted rs = 16%. Thus, the project should be rejected.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk and projects KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 44. The Anderson 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 low-risk projects and reject too many high-risk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. The company will take on too many high-risk projects and reject too many low-risk projects.

ANS: E Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement e is correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk-adjusted capital cost KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 45. Suppose Acme Industries 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 less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. 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. e. become riskier over time, but its intrinsic value will be maximized.

ANS: C Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline. Therefore, statement c is correct.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk-adjusted capital cost KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 46. Which of the following statements is CORRECT? a. All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. b. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. c. Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. d. 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. e. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

ANS: D © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Statement d is true, because the after-tax cost of debt is rd(1 − T). So, if rd remains constant but T increases, rd(1 − T) will decline. The other statements are false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-9 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital components KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 47. Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. b. 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. c. 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 reinvested earnings to take care of its equity financing and hence must issue new stock. d. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

ANS: E Statement e is true; interest payments on debt are tax deductible. The other statements are false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital components KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 48. Which of the following statements is CORRECT? a. 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. b. The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. c. A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock. d. 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. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital components KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 49. Which of the following statements is CORRECT? a. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. b. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free." d. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. e. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 50. Which of the following statements is CORRECT? a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. Flotation costs associated with issuing new common stock normally reduce the WACC. c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. d. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. e. A change in a company's target capital structure cannot affect its WACC. ANS: C Statement c is true, because the cost of debt for WACC purposes = rd(1 − T), so if T increases, then rd(1 − T) declines.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 51. Which of the following statements is CORRECT? a. The after-tax cost of debt usually exceeds the after-tax cost of equity. b. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. c. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. d. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. e. The WACC is calculated using before-tax costs for all components.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC and cap. components KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 52. Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity. a. The WACC is calculated on a before-tax basis. b. The WACC exceeds the cost of equity. c. The cost of equity is always equal to or greater than the cost of debt. d. The cost of reinvested earnings typically exceeds the cost of new common stock. e. The interest rate used to calculate the WACC is the average after-tax cost of all the © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

company's outstanding debt as shown on its balance sheet.

ANS: C Statement c is true, because equity is more risky than debt and hence investors require a higher return on equity. Also, interest on debt is deductible, and this further reduces the cost of debt. The other statements are false.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC and cap. components KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 53. Which of the following statements is CORRECT? a. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. b. 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. c. Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. d. Higher flotation costs tend to reduce the cost of equity capital. e. 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.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of capital concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 54. The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers.

Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. 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. e. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: B By not making the risk adjustment, the firm will accept too many projects in the manufacturing division and too few in the data processing division. As a result, the company will become riskier overall, raising its cost of capital. Investors will discount the firm's cash flows at a higher rate, and the firm's value will fall. Therefore, statement b is true and the other statements are false.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk-adjusted capital cost KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 55. Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project.

Now assume that the two companies merge and form a new company, Careco/Audaco 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 evaluated using the correct post-merger WACC, Project X would have a negative NPV. b. After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. c. Careco/Audaco's WACC, as a result of the merger, would be 10%. d. After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

ANS: E PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Div. risk and projects KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 56. Which of the following statements is CORRECT? a. A cost should be assigned to reinvested 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 distributed rather than retained and reinvested. b. No cost should be assigned to reinvested 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." c. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt 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 5 years. d. If a firm has enough reinvested 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. e. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: A PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital components KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 57. Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of capital KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 58. Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. 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. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of equity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

59. Which of the following statements is CORRECT? a. 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. b. 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. c. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required. d. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach. e. 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.

ANS: B PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: CAPM and DCF KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 60. Which of the following statements is CORRECT? a. 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. b. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. c. 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. d. 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. e. 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.

ANS: C Statement c is true⎯the WACC will increase if the firm raises more funds than can be supported by reinvested earnings.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 61. Which of the following statements is CORRECT? a. 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. b. An increase in a firm's tax rate will increase the component cost of debt, provided the © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

YTM on the firm's bonds is not affected by the change in the tax rate. c. When the WACC is calculated, it should reflect the costs of new common stock, reinvested 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. d. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. e. 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 reinvested earnings.

ANS: D Statement d is true. The firm would receive no tax savings on interest, so its cost of debt would not be reduced by the tax factor. However, corporate investors would be able to deduct 70% of the preferred dividends they receive, which would make them willing to accept a lower before-tax yield on preferred stock than on bonds. Put another way, the market yield on this firm's preferred could be lower than the interest rate on its debt because of the 70% exclusion; however, with a zero tax rate there would be no reduction in the firm's cost of debt.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 62. 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's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. b. 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. c. 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. d. 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 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. e. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

ANS: D The fact that A's returns are negatively correlated means that it serves as a sort of insurance policy to the firm. The fact that its SD is high is actually good, because the negative correlation will cause the project's beta versus the market and also with the firm's other assets to be relatively low, denoting a low risk and thus justifying a relatively low cost of capital. This answer is theoretically always true, and it is especially true if the firm is large, has many projects, and Project A is not a "bet the company" project.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Beta and project risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

63. Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F's earnings and stock price move counter cyclically with J and other S&P companies. Both J and F 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. J and F should have identical WACCs because their risks as measured by the standard deviation of returns are identical. b. If J and F merge, then the merged firm MW should have a WACC that is a simple average of J's and F's WACCs. c. Without additional information, it is impossible to predict what the merged firm's WACC would be if J and F merged. d. Since J and F 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. e. J should have the lower WACC because it is like most other companies, and investors like that fact.

ANS: B Statement b is true. The merged firm would have a beta that is a simple average of J's and F's betas, and that would result in a cost of equity that is an average of the two firms' costs of equity. Since they are financed only with equity, their WACCs could also be averaged to find the merged firm's WACC. PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 64. Perpetual preferred stock from Franklin Inc. sells for $97.50 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. 8.72% b. 9.08% c. 9.44% d. 9.82% e. 10.22% ANS: B Preferred stock price Preferred dividend Flotation cost rp = Dp/(Pp(1 − F))

$97.50 $8.50 4.00% 9.08%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of preferred stock KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 65. A company's perpetual preferred stock currently sells for $92.50 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? a. 7.81% b. 8.22% c. 8.65% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. 9.10% e. 9.56% ANS: D Preferred stock price Preferred dividend Flotation cost rp = Dp/(Pp(1 − F))

$92.50 $8.00 5.00% 9.10%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of preferred stock KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 66. Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from reinvested earnings based on the CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72% ANS: A rRF RPM b rs = rRF + (RPM  b)

5.00% 6.00% 1.05 11.30%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-6 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: CAPM KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 67. You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30.

Based on the CAPM approach, what is the cost of common from reinvested earnings? a. 9.67% b. 9.97% c. 10.28% d. 10.60% e. 10.93% ANS: E rRF RPM b rs = rRF + (RPM  b)

4.10% 5.25% 1.30 10.925%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-6 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: CAPM KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

68. As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of common from reinvested earnings based on the DCF approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51% ANS: C D1 P0 g rs = D1/P0 + g

$0.67 $27.50 8.00% 10.44%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: DCF KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 69. To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings? a. 11.10% b. 11.68% c. 12.30% d. 12.94% e. 13.59% ANS: D D1 P0 g rs = D1/P0 + g

$1.45 $22.50 6.50% 12.94%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: DCF KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 70. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common 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 common from reinvested earnings? a. 12.60% b. 13.10% c. 13.63% d. 14.17% e. 14.74% ANS: A Bond yield Risk premium rs = rd + Risk premium

8.75% 3.85% 12.60%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: BY + RP KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 71. Bartlett Company's 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 common using reinvested earnings is 12.75%. The firm will not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is its WACC? a. 8.98% b. 9.26% c. 9.54% d. 9.83% e. 10.12% ANS: B Debt Preferred Common WACC = wd  rd  (1 − T) + wp  rp + ws  rs

Weights 40% 15% 45%

Costs 6.00% 7.50% 12.75% 9.26%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 72. Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation? a. 4.35% b. 4.58% c. 4.83% d. 5.08% e. 5.33% ANS: D Coupon rate Periods/year Maturity (yr) Bond price Par value Tax rate

9.25% 2 20 $1,075.00 $1,000 40%

Calculator inputs: N = Periods/year  Maturity PV = Bond's price PMT = Coupon rate  Par/2 FV = Par = Maturity value Calculator output: I/YR, semiannual rate Annual rate = 2  (I/YR) = Before-tax cost of debt = rd(1 − T) for use in WACC

40 −$1,075.00 $46.25 $1,000 4.23% 8.47% 5.08%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of debt KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 73. The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation? a. 4.28% b. 4.46% c. 4.65% d. 4.83% e. 5.03% ANS: C Coupon rate Periods/year Maturity (yr) Bond price Par value Tax rate

7.00% 2 20 $925.00 $1,000 40%

Calculator inputs: N = Periods/year  Maturity PV = Bond's price PMT = Coupon rate  Par/2 FV = Par = Maturity value I/YR Times periods/yr = before-tax cost of debt = rd(1 − T) for use in WACC

40 −$925.00 $35 $1,000 3.87% 7.74% 4.65%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of debt KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 74. To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings? a. 9.29% b. 9.68% c. 10.08% d. 10.50% e. 10.92% ANS: D D0 P0 g D1 = D0  (1 + g) rs = D1/P0 + g

$0.90 $27.50 7.00% $0.963 10.50%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: DCF KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 75. As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings? a. 10.69% b. 11.25% c. 11.84% d. 12.43% e. 13.05% ANS: C D0 P0 g D1 = D0  (1 + g) rs = D1/P0 + g

$0.80 $22.50 8.00% $0.864 11.84%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: DCF KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 76. Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. 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? a. 12.70% b. 13.37% c. 14.04% d. 14.74% e. 15.48% ANS: B Expected EPS1 Payout ratio Expected dividend, D1 = EPS  Payout Current stock price g F re = D1/(P0  (1 − F)) + g

$3.50 65% $2.275 $32.50 6.00% 5.00% 13.37%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-9 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of new common stock KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 77. You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock? a. 9.06% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

9.44% 9.84% 10.23% 10.64%

ANS: C D1 P0 g F re = D1/(P0  (1 − F)) + g =

$1.25 $27.50 5.00% 6.00% 9.84%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-9 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of new common stock KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 78. You were recently hired by Garrett Design, Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock? a. 10.77% b. 11.33% c. 11.90% d. 12.50% e. 13.12% ANS: B D1 P0 g F re = D1/(P0  (1 − F)) + g

$1.75 $42.50 7.00% 5.00% 11.33%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-9 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of new common stock KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 79. Quinlan Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year end (D1 = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year. The before-tax cost of debt is 7.50%, and the tax rate is 40%. 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 reinvested earnings? a. 7.07% b. 7.36% c. 7.67% d. 7.98% e. 8.29% ANS: C D1 g P0 rd

$2.50 5.50% $52.50 7.50%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Tax rate wd ws rd(1 − T) rs = D1/P0 + g WACC = wd(rd)(1 − T) + ws(rs) =

40% 45% 55% 4.50% 10.26% 7.67%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 80. Avery Corporation's 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 common from reinvested earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new common stock. What is Avery's WACC? a. 8.15% b. 8.48% c. 8.82% d. 9.17% e. 9.54% ANS: A Tax rate = 40% Debt Preferred Common WACC

Weights 35% 10% 55% 100%

rd 6.50%

AT Costs 3.90% 6.00% 11.25% 8.15%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC and target cap. struc.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 81. Westbrook's Painting Co. 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 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted? a. 0.57% b. 0.63% c. 0.70% d. 0.77% e. 0.85% ANS: C

Coupon rate Periods/year Maturity (yr) Bond price = Par value Old and New tax rates

Tax Rate Old rate, 40% 7.00% 2 20 $1,000 40%

New rate 7.00% 2 20 $1,000 30%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculator inputs: N = Periods/year  Maturity PV = Bond's price PMT = Coupon rate  Par/2 FV = Par = Maturity value I/YR Times periods/yr = before-tax cost of debt = rd(1 − T) for use in WACC Difference = Cost at new rate − Cost at old rate =

40 −$1,000 $35.00 −$1,000 3.50% 7.00% 4.20% 0.70%

40 −$1,000 $35.00 −$1,000 3.50% 7.00% 4.90%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Taxes and cost of debt KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 82. The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. 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 common from reinvested earnings change if the stock price changes as the CEO expects? a. −1.49% b. −1.66% c. −1.84% d. −2.03% e. −2.23% ANS: C D0 P0 g D1 = D0  (1 + g) rs = D1/P0 + g Difference, rs0 − rs1

Old Price $0.85 $22.00 6.00% $0.901 10.10% −1.84%

New Price $0.85 $40.00 6.00% $0.901 8.25%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: DCF KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 83. The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC. Spellman'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 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 $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. 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. 1.55% b. 1.72% c. 1.91% d. 2.13% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. 2.36% ANS: E P0 Shares outstanding (millions) bond coupon rate (not used) YTM = rd rs Tax rate BV debt (millions) BV equity (millions) MV debt (millions) MV equity (millions) = # sh  P0 = AT cost of debt = rd(1 − T)

Debt Equity Total

Capital $45.00 $65.00 $110.00

Debt Equity Total

Capital $50.00 $225.00 $275.00

$22.50 10 7.00% 6.00% 14.00% 40% $45.00 $65.00 $50.00 $225.00 3.60%

Book value weights⎯WRONG!!!

Weights Cost rates 40.91% 3.60% 59.09% 14.00% 100.00% WACC =

Product 1.47% 8.27% 9.75%

Market value weights⎯RIGHT!!!

Weights Cost rates 18.18% 3.60% 81.82% 14.00% 100.00% WACC = Difference =

Product 0.65% 11.45% 12.11% 2.36%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC and market cap. struc.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 84. As the winner of a contest, you are now CFO for the day for Maguire Inc. and your day's job involves raising capital for expansion. Maguire's common stock currently sells for $45.00 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 common from reinvested earnings? a. 0.09% b. 0.19% c. 0.37% d. 0.56% e. 0.84% ANS: C Expected EPS1 Payout ratio Current stk price g F D1 rs = D1/P0 + g re = D1/(P0  (1 − F)) + g

$2.75 70% $45.00 6.00% 8.00% $1.925 10.28% 10.65%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Difference = re − rs

0.37%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-9 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common stock vs. cost of new common equity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 85. Granby Foods' (GF) 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 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 40%. Calculate WACCs based on book, market, and target capital structures. What is the sum of these three WACCs? a. 28.36% b. 29.54% c. 30.77% d. 32.00% e. 33.28% ANS: C Tax rate Target wd Target wce Coupon rate YTM = rd rd(1 − T) rs Number of shares (millions)

40% 35.00% 65.00% 8.50% 8.00% 4.80% 12.25% 10

Price per share BV per share Book equity = BV/sh  No. Shs Market equity = P0  No. Shs Book value of debt (millions) Market value of debt (millions)

$20.00 $5.00 $50.00 $200.00 $25.00 $27.00

Debt Equity Total capital

Capital $25.00 $50.00 $75.00

BOOK VALUE WEIGHTS Weights Cost rates 33.33% 4.80% 66.67% 12.25% 100.00% WACC =

Product 1.60% 8.17% 9.77%

Debt Equity Total capital

Capital $27.00 $200.00 $227.00

MARKET VALUE WEIGHTS Weights Cost rates 11.89% 4.80% 88.11% 12.25% 100.00% WACC =

Product 0.57% 10.79% 11.36%

Debt Equity Total capital

Capital NA NA NA

TARGET WEIGHTS Weights Cost rates 35.00% 4.80% 65.00% 12.25% 100.00% WACC =

Product 1.68% 7.96% 9.64%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sum of the 3 WACCS =

30.77%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC: target, book & mkt. struc. KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 86. To estimate the company's WACC, Marshall Inc. recently hired you as a consultant. 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 $1,050.00. (2) The company's tax rate is 40%. (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 common stock, and it does not expect to issue any new shares.

What is its WACC? a. 7.16% b. 7.54% c. 7.93% d. 8.35% e. 8.79% ANS: E Coupon rate Maturity Bond price Par value Tax rate rRF RPM b wd ws Bond yield rd(1 − T) Cost of equity, rs = rRF + b(RPM) WACC = wd(rd)(1 − T) + ws(rs) =

8.00% 20 $1,050.00 $1,000 40% 4.50% 5.50% 1.20 35% 65% 7.51% 4.51% 11.10% 8.79%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC and common from RE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 87. Assume that you are an intern with the Brayton Company, and you have collected the following data: The yield on the company's outstanding bonds is 7.75%; its tax rate is 40%; 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 $15.00 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. 6.89% b. 7.26% c. 7.64% d. 8.04% e. 8.44% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: D YTM Tax rate D1 g P0 F wd ws

7.75% 40% $0.65 6.00% $15.00 10.0% 45% 55%

rd(1 − T) re = D1/(P0  (1 − F)) + g WACC = wd(rd)(1 − T) + ws(rs) =

4.65% 10.81% 8.04%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC and new equity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 88. You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity.

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 = 1.25. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of common 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. 1.13% b. 1.50% c. 1.88% d. 2.34% e. 2.58% ANS: B Bond yield Risk premium rs rRF RPM b rs

7.00% D1 4.00% P0 11.00% g rs 5.00% 6.00% Max 1.25 Min 12.50% Difference

$1.20 $35.00 8.00% 11.43% 12.50% 11.00% 1.50%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk premium, CAPM, and DCF KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 89. Refer to Exhibit 9.1. What is the best estimate of the after-tax cost of debt? a. 4.64% b. 4.88% c. 5.14% d. 5.40% e. 5.67% ANS: C © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Coupon rate Periods/year Maturity (yr) Bond price Par value Tax rate

7.25% 2 20 $875 $1,000 40%

Calculator inputs: N = 2  Years = PV = −Bond Price = PMT = (Coupon rate  Par)/2 = FV = Par value = Yield = I/YR, which we solve for = Before-tax cost of debt = rd = yield  2 = After-tax cost of debt for use in WACC = rd(1 − T) =

40 −$875.00 $36.25 $1,000 4.28% 8.57% 5.14%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: After-tax cost of debt KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part 90. Refer to Exhibit 9.1. Based on the CAPM, what is the firm's cost of common stock? a. 11.15% b. 11.73% c. 12.35% d. 13.00% e. 13.65% ANS: D rRF Expected rM RPM = Expected return on Market − rRF = b rs = rRF + rRF(RPM  b)

5.50% 11.50% 6.00% 1.25 13.00%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-6 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Cost of common: CAPM KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part 91. Refer to Exhibit 9.1. Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC? a. 18.67% b. 19.60% c. 20.58% d. 21.61% e. 22.69% ANS: A Bond price Number of bonds MV of debt = D Stock price = P0 Shares outstanding

$875.00 40,000 $35,000,000 $15.25 10,000,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MV of equity = E Total MV = D + E Weight debt = wd = D/Total MV

$152,500,000 $187,500,000 18.67%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Weights for WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part 92. Refer to Exhibit 9.1. What is the best estimate of the firm's WACC? a. 10.85% b. 11.19% c. 11.53% d. 11.88% e. 12.24% ANS: C wd rd(1 − T) wc = 100.00% − wd = rs WACC = wd(rd)(1 − T) + ws(rs) =

18.67% 5.14% 81.33% 13.00% 11.53%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 9-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 10—THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH FLOWS TRUE/FALSE 1. A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital budget KEY: Bloom’s: Knowledge 2. 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: PV of cash flows KEY: Bloom’s: Knowledge 3. Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Knowledge 4. A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Knowledge 5. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the higher positive NPV. ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Mutually exclusive projects KEY: Bloom’s: Knowledge 6. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the higher positive IRR. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Mutually exclusive projects KEY: Bloom’s: Knowledge 7. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Knowledge 8. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR. ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Knowledge 9. A project's IRR is independent of the firm's cost of capital. In other words, a project's IRR doesn't change with a change in the firm's cost of capital.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Knowledge 10. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Multiple IRRs KEY: Bloom’s: Knowledge 11. The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are compared to one another.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Multiple IRRs KEY: Bloom’s: Knowledge 12. The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Reinvestment rate assumption KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Reinvestment rate assumption KEY: Bloom’s: Knowledge 14. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Reinvestment rate assumption KEY: Bloom’s: Knowledge 15. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Modified IRR KEY: Bloom’s: Knowledge 16. Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Modified IRR KEY: Bloom’s: Knowledge 17. 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Modified IRR KEY: Bloom’s: Knowledge 18. One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback period KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. 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.

ANS: F Think about the following equally risky projects. The cost of capital is WACC = 10% 0 1 2 3 4 5 6 S 1,400 −1,000 L 378.34 378.34 378.34 378.34 378.34 378.34 −1,000 IRRS = 40.0% IRRL = 30.0%

NPVS = $272.73 NPVL = $647.77

S has the higher IRR, but L has a much higher NPV and is therefore preferable.

If the project could be repeated, though, S would turn out to be better⎯it would have both a higher NPV and IRR. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Mutually exclusive projects KEY: Bloom’s: Comprehension 20. The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Comprehension 21. 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 cost of capital.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Comprehension 22. 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 less than the projects' cost of capital.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Comprehension 23. No 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 exceeds the rate at which the projects' NPV profiles cross. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Comprehension 24. 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. ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Comprehension 25. 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.

ANS: F The discounted payback corrects the fault of not considering the timing of cash flows, but it does not correct for the nonconsideration of after-payback cash flows.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Discounted payback KEY: Bloom’s: Comprehension 26. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital budgeting methods KEY: Bloom’s: Comprehension 27. 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.

ANS: F One project might have cash flows that extend well past the payback year, leading to different rankings.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital budgeting methods KEY: Bloom’s: Comprehension 28. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

TOP: NPV and IRR

KEY: Bloom’s: Comprehension

29. 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. ANS: F Project X may have a negative NPV if r > IRR. The NPV profile line crosses the horizontal axis, and the NPV at the cost of capital is in the lower right quadrant.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Comprehension 30. 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. ANS: F We can see from the graph that S has the higher NPV if r > 0.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Comprehension 31. 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.

ANS: F We do not know if the cost of capital is to the right or left of the crossover point. Therefore, NPVX may be either higher or lower than NPVY. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Comprehension MULTIPLE CHOICE 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. The lower the WACC used to calculate a project's NPV, the lower the calculated NPV will be. b. If a project's NPV is less than zero, then its IRR must be less than the WACC. c. If a project's NPV is greater than zero, then its IRR must be less than zero. d. The NPV of a relatively low-risk project should be found using a relatively high WACC. e. 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. ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 33. 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 the time value of money. b. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. c. 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. d. 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. e. 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.

ANS: D The IRR would rank a project that cost $100 and had a 100% IRR ahead of a project that cost $1,000,000 and had an IRR of 90%. The larger project would increase the firm's value more, as the NPV would demonstrate.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 34. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. b. If a project's IRR is greater than the WACC, then its NPV must be negative. c. 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. d. To find a project's IRR, we must find a discount rate that is equal to the WACC. e. A project's regular IRR is found by compounding the cash inflows at the WACC to find © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

the terminal value (TV), then discounting this TV at the WACC. ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 35. 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 present value (PV), then discounting the TV to find the IRR. b. If a project's IRR is smaller than the WACC, then its NPV will be positive. c. A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost. d. If a project's IRR is positive, then its NPV must also be positive. e. 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. ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 36. Which of the following statements is CORRECT? a. If a project has "normal" cash flows, then its MIRR must be positive. b. If a project has "normal" cash flows, then it will have exactly two real IRRs. c. 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. d. 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. e. If a project has "normal" cash flows, then its IRR must be positive.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Normal vs. nonnormal CFs KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 37. Which of the following statements is CORRECT? a. Projects with "normal" cash flows can have two or more real IRRs. b. 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." c. The "multiple IRR problem" can arise if a project's cash flows are "normal." d. Projects with "nonnormal" cash flows are almost never encountered in the real world. e. Projects with "normal" cash flows can have only one real IRR. ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Normal vs. nonnormal CFs KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

38. Which of the following statements is CORRECT? a. One defect of the IRR method is that it does not take account of the time value of money. b. One defect of the IRR method is that it does not take account of the cost of capital. c. 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. d. 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. e. One defect of the IRR method is that it does not take account of cash flows over a project's full life.

ANS: D The IRR assumes reinvestment at the IRR, and that is generally not as valid as assuming reinvestment at the WACC, as with the NPV. PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Reinvestment rate KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 39. Which of the following statements is CORRECT? a. 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. b. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. c. 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. d. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect. e. The regular payback method recognizes all cash flows over a project's life.

ANS: C Statement d is true. The payback does indicate how long it should take to recover the investment; hence, it is a measure of liquidity.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 40. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money. b. If a project's payback is positive, then the project should be rejected because it must have a negative NPV. c. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. d. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 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. e. The longer a project's payback period, the more desirable the project is normally considered to be by this criterion.

ANS: A

PTS: 1

DIF: Difficulty: Easy

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital TOP: Payback KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual

LOC: TBA

41. Which of the following statements is CORRECT? a. One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period. b. If a project's payback is positive, then the project should be accepted because it must have a positive NPV. c. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. d. 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. e. The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 42. Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project's NPV increases as the WACC declines. b. A project's MIRR is unaffected by changes in the WACC. c. A project's regular payback increases as the WACC declines. d. A project's discounted payback increases as the WACC declines. e. A project's IRR increases as the WACC declines.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital budgeting methods KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 43. Which of the following statements is CORRECT? a. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-8 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital budgeting methods KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

44. Which of the following statements is CORRECT? a. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. b. An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life. c. 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. d. We cannot draw a project's NPV profile unless we know the appropriate WACC for use in evaluating the project's NPV. e. An NPV profile graph shows how a project's payback varies as the cost of capital changes.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 45. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. b. If a project's NPV is greater than zero, then its IRR must be less than the WACC. c. If a project's NPV is greater than zero, then its IRR must be less than zero. d. The NPVs of relatively risky projects should be found using relatively low WACCs. e. 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. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 46. Which of the following statements is CORRECT? a. If the cost of capital declines, this lowers a project's NPV. b. 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. c. 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. d. 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. e. 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.

ANS: D Statement e is correct. The others are false. If you draw an NPV profile for one project, you will see that if the WACC is less than the IRR, the NPV will be positive.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV and IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

47. 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 also have a higher NPV. b. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. c. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. d. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive. e. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV and IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 48. Which of the following statements is CORRECT? a. If two projects are mutually exclusive, then they are likely to have multiple IRRs. b. If a project is independent, then it cannot have multiple IRRs. c. Multiple IRRs can occur only if the signs of the cash flows change more than once. d. 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. e. For a project to have more than one IRR, then both IRRs must be greater than the WACC. ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Multiple IRRs KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 49. Which of the following statements is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. c. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. d. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Reinvestment rate KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 50. 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:

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Which of the following statements is CORRECT? a. More of Project B's cash flows occur in the later years. b. We must have information on the cost of capital in order to determine which project has the larger early cash flows. c. The NPV profile graph is inconsistent with the statement made in the problem. d. The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is greater than either project's IRR. e. More of Project A's cash flows occur in the later years.

ANS: E Statement e is true and the other statements are false. Distant cash flows are more severely penalized by high discount rates, so if the NPV profile line has a steep slope, this indicates that cash flows occur relatively late.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 51. Projects S and L are both normal projects with 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 L. b. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. c. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. d. The solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative IRRs. e. Project S. ANS: A Statement a is true, while the other statements are false. Since Project L's undiscounted CFs are larger, they must occur in the more distant future, and since distant cash flows are impacted more by changes in the discount rate, L's NPV profile must be steeper. One can also see this in an NPV profile graph like the one in Question 50. The higher Y-axis intercept indicates more undiscounted CFs, and for the profiles to cross, the one with the higher intercept must be steeper.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

52. Projects C and D both have normal cash flows and are mutually exclusive. 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 is probably larger in scale than Project C. b. Project C probably has a faster payback. c. Project C probably has a higher IRR. d. The crossover rate between the two projects is below 12%. e. Project D probably has a higher IRR. ANS: E The NPV profiles cross at 12%. To the left, or at lower discount rates, C has the higher NPV, so its slope is steeper, causing its profile to hit the X-axis sooner. This means that C has the lower IRR; hence, D has the higher IRR. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 53. The WACC for two mutually exclusive projects that are being considered is 8%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that 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 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. b. You should recommend Project R, because at the new WACC it will have the higher NPV. c. You should recommend Project K, because at the new WACC it will have the higher NPV. d. You should recommend Project K because it has the higher IRR and will continue to have the higher IRR even at the new WACC. e. You should reject both projects because they will both have negative NPVs under the new conditions.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 54. The WACC for two mutually exclusive projects that are being considered is 12%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 12% current WACC. Interest rates are currently high. However, you believe that 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 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. b. You should recommend Project R, because at the new WACC it will have the higher NPV. c. You should recommend Project K, because at the new WACC it will have the higher NPV. d. You should recommend Project R because it will have both a higher IRR and a higher © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NPV under the new conditions. e. You should reject both projects because they will both have negative NPVs under the new conditions.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 55. Which of the following statements is NOT a disadvantage of the regular payback method? a. Ignores cash flows beyond the payback period. b. Does not directly account for the time value of money. c. Does not provide any indication regarding a project's liquidity or risk. d. Does not take account of differences in size among projects. e. Lacks an objective, market-determined benchmark for making decisions.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 56. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year 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 long-term projects and reject too many short-term projects (as judged by the NPV). b. The firm will accept too many projects in all economic states because a 4-year payback is too low. c. The firm will accept too few projects in all economic states because a 4-year payback is too high. d. If the 4-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. e. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).

ANS: D Statement d is correct. In a weak economy, the interest rates and the WACC are likely to be low, and these conditions favor long-term projects. But the constant 4-year payback would not recognize this situation.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 57. Which of the following statements is CORRECT? a. If Project A's IRR exceeds Project B's, then A must have the higher NPV. b. A project's MIRR can never exceed its IRR. c. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. d. If the NPV is negative, the IRR must also be negative. e. If a project with normal cash flows has an IRR greater than the WACC, the project must © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

also have a positive NPV. ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV, IRR, and MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 58. Which of the following statements is CORRECT? a. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. b. 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. c. The higher the WACC, the shorter the discounted payback period. d. The MIRR method assumes that cash flows are reinvested at the crossover rate. e. The MIRR and NPV decision criteria can never conflict.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV, IRR, and MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 59. Which of the following statements is CORRECT? a. 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. b. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR. c. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years. d. The percentage difference between the MIRR and the IRR is equal to the project's WACC. e. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV, IRR, and MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 60. Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. 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. e. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV, IRR, and MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 61. Which of the following statements is CORRECT? a. 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. b. 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. c. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. d. 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. e. 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.

ANS: A Statement a is correct, and the others are false. Cash flows from a project can be used to replace funds that would be raised in the market at the WACC, so the WACC is the opportunity cost for reinvested cash flows. Since the NPV assumes reinvestment at the WACC while the IRR assumes reinvestment at the IRR, NPV is generally the better method.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Capital budgeting: NPV KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 62. Which of the following statements is CORRECT? a. The discounted payback method eliminates all of the problems associated with the payback method. b. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability. c. To find the MIRR, we discount the TV at the IRR. d. A project's NPV profile must intersect the X-axis at the project's WACC. e. 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.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Miscellaneous concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 63. 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 6%, Project S will have the higher NPV. b. If the WACC is 13%, Project S will have the lower NPV. c. If the WACC is 10%, both projects will have a negative NPV. d. Project S's NPV is more sensitive to changes in WACC than Project L's. e. If the WACC is 10%, both projects will have positive NPVs. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: E The easiest way to think about this question is to begin by drawing an NPV profile as shown below, then using it to decide which statement is correct.

Statement e is true, because both projects have an IRR greater than the WACC and thus will have a positive NPV. Statement a is false, because at 6%, the WACC is less than the crossover rate and Project L has a higher NPV than S. Statement b is false, because at 13% the WACC is greater than the crossover rate and S would have a higher NPV than L. Statement c is false, because of reasons mentioned in statement a. Statement d is false, because Project L's NPV profile is steeper, which means Project L's NPV is more sensitive to changes in WACC than Project S's NPV. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 64. Lancaster 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 9%, Project A's NPV will be higher than Project B's. b. If the WACC is 6%, Project B's NPV will be higher than Project A's. c. If the WACC is greater than 14%, Project A's IRR will exceed Project B's. d. If the WACC is 9%, Project B's NPV will be higher than Project A's. e. If the WACC is 13%, Project A's NPV will be higher than Project B's.

ANS: D

Statement d is true, while the others are false. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 65. You are considering two mutually exclusive, equally risky, projects. Both have IRRs that exceed the WACC. Which of the following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by a series of inflows. a. If the 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. The same project will rank higher by both criteria. b. 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. The same project will rank higher by both criteria. c. For a conflict to exist between NPV and IRR, the initial investment cost of one project must exceed the cost of the other. d. 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. e. If the two projects' NPV profiles do not cross, then there will be a sharp conflict as to which one should be selected.

ANS: A Again, it is useful to draw NPV profiles that fit the description given in the question. Any numbers that meet the criteria will do.

Statement a is true. Statement b is false. Statement c is false because a conflict can result from differences in the timing of the cash flows. Statement d is false because scale differences can result in profile crossovers and thus conflicts. Statement e is false, because if the profiles do not cross, then one will dominate the other, with both a higher IRR and a higher NPV at every discount rate.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 66. Consider two projects, X and Y. 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 greater than 10%. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

If the WACC is 8%, Project X will have the higher NPV. If the WACC is 18%, Project Y will have the higher NPV. Project X is larger in the sense that it has the higher initial cost.

The crossover rate must be less than 10%.

ANS: A Again, it is useful to draw NPV profiles that fit the description given in the question. Any number that meets the criteria will do.

As we can see from the graph, statement a is true; the other statements are false.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 67. You are on the staff of O'Hara Inc. The CFO believes project acceptance should be based on the NPV, but Andrew O'Hara, 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%, 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, although its NPV is positive, it has an IRR that is less than the WACC. b. 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. c. You should recommend that the project be rejected. Although its NPV is positive it has two IRRs, one of which is less than the WACC, which indicates that the firm's value will decline if the project is accepted. d. You should recommend that the project be 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. e. You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC. ANS: B © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Statement b is true, while the other statements are false. It is not necessary to calculate the two IRRs and the MIRR as the data in the problem are correct, but we show the Excel calculations below.

WACC Years CF NPV IRR1 IRR2 MIRR

10% 0 −$15,000

1 $110,000

2 −$100,000

$2,355.37 6.33% 527.01% 11.32%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Multiple IRRs KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 68. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows. a. A project's MIRR is always less than its regular IRR. b. If a project's IRR is greater than its WACC, then its MIRR will be greater than the IRR. c. 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. d. 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. e. A project's MIRR is always greater than its regular IRR. ANS: D Answer d is essentially the definition of the MIRR; hence, it is correct.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-5 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 69. 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 less than its regular IRR. b. If a project's IRR is greater than its WACC, then the MIRR will be less than the IRR. c. If a project's IRR is greater than its WACC, then the MIRR will be greater than the IRR. d. 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. e. A project's MIRR is always greater than its regular IRR. ANS: B One could prove that (1) if the IRR is equal to the WACC, then the MIRR and the IRR will be equal, (2) if the IRR is greater than the WACC, the MIRR will be less than the IRR, and (3) the MIRR will be greater than the IRR if the IRR is less than the WACC. This situation exists because the MIRR assumes reinvestment at the WACC and therefore compounds at that rate, while the IRR assumes reinvestment at the IRR itself and therefore compounds at the IRR. Therefore, if the IRR exceeds the WACC, the TV found under the IRR method will be larger, and vice versa. The IRR and the MIRR are found as the rate that causes the PV of the TV to equal the cost. Therefore, if the IRR exceeds the WACC, causing the IRR's TV to be larger, then the IRR will exceed the MIRR, and vice versa. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

As a result, statement b is correct⎯if the IRR exceeds the WACC, the IRR will exceed the MIRR. The other statements are false. Note too that this answer could also be confirmed with a numerical example.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-5 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 70. Consider 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. If Project S has a positive NPV, Project L must also have a positive NPV. b. If the WACC falls, each project's IRR will increase. c. If the WACC increases, each project's IRR will decrease. d. 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. e. Project S must have a higher NPV than Project L. ANS: D Refer to the NPV profile below. Statement a is false, because if the WACC is greater than IRRL but less than IRRS then Project S will have a positive NPV and Project L's NPV will be negative.

Statements b and c are false, because IRR is independent of WACC. Statement d is true, because Project S has the higher IRR, so Project L's NPV profile is above Project S's when the WACC is less than the crossover rate. Statement e is false, because you do not know which project has the higher NPV unless you know the WACC.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 71. 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 IRR must be negative. b. If a project's IRR is equal to its WACC, then under all reasonable conditions the project's NPV must be zero. c. There is no necessary relationship between a project's IRR, its WACC, and its NPV. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. 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. e. If a project's IRR is equal to its WACC, then, under all reasonable conditions, the project's NPV must be negative.

ANS: B

Recall that the very definition of the IRR is the discount rate at which the NPV is zero. Therefore, statement b is true. The other statements are false.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 72. Clifford Company is choosing between two projects. The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%. The smaller project has an initial cost of $50,000, annual cash flows of $16,000 for 5 years, and an IRR of 16.63%. 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 will cross, and the larger project will look better based on the NPV at all positive values of WACC. b. If the company uses the NPV method, it will tend to favor smaller, shorter-term projects over larger, longer-term projects, regardless of how high or low the WACC is. c. 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. d. 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. e. 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. ANS: C

Statement c is true; the other statements are false. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 73. Martin Manufacturing is considering two normal, equally risky, mutually exclusive, but not repeatable projects. Martin's WACC is 10%. 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? a. Since the projects are mutually exclusive, the firm should always select Project B. b. If the crossover rate is 8%, Project B will have the higher NPV. c. Only one project has a positive NPV. d. If the crossover rate is 8%, Project A will have the higher NPV. e. Each project must have a negative NPV. ANS: B Statement b is true, while the other statements are false. If we draw an NPV profile graph, we would see that A must have the steeper slope. If the crossover is 8% and the WACC is 10%, then B will have the higher NPV. PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 74. 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. Assuming the timing pattern of the two projects' cash flows is the same, Project B probably has a higher cost (and larger scale). b. Assuming the two projects have the same scale, Project B probably has a faster payback than Project A. c. The crossover rate for the two projects must be 12%. d. 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%. e. The crossover rate for the two projects must be less than 12%.

ANS: B Consider the following NPV profile graph:

We can see that statements c, d, and e are incorrect. Statement a is also incorrect, because if the projects have the same timing pattern, then A must have the higher cost. That leaves statement b as being correct, and that conclusion is confirmed by noting that since A have the steeper slope, its cash flows must come in slower; hence, B's cash flows come in more quickly and thus has the faster payback. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV profiles KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 75. Ellmann 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 expected NPV is negative, it should be rejected.

WACC: Year Cash flows a. b. c. d. e.

9.00% 0 −$1,000

1 $500

2 $500

3 $500

9.00% 0 −$1,000

1 $500

2 $500

3 $500

$265.65 $278.93 $292.88 $307.52 $322.90

ANS: A WACC: Year Cash flows NPV = $265.65

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 76. Scott 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 expected NPV is negative, it should be rejected.

WACC: Year Cash flows a. b. c. d. e.

11.00% 0 −$1,000

1 $350

2 $350

3 $350

4 $350

11.00% 0 −$1,000

1 $350

2 $350

3 $350

4 $350

$77.49 $81.56 $85.86 $90.15 $94.66

ANS: C WACC: Year Cash flows NPV = $85.86

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Application © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 77. Robbins 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 expected NPV is negative, it should be rejected.

WACC: Year Cash flows a. b. c. d. e.

10.25% 0 −$1,000

1 $300

2 $300

3 $300

4 $300

5 $300

10.25% 0 −$1,000

1 $300

2 $300

3 $300

4 $300

5 $300

$105.89 $111.47 $117.33 $123.51 $130.01

ANS: E WACC: Year Cash flows NPV = $130.01

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 78. Hart Corp. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC or negative, in both cases it will be rejected.

Year Cash flows a. b. c. d. e.

0 −$1,000

1 $425

2 $425

3 $425

0 −$1,000

1 $425

2 $425

3 $425

12.55% 13.21% 13.87% 14.56% 15.29%

ANS: B Year Cash flows IRR = 13.21%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 79. Spence Company is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC or negative, in both cases it will be rejected. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Year Cash flows a. b. c. d. e.

0 −$1,050

1 $400

2 $400

3 $400

4 $400

0 −$1,050

1 $400

2 $400

3 $400

4 $400

14.05% 15.61% 17.34% 19.27% 21.20%

ANS: D Year Cash flows IRR = 19.27%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 80. Nichols Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC or negative, in both cases it will be rejected.

Year Cash flows a. b. c. d. e.

0 −$1,250

1 $325

2 $325

3 $325

4 $325

5 $325

0 −$1,250

1 $325

2 $325

3 $325

4 $325

5 $325

9.43% 9.91% 10.40% 10.92% 11.47%

ANS: A Year Cash flows IRR = 9.43%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 81. McGlothin Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. b. c. d. e.

0 −$1,150

1 $500

2 $500

3 $500

1.86 years 2.07 years 2.30 years 2.53 years 2.78 years

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: C Year Cash flows Cumulative CF Payback = 2.30 years

0 −$1,150 −$1,150

1 $500 −$650

2 $500 −$150

3 $500 $350

−

−

−

2.30

Payback = last year before cum CF turns positive + abs. val. last neg. cum CF/CF in payback year.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 82. Garner Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. b. c. d. e.

0 −$350

1 $200

2 $200

3 $200

0 −$350 −$350

1 $200 −$150

2 $200 $50

3 $200 $250

−

−

1.75

−

1.42 years 1.58 years 1.75 years 1.93 years 2.12 years

ANS: C Year Cash flows Cumulative CF Payback = 1.75 years

Payback = last year before cum CF turns positive + abs. val. last neg. cum CF/CF in payback year.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 83. Worthington Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. b. c. d. e.

0 −$500

1 $150

2 $200

3 $300

2.03 years 2.25 years 2.50 years 2.75 years 3.03 years

ANS: C © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Year Cash flows Cumulative CF Payback = 2.50 years

0 −$500 −$500

1 $150 −$350

2 $200 −$150

3 $300 $150

−

−

−

2.50

Payback = last year before cum CF turns positive + abs. val. last neg. cum CF/CF in payback year.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 84. Poder Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. b. c. d. e.

0 −$750

1 $300

2 $325

3 $350

0 −$750 −$750

1 $300 −$450

2 $325 −$125

3 $350 $225

−

−

−

2.36

1.91 years 2.12 years 2.36 years 2.59 years 2.85 years

ANS: C Year Cash flows Cumulative CF Payback = 2.36 years

Payback = last year before cum CF turns positive + abs. val. last neg. cum CF/CF in payback year.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 85. Reed 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 expected NPV can be negative, in which case it will be rejected.

WACC: Year Cash flows a. b. c. d. e.

10.00% 0 −$1,050

1 $450

2 $460

3 $470

$92.37 $96.99 $101.84 $106.93 $112.28

ANS: A WACC:

10.00%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Year Cash flows

0 −$1,050

1 $450

2 $460

3 $470

NPV = $92.37 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 86. Patterson Co. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected.

WACC: Year Cash flows a. b. c. d. e.

10.00% 0 −$950

1 $500

2 $400

3 $300

10.00% 0 −$950

1 $500

2 $400

3 $300

$54.62 $57.49 $60.52 $63.54 $66.72

ANS: C WACC: Year Cash flows NPV = $60.52

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 87. Yoga Center 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 expected NPV can be negative, in which case it will be rejected.

WACC: Year Cash flows a. b. c. d. e.

14.00% 0 −$1,200

1 $400

2 $425

3 $450

4 $475

14.00% 0 −$1,200

1 $400

2 $425

3 $450

4 $475

$41.25 $45.84 $50.93 $56.59 $62.88

ANS: E WACC: Year Cash flows

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NPV = $62.88 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 88. Dickson Co. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected.

WACC: Year Cash flows a. b. c. d. e.

12.00% 0 −$1,100

1 $400

2 $390

3 $380

4 $370

5 $360

12.00% 0 −$1,100

1 $400

2 $390

3 $380

4 $370

5 $360

$250.15 $277.94 $305.73 $336.31 $369.94

ANS: B WACC: Year Cash flows NPV = $277.94

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 89. Kiley Electronics is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year Cash flows a. b. c. d. e.

0 −$1,100

1 $450

2 $470

3 $490

0 −$1,100

1 $450

2 $470

3 $490

9.70% 10.78% 11.98% 13.31% 14.64%

ANS: D Year Cash flows IRR = 13.31%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 90. Modern Refurbishing Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year Cash flows a. b. c. d. e.

0 −$850

1 $300

2 $290

3 $280

4 $270

0 −$850

1 $300

2 $290

3 $280

4 $270

13.13% 14.44% 15.89% 17.48% 19.22%

ANS: A Year Cash flows IRR = 13.13%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 91. Pet World is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year Cash flows a. b. c. d. e.

0 −$9,500

1 $2,000

2 $2,025

3 $2,050

4 $2,075

5 $2,100

0 −$9,500

1 $2,000

2 $2,025

3 $2,050

4 $2,075

5 $2,100

2.08% 2.31% 2.57% 2.82% 3.10%

ANS: C Year Cash flows IRR = 2.57%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

92. Last month, Standard Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project took place, the Federal Reserve 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 expected NPV can be negative, in which case it should be rejected.

Old WACC: Year Cash flows a. b. c. d. e.

10.00% 0 −$1,000

New WACC: 1 $410

11.25% 2 $410

3 $410

10.00% 0 −$1,000

New WACC: 1 $410

11.25% 2 $410

3 $410

−$18.89 −$19.88 −$20.93 −$22.03 −$23.13

ANS: D Old WACC: Year Cash flows

Old NPV = $19.61 New NPV = −$2.42 Change = −$22.03 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV sensitivity to WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 93. Corner Jewelers, Inc. recently analyzed the project whose cash flows are shown below. However, before the company decided to accept or reject the project, the Federal Reserve 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 expected NPV can be negative, in which case it should be rejected.

Old WACC: Year Cash flows a. b. c. d. e.

8.00% 0 −$1,000

New WACC: 1 $410

11.25% 2 $410

3 $410

8.00% 0 −$1,000

New WACC: 1 $410

11.25% 2 $410

3 $410

−$59.03 −$56.08 −$53.27 −$50.61 −$48.08

ANS: A Old WACC: Year Cash flows

Old NPV = $56.61 New NPV = −$2.42 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Change = −$59.03 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV sensitivity to WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 94. Computer Consultants 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 MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: Year Cash flows a. b. c. d. e.

10.00% 0 −$1,000

1 $450

2 $450

3 $450

9.32% 10.35% 11.50% 12.78% 14.20%

ANS: E WACC: 10.00% Year 0 Cash flows −$1,000 Compounded values, FVs

1 $450 $544.50

2 $450 $495.00

3 $450 $450.00

TV = Sum of compounded inflows: $1,489.50 MIRR = 14.20% MIRR = 14.20%

Found as discount rate that equates PV of TV to cost, discounted back 3 years @ WACC Alternative calculation, using Excel's MIRR function

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-5 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 95. Wiley's Wire 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 MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: Year Cash flows a. b. c. d. e.

11.00% 0 −$800

1 $350

2 $350

3 $350

8.86% 9.84% 10.94% 12.15% 13.50%

ANS: E WACC:

11.00%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Year 0 Cash flows −$800 Compounded values, FVs

1 $350 $431.24

2 $350 $388.50

3 $350 $350.00

TV = Sum of compounded inflows: $1,169.74 MIRR = 13.50% MIRR = 13.50%

Found as discount rate that equates PV of TV to cost, discounted back 3 years @ WACC Alternative calculation, using Excel's MIRR function

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-5 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 96. Watts Co. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: Year Cash flows a. b. c. d. e.

10.00% 0 −$850

1 $300

2 $320

3 $340

4 $360

3 $340 $374.00

4 $360 $360.00

14.08% 15.65% 17.21% 18.94% 20.83%

ANS: B WACC: Year Cash flows Compounded values

10.00% 0 −$850

1 $300 $399.30

2 $320 $387.20

TV = Sum of comp'ed inflows: $1,520.50 MIRR = 15.65% MIRR = 15.65%

Found as discount rate that equates PV of TV to cost, discounted back 4 years @ WACC Alternative calculation, using Excel's MIRR function

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-5 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 97. Westwood Painting Co. is considering a project that has the following cash flow and WACC data.

What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: Year Cash flows

12.25% 0 −$850

1 $300

2 $320

3 $340

4 $360

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

13.42% 14.91% 16.56% 18.22% 20.04%

ANS: C WACC: Year Cash flows Compounded values

12.25% 0 −$850

1 $300 $424.31

2 $320 $403.20

3 $340 $381.65

4 $360 $360.00

TV = Sum of comp'ed inflows: $1,569.16 MIRR = 16.56%

Found as discount rate that equates PV of TV to cost, discounted back 4 years @ WACC Alternative calculation, using Excel's MIRR function

MIRR = 16.56%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-5 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 98. Suzanne's Cleaners is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. b. c. d. e.

0 −$1,100

1 $300

2 $310

3 $320

4 $330

5 $340

0 −$1,100 −$1,100

1 $300 −$800

2 $310 −$490

3 $320 −$170

4 $330 $160

5 $340 $500

−

−

−

−

3.52

−

2.31 years 2.56 years 2.85 years 3.16 years 3.52 years

ANS: E Year Cash flows Cumulative CF Payback = 3.52 years

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Payback KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 99. Craig's Car Wash Inc. is considering a project that has the following cash flow and WACC data. What is the project's discounted payback?

WACC: Year

10.00% 0

1

2

3

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash flows a. b. c. d. e.

−$900

$500

$500

$500

10.00% 0 −$900 −$900 −$900

1 $500 $455 −$445

2 $500 $413 −$32

3 $500 $376 $343

−

−

2.09

1.88 years 2.09 years 2.29 years 2.52 years 2.78 years

ANS: B WACC: Year Cash flows PV of CFs Cumulative CF

−

Payback = 2.09 years

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Discounted payback KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 100. Shannon Co. 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. b. c. d. e.

10.00% 0 −$950

1 $525

2 $485

3 $445

4 $405

1.61 years 1.79 years 1.99 years 2.22 years 2.44 years

ANS: D WACC: Year Cash flows PV of CFs Cumulative CF Payback = 2.22 years

10.00% 0 −$950 −$950 −$950

1 $525 $477 −$473

2 $485 $401 −$72

3 $445 $334 $262

4 $405 $277 $539

−

−

−

2.22

−

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Discounted payback KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

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101. Current Design Co. is considering two mutually exclusive, equally risky, and not repeatable projects, S and L. Their cash flows are shown below. 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: Year CFS CFL a. b. c. d. e.

7.50% 0 −$1,100 −$2,700

1 $550 $650

2 $600 $725

3 $100 $800

4 $100 $1,400

$138.10 $149.21 $160.31 $171.42 $182.52

ANS: A First, recognize that NPV makes theoretically correct capital budgeting decisions, so the highest NPV tells us how much value could be added. We calculate the two projects' NPVs, IRRs, and MIRRs, but the MIRR information is not needed for this problem. We then see what NPV would result if the decision were based on the IRR (and the MIRR). The difference between the NPVs is the loss incurred if the IRR criterion is used. Of course, it's possible that IRR could choose the correct project.

WACC: 7.5000% Year 0 1 CFS −$1,100 $550 Compounded CFs: 683.26 CFL −$2,700 $650 Compounded CFs: 807.49  −$1,600 $100

2 $600 693.38 $725 837.83 $125

3 $100 107.50 $800 860.00 $700

4 $100 100.00 $1,400 1,400.00 $1,300

TV

MIRR

$1,584.14

9.5469%

$3,905.32

9.6663%

Crossover rate = 10.16%

At interest rates < crossover rate, conflict exists.

MIRRL = MIRRS = MIRR Choice: NPV using MIRR:

IRRL = IRRS = IRR Choice: NPV using IRR:

9.67% 9.55% L $224.31

Lost value using IRR versus MIRR: Lost value using MIRR versus NPV: Lost value using IRR versus NPV:

10.71181% 12.24157% S $86.20

NPVL = NPVS = NPV Choice: NPV using NPV:

$224.3065 $86.2036 L $224.31

$138.10 $0.00 $138.10

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

102. Murray 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 wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise Murray on the best procedure. If the wrong decision criterion is used, how much potential value would Murray lose?

WACC: Year CFS CFL a. b. c. d. e.

6.00% 0 −$1,025 −$2,150

1 $380 $765

2 $380 $765

3 $380 $765

4 $380 $765

6.000% 0 −$1,025 −$2,150 −$1,125

1 $380 $765 $385

2 $380 $765 $385

3 $380 $765 $385

4 $380 $765 $385

$188.68 $198.61 $209.07 $219.52 $230.49

ANS: C WACC: Year CFS CFL 

Crossover rate = 13.86%

At interest rates < crossover rate, conflict exists.

IRRL IRRS

15.781% 17.861%

NPVL NPVS

$500.81 $291.74 $209.07 = Value lost if use the IRR criterion

S

L

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0% 2% 4% 6% 8% 10% 12% 13.860% 14% 16% 18% 20% 22% 24%

291.7 495.0 421.9 354.4 291.7 233.6 179.5 129.2 85.4 82.2 38.3 −2.8 −41.3 −77.4 −111.4

500.8 910.0 762.9 626.9 500.8 383.8 274.9 173.6 85.4 79.0 −9.4 −92.1 −169.6 −242.4 −310.7

Note that the WACC is constrained to be less than the crossover rate. So, there is a conflict between NPV and IRR; hence, following the IRR rule results in a loss of value. In the next problem the constraint is relaxed.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 103. Projects S and L, whose cash flows are shown below, are mutually exclusive, equally risky, and not repeatable. Hooper Inc. is considering which of these two projects to undertake. 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 project with the higher IRR will also have the higher NPV, so no value will be lost if the IRR method is used.

WACC: Year CFS CFL a. b. c. d. e.

10.25% 0 −$2,050 −$4,300

1 $750 $1,500

2 $760 $1,518

3 $770 $1,536

4 $780 $1,554

10.25% 0 −$2,050 −$4,300 −$2,250

1 $750 $1,500 $750

2 $760 $1,518 $758

3 $770 $1,536 $766

4 $780 $1,554 $774

$134.79 $141.89 $149.36 $164.29 $205.36

ANS: C WACC: Year CFS CFL 

Crossover rate = 13.275% IRRL

At interest rates < crossover rate, conflict exists.

15.58%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

IRRS

18.06%

NPVL NPVS

$507.40 $358.05 $149.36 = Value lost if use the IRR criterion

Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and IRR; hence, following the IRR rule may not result in a loss of value. In that case, the correct answer is $0.00.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 104. Markman & Sons is considering Projects S and L. These projects are mutually exclusive, equally risky, and not repeatable and their cash flows are shown below. 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 project with the higher IRR will also have the higher NPV, i.e., no conflict will exist.

WACC: Year CFS CFL a. b. c. d. e.

10.00% 0 −$1,025 −$1,025

1 $650 $100

2 $450 $300

3 $250 $500

4 $50 $700

10.000% 0 −$1,025 −$1,025 $0

1 $650 $100 −$550

2 $450 $300 −$150

3 $250 $500 $250

4 $50 $700 $650

$5.47 $6.02 $6.62 $7.29 $7.82

ANS: E WACC: Year CFS CFL 

Crossover rate = 10.549%

At interest rates < crossover rate, conflict exists.

IRRL IRRS

15.66% 19.86%

NPVL NPVS

$167.61 $159.79 $7.82 = Value lost if use the IRR criterion

Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and IRR; hence, following the IRR rule may not result in a loss of value. In that case, the correct answer is $0.00.

PTS: 1

DIF: Difficulty: Challenging

OBJ: LO: 10-4

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 105. Carolina 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: Year CFS CFL a. b. c. d. e.

7.75% 0 −$1,050 −$1,050

1 $675 $360

2 $650 $360

7.75% 0 −$1,050 −$1,050 $0

1 $675 $360 −$315

2 $650 $360 −$290

3

4

$360

$360

3

4

$360 $360

$360 $360

$11.45 $12.72 $14.63 $16.82 $19.35

ANS: B WACC: Year CFS CFL 

Crossover rate = 8.994%

At interest rates < crossover rate, conflict exists.

IRRL IRRS

13.95% 17.13%

NPVL NPVS

$149.03 $136.31 $12.72 = Value lost if use the IRR criterion

Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and IRR; hence, following the IRR rule may not result in a loss of value. In that case, the correct answer is $0.00.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. IRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 106. Silverman 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 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: Year

8.75% 0

1

2

3

4

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

−$1,100 −$2,200

CFS CFL a. b. c. d. e.

$375 $725

$375 $725

$375 $725

$375 $725

$32.12 $35.33 $38.87 $40.15 $42.16

ANS: D WACC: Year CFS

8.750% 0 −$1,100

CFL

−$2,200



−$1,100

1 $375 482.30 $725 932.45 $350

2 $375 443.50 $725 857.43 $350

3 $375 407.81 $725 788.44 $350

4 $375 375.00 $725 725.00 $350

TV

MIRR

$1,708.61

11.64%

$3,303.31

10.70%

Crossover rate = 10.396% MIRRL MIRRS

10.70% 11.64%

NPVL NPVS

$161.74 $121.59 $ 40.15 = Value lost if use the MIRR criterion

Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and IRR; hence, following the MIRR rule may not result in a loss of value. In that case, the correct answer is $0.00.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 107. Farmer 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 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: Year CFS CFL a. b. c. d. e.

10.25% 0 −$950 −$2,100

1 $500 $400

2 $800 $800

3

4

$0 $800

$0 $1,000

$24.14 $26.82 $29.80 $33.11 $36.42

ANS: D © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

WACC: Year CFS CFL Cumulative CFS Cumulative CFL 

10.250% 0 −$950 −$2,100 −$950 −$2,100 −$1,150

Crossover rate = 11.093%

2 $800 $800 $350 −$900 $0

3

4

$0 $800 $350 −$100 $800

$0 $1,000 $350 $900 $1,000

At interest rates < crossover rate, conflict exists. − −

PaybackS = 1.56 PaybackL = 3.10 NPVL = NPVS = Value lost

1 $500 $400 −$450 −$1,700 −$100

− −

1.56 −

− −

− 3.10

$194.79 $161.68 $ 33.11

Note that the WACC is not constrained to be less than the crossover rate. So, there may not be a conflict between NPV and payback; hence following the IRR rule may not result in a loss of value, so the correct answer may be $0.00.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: NPV vs. payback KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 108. Langton 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. In other words, 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: Year CFS CFL a. b. c. d. e.

7.00% 0 −$1,100 −$2,750

1 $550 $725

2 $600 $725

3 $100 $800

4 $100 $1,400

$185.90 $197.01 $208.11 $219.22 $230.32

ANS: A First, recognize that NPV makes theoretically correct capital budgeting decisions, so the higher NPV tells us how much value could be added. We calculate the two projects' NPVs, IRRs, and MIRRs. We then see what NPV would result if the decision were based on the IRR and the MIRR. Under some conditions, MIRR will choose the project with the higher NPV while the IRR chooses the lower NPV project. Then, the difference between the NPVs is the loss incurred if the IRR criterion is used. Of course, it's possible that both the MIRR and the IRR could choose the wrong project; with this set of cash flows, that happens at 8.62133% < WACC < 10.53093%. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

WACC: 7.00% Year 0 CFS −$1,100 Compounded CFs: CFL −$2,750 Compounded CFs:  −$1,650

1 $550 673.77 $725 888.16 $175

2 $600 686.94 $725 830.05 $125

3 $100 107.00 $800 856.00 $700

4 $100 100.00 $1,400 1,400.00 $1,300

TV $1,567.71

IRR/MIRR 12.2416% 9.2618%

$3,974.21

10.9810% 9.6426%

Crossover rate = 10.53093%

At interest rates < crossover rate, conflict exists between IRR and NPV.

MIRRS = MIRRL = MIRR Choice: NPV based on MIRR:

IRRS = IRRL = IRR Choice: NPV based on IRR:

9.2618% 9.6426% L $281.90

12.2416% 10.9810% S $96.00

NPVS = NPVL = NPV Choice: NPV using NPV:

$96.00 $281.90 L $281.90

Lost value using IRR versus MIRR: NPVL − NPVS = $185.90 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 10-4 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: IRR vs. MIRR KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 11—CASH FLOW ESTIMATION AND RISK ANALYSIS TRUE/FALSE 1. Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Cash flow estimation KEY: Bloom’s: Knowledge 2. Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process. Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects' cash flows.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Cash flow estimation KEY: Bloom’s: Knowledge 3. 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Cash flow estimation KEY: Bloom’s: Knowledge 4. 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Knowledge 5. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Knowledge 7. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Knowledge 8. 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Externalities KEY: Bloom’s: Knowledge 9. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Externalities KEY: Bloom’s: Knowledge 10. 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.

ANS: F If the externality is potentially important, it should not be ignored, because then a large error might be made. At the very least, it should be discussed, and possibly the analysis should be done using several scenarios of the possible effects of the externality.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Externalities KEY: Bloom’s: Knowledge 11. Changes in net working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Changes in NWC KEY: Bloom’s: Knowledge 12. The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Depreciation cash flows KEY: Bloom’s: Knowledge 13. The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Depreciation cash flows KEY: Bloom’s: Knowledge 14. Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation. This is because the total cash flows over the project's life will be higher if accelerated depreciation is used, other things held constant.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Depreciation cash flows KEY: Bloom’s: Knowledge 15. A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Depreciation cash flows KEY: Bloom’s: Knowledge 16. Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus increasing their present value. On the other hand, using accelerated depreciation generally lowers the reported current year's profits 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

and cash flows LOC: KEY: Bloom’s: Knowledge

TBA TOP:

Depreciation cash flows

17. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Risk-adjusted discount rate KEY: Bloom’s: Knowledge 18. 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.

ANS: T OBJ: LO: 11-6 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Coefficient of variation KEY: Bloom’s: Knowledge

19. 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.

ANS: F OBJ: LO: 11-6 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: CV vs. SD KEY: Bloom’s: Knowledge

20. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Cash flow estimation KEY: Bloom’s: Comprehension 21. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Cash flow estimation KEY: Bloom’s: Comprehension 22. The two cardinal rules that financial analysts should follow to avoid capital budgeting 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

and cash flows LOC: KEY: Bloom’s: Comprehension

TBA TOP:

Relevant cash flows

23. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Opportunity costs KEY: Bloom’s: Comprehension 24. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Sunk costs KEY: Bloom’s: Comprehension 25. The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is especially true for replacement projects.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Net working capital KEY: Bloom’s: Comprehension 26. The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Depreciation cash flows KEY: Bloom’s: Comprehension 27. 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 more risky the project, other things held constant.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Sensitivity analysis KEY: Bloom’s: Comprehension 28. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T OBJ: LO: 6-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Risk and return TOP: Coefficient of variation KEY: Bloom’s: Comprehension

MULTIPLE CHOICE 29. Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project? a. Shipping and installation costs. b. Cannibalization effects. c. Opportunity costs. d. Sunk costs that have been expensed for tax purposes. e. Changes in net working capital.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Cash flow issues KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 30. Which of the following procedures best accounts for the relative risk of a proposed project? a. Adjusting the discount rate downward if the project is judged to have above-average risk. b. Reducing the NPV by 10% for risky projects. c. Picking a risk factor equal to the average discount rate. d. Ignoring risk because project risk cannot be measured accurately. e. Adjusting the discount rate upward if the project is judged to have above-average risk.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk adjustment KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 31. Puckett Inc. risk-adjusts its WACC to account for project risk. It 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 Puckett accept, assuming that the company uses the NPV method when choosing projects? a. Project B, which has below-average risk and an IRR = 8.5%. b. Project C, which has above-average risk and an IRR = 11%. c. Without information about the projects' NPVs we cannot determine which project(s) should be accepted. d. All of these projects should be accepted. e. Project A, which has average risk and an IRR = 9%.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk-adjusted discount rate KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 32. Which of the following statements is CORRECT? a. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. 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. c. Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project. d. 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. e. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Sunk costs KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 33. Which of the following statements is CORRECT? a. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method. b. 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. c. 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. d. 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 be. e. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Sunk costs KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 34. Which of the following statements is CORRECT? a. 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. b. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. c. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. d. Identifying an externality can never lead to an increase in the calculated NPV. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Externalities KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 35. Which of the following statements is CORRECT? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 customers. Thus, cannibalization is dealt with by society through the antitrust laws. b. 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. c. 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. d. 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. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Externalities KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 36. Which of the following statements is CORRECT? a. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. b. Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes. c. Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions. d. Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV. e. Using accelerated depreciation rather than straight line 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. ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Depreciation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 37. Which of the following statements is CORRECT? a. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. b. Corporations must use the same depreciation method for both stockholder reporting and tax purposes. c. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV. d. Using accelerated depreciation rather than straight line normally has no effect on a project's total projected cash flows nor would it affect the timing of those cash flows or the resulting NPV of the project. e. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Depreciation KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 38. Which of the following statements is CORRECT? a. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer. b. If firms use accelerated depreciation, they will write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. c. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. d. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Depreciation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 39. The CFO of Cicero Industries plans to calculate a new 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 flow), 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 investment in working capital 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 40. Which of the following factors should be included in the cash flows used to estimate a project's NPV? a. Interest on funds borrowed to help finance the project. b. The end-of-project recovery of any working capital required to operate the project. c. Cannibalization effects, but only if those effects increase the project's projected cash flows. d. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes. e. All costs associated with the project that have been incurred prior to the time the analysis is being conducted.

ANS: B OBJ: LO: 11-1

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 41. When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: a. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. b. The value of a building owned by the firm that will be used for this project. c. A decline in the sales of an existing product, provided that decline is directly attributable to this project. d. The salvage value of assets used for the project that will be recovered at the end of the project's life. e. Changes in net working capital attributable to the project.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 42. While developing a new product line, Cook 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. Cook owns the building free and clear⎯there is no mortgage on it. Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. 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. e. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 43. Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? a. Since the firm's director of capital budgeting spent 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. b. The company has spent and expensed $1 million on R&D associated with the new project. c. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. d. 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. e. The new project is expected to reduce sales of one of the company's existing products by © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5%.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 44. Collins Inc. is investigating whether to develop a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated? a. The project will utilize some equipment the company currently owns but is not now using.

A used equipment dealer has offered to buy the equipment. b. The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. c. The new product will cut into sales of some of the firm's other products. d. If the project is accepted, the company must invest $2 million in working capital.

However, all of these funds will be recovered at the end of the project's life. e. The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 45. Which of the following rules is CORRECT for capital budgeting analysis? a. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. b. 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. c. 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. d. If a product is competitive with some of the firm's other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm's other products, this fact need not be reflected in the analysis. e. The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 46. 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 a downward bias in the NPV. b. The existence of any type of "externality" will reduce the calculated NPV versus the NPV © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

that would exist without the externality. c. 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 after-tax proceeds that could be obtained should be charged as a cost to the project under consideration. d. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored. e. 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. ANS: C Regarding e and a, note that since interest should not be considered, exclusion will not lead to any type of bias, positive or negative.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Relevant cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 47. Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products. b. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. c. A firm has spent $2 million on R&D 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. d. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products. e. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Incremental cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 48. Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. Revenues from an existing product would be lost as a result of customers switching to the new product. b. Shipping and installation costs associated with a machine that would be used to produce the new product. c. The cost of a study relating to the market for the new product that was completed last year.

The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year. d. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm. e. Using some of the firm's high-quality factory floor space that is currently unused to © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Incremental cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 49. Which of the following statements is CORRECT? a. 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. b. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. c. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. d. Identifying an externality can never lead to an increase in the calculated NPV. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-1 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Externalities KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 50. To increase productive capacity, a company is considering a proposed new plant. Which of the following statements is CORRECT? a. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. b. 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. c. Capital budgeting decisions should be based on before-tax cash flows. d. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. e. 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.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: New project cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 51. Tallant 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

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Expected NPV Standard deviation (NPV) Project beta (vs. market)

$500,000 $200,000 1.4

$500,000 $250,000 0.8

Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects.

Which of the following statements is CORRECT? a. Project X has more corporate (or within-firm) risk than Project Y. b. Project X has more market risk than Project Y. c. Project X has the same level of corporate risk as Project Y. d. Project X has less market risk than Project Y. e. Project X has more stand-alone risk than Project Y. ANS: B Statement b is true, while the other statements are false. Stand-alone risk is measured by standard deviation. Therefore, since Y's standard deviation is higher than X's, Y has higher stand-alone risk than X. Statement a is false because corporate risk is affected by the correlation of project cash flows with other company cash flows, and since Y's cash flows are more highly correlated with the cash flows of existing projects than X's, Y has more corporate risk than X. Market risk is measured by beta.

Therefore, since X's beta is greater than Y's, statement b is true.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 52. Wansley Enterprises is considering a new project. The company has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that the proposed new project would have a higher standard deviation and coefficient of 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 increase the firm's corporate risk. b. The proposed new project would increase the firm's market risk. c. The proposed new project would not affect the firm's risk at all. d. The proposed new project would have less stand-alone risk than the firm's typical project. e. The proposed new project would have more stand-alone risk than the firm's typical project.

ANS: E Statement e is true because the project has a relatively high standard deviation and thus more stand-alone risk than average. The project's revenues would be countercyclical to the rest of the firm's and to other firms' revenues, hence its within-firm and market risks would be relatively low.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 53. 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? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. Increase the estimated NPV of the project to reflect its greater risk. b. Reject the project, since its acceptance would increase the firm's risk. c. Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. d. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. e. Increase the estimated IRR of the project to reflect its greater risk.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Project's effect on firm risk KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 54. Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its overall (composite) WACC is 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Laramie 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. e. A, B, C, D, and E. ANS: C Statement b is true; the others are false. The following table shows the required return for each project on the basis of its risk level.

Project A B C D E

Risk High Average High Low Low

Expected Return 15% 12% 11% 9% 6%

Req'd Return for This Risk 12% 10% 12% 8% 8%

Decision Accept Accept Reject Accept Reject

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-3 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk-adjusted discount rate KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 55. Which of the following statements is CORRECT? a. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. Well-diversified stockholders do not need to consider market risk when determining required rates of return. c. Market risk is important, but it does not have a direct effect on stock prices because it only affects beta. d. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions. e. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Sensitivity, scenario, & sim.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 56. Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis. e. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Sensitivity, scenario, & sim.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 57. Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses? a. 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. b. 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. c. 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 a sensitivity analysis, hence simulation is the most frequently used procedure. d. DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments⎯managers can often take positive actions after the investment has been made that alter the cash flow © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately. e. 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.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-7 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Risk adjustment KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 58. Which of the following statements is CORRECT? a. 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. b. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project's life. c. 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. d. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: CFs and accounting measures KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 59. You have just landed an internship in the CFO's office of Hawkesworth Inc. Your first task is to estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow?

Sales revenues Depreciation Other operating costs Tax rate a. b. c. d. e.

$13,000 $4,000 $6,000 35.0%

$5,950 $6,099 $6,251 $6,407 $6,568

ANS: A Sales revenues − Operating costs (excl. deprec.)

$13,000 6,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

− Depreciation Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow, Year 1

4,000 $ 3,000 1,050 $ 1,950 4,000 $ 5,950

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual CF KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

60. In your first job with TBL Inc. your task is to consider a new project whose data are shown below.

What is the project's Year 1 cash flow?

Sales revenues Depreciation Other operating costs Tax rate a. b. c. d. e.

$22,250 $8,000 $12,000 35.0%

$8,903 $9,179 $9,463 $9,746 $10,039

ANS: C Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow, Year 1

$22,250 12,000 8,000 $ 2,250 788 $ 1,463 8,000 $ 9,463

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual CF KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

61. Fitzgerald Computers is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow?

Equipment cost (depreciable basis)

$65,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Straight-line depreciation rate Sales revenues, each year Operating costs (excl. deprec.)

Tax rate a. b. c. d. e.

33.333% $60,000 $25,000 35.0%

$28,115 $28,836 $29,575 $30,333 $31,092

ANS: D Equipment life, years Equipment cost Depreciation: Rate = 33.333%

3 $65,000 $21,667

Sales revenues − Basis  rate = depreciation − Operating costs (excl. deprec.)

Operating income (EBIT) Rate = 35.0% − Taxes After-tax EBIT + Depreciation Cash flow, Year 1

$60,000 21,667 25,000 $13,333 4,667 $ 8,667 21,667 $30,333

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual CF KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

62. VR Corporation has the opportunity to invest in a new project, the details of which are shown below.

What is the Year 1 cash flow for the project?

Sales revenues, each year Depreciation Other operating costs Interest expense Tax rate a. b. c. d. e.

$42,500 $10,000 $17,000 $4,000 35.0%

$16,351 $17,212 $18,118 $19,071 $20,075

ANS: E This problem is a bit harder than some of the other ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the cash flows.

Sales revenues

$42,500

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

− Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow, Year 1

17,000 10,000 $15,500 5,425 $10,075 10,000 $20,075

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual CF KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

63. Taylor Inc., the company you work for, is considering a new project whose data are shown below.

What is the project's Year 1 cash flow?

Sales revenues, each year Depreciation Other operating costs Interest expense Tax rate a. b. c. d. e.

$62,500 $8,000 $25,000 $8,000 35.0%

$25,816 $27,175 $28,534 $29,960 $31,458

ANS: B This problem is a bit harder than some of the other ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the cash flows.

Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow, Year 1

$62,500 25,000 8,000 $29,500 10,325 $19,175 8,000 $27,175

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual CF KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

64. Erickson Inc. is considering a capital budgeting project that has an expected return of 25% and a standard deviation of 30%. What is the project's coefficient of variation? a. 1.20 b. 1.26 c. 1.32 d. 1.39 e. 1.46 ANS: A Expected return Standard deviation Coefficient of variation = Std dev/Expected return =

25.0% 30.0% 1.20

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Coefficient of variation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 65. McLeod Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What is the investment's coefficient of variation? a. 0.67 b. 0.73 c. 0.81 d. 0.89 e. 0.98 ANS: A Expected return Standard deviation Coefficient of variation = Std dev/Expected return =

15.0% 10.0% 0.67

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 11-6 NAT: BUSPROG: Analytic STA: DISC: Risk and return LOC: TBA TOP: Coefficient of variation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 66. Your new employer, Freeman Software, is considering a new project whose data are shown below.

The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33.33%, 44.45%, 14.81%, and 7.41% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow?

Equipment cost (depreciable basis) Sales revenues, each year Operating costs (excl. deprec.)

Tax rate a. b. c. d. e.

$65,000 $60,000 $25,000 35.0%

$30,333 $31,849 $33,442 $35,114 $36,869

ANS: A © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Equipment cost Depreciation rate

$65,000 33.33%

Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow, Year 1

$60,000 25,000 21,665 $13,336 4,667 $ 8,668 21,665 $30,333

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual CF | MACRS KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

67. Whitestone Products is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33.33%, 44.45%, 14.81%, and 7.41% for Years 1 through 4. Revenues and other 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 (depreciable basis) Sales revenues, each year Operating costs (excl. deprec.)

Tax rate a. b. c. d. e.

$70,000 $42,500 $25,000 35.0%

$11,904 $12,531 $13,190 $13,850 $14,542

ANS: C Equipment cost Depreciation rate, Year 4

$70,000 7.41%

Sales revenues − Operating costs (excl. deprec.) − Depreciation Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow, Year 4

$42,500 25,000 5,187 $12,313 4,310 $ 8,003 5,187 $13,190

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Annual CF | MACRS © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

68. DeVault Services recently hired you as a consultant to help with its capital budgeting process. The company is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Risk-adjusted WACC Net investment cost (depreciable basis) Straight-line deprec. rate Sales revenues, each year Operating costs (excl. deprec.), each year Tax rate a. b. c. d. e.

10.0% $65,000 33.3333% $65,500 $25,000 35.0%

$15,740 $16,569 $17,441 $18,359 $19,325

ANS: E WACC 10.0% Years Investment cost Sales revenues − Operating costs (excl. deprec.) − Depreciation rate = 33.333% Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow NPV

0 −$65,000

−$65,000 $19,325

1

2

3

$65,500 25,000 21,667 $18,833 6,592 $12,242 21,667 $33,908

$65,500 25,000 21,667 $18,833 6,592 $12,242 21,667 $33,908

$65,500 25,000 21,667 $18,833 6,592 $12,242 21,667 $33,908

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Project NPV KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

69. Kasper Film Co. is selling off some old equipment it no longer needs because its associated project has come to an end. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. 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. a. $5,558 b. $5,850 c. $6,143 d. $6,450 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. $6,772 ANS: B % depreciated on equip.

Tax rate

75% 40%

Equipment cost − Accumulated deprec.

Current book value of equipment Market value of equipment Gain (or loss): Market value − Book value Taxes paid on gain (−) or credited (+) on loss AT salvage value = market value +/− taxes

$22,500 16,875 $ 5,625 6,000 $ 375 −150 $ 5,850

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Salvage value KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

70. McPherson Company must purchase a new milling machine. The purchase price is $50,000, including installation. The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

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

Depreciation Rate 0.20 0.32 0.19 0.12 0.11 0.06

$8,878 $9,345 $9,837 $10,355 $10,900

ANS: E Year 1 2 3 4 5 6

Deprec.

Rate 0.20 0.32 0.19 0.12 0.11 0.06 1.00

Gross sales proceeds (Market value) Book value, end of Year 4

Annual Deprec. $10,000 16,000 9,500 6,000 5,500 3,000 $50,000

Basis $50,000 50,000 50,000 50,000 50,000 50,000

Year-end Book Value $40,000 24,000 14,500 8,500 3,000 0

$12,500 8,500

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Profit Tax on profit Rate = 40% AT salvage value = market value +/− taxes

$ 4,000 1,600 $10,900

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Salvage value KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: This question is not conceptually hard, but may require a significant amount of arithmetic. The additional work will increase the length of time that students need to find the correct answer.

71. Weston Clothing Company is considering manufacturing a new style of shirt, whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other Weston's 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.)

WACC Pre-tax cash flow reduction for other products (cannibalization) Investment cost (depreciable basis) Straight-line deprec. rate Sales revenues, each year for 3 years Annual operating costs (excl. deprec.)

Tax rate a. b. c. d. e.

10.0% $5,000 $80,000 33.333% $67,500 $25,000 35.0%

$3,636 $3,828 $4,019 $4,220 $4,431

ANS: B Investment (Basis) WACC = 10% Sales revenues − Cannibalization cost − Operating costs (excl. deprec.)

Rate = 33.33% − Basis  rate = deprec.

Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow NPV $3,828

t=0 −$80,000

−$80,000

t=1

t=2

t=3

$67,500 5,000 25,000 26,667 $10,833 3,792 $ 7,042 26,667 $33,708

$67,500 5,000 25,000 26,667 $10,833 3,792 $ 7,042 26,667 $33,708

$67,500 5,000 25,000 26,667 $10,833 3,792 $ 7,042 26,667 $33,708

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Project NPV KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

72. Century Roofing is thinking of opening a new warehouse, 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 warehouse. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

WACC Opportunity cost Net equipment cost (depreciable basis) Straight-line deprec. rate for equipment Sales revenues, each year Operating costs (excl. deprec.), each year Tax rate a. b. c. d. e.

10.0% $100,000 $65,000 33.333% $123,000 $25,000 35%

$10,521 $11,075 $11,658 $12,271 $12,885

ANS: D t=0 Investment WACC = 10% −$ 65,000 Opportunity cost −100,000 Revenues − Operating costs (excl. deprec.)

Rate = 33.33% − Basis  rate = deprec.

Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow −$165,000 NPV $12,271

t=1

t=2

t=3

$123,000 25,000 21,667 $ 76,333 26,717 $ 49,617 21,667 $ 71,283

$123,000 25,000 21,667 $ 76,333 26,717 $ 49,617 21,667 $ 71,283

$123,000 25,000 21,667 $ 76,333 26,717 $ 49,617 21,667 $ 71,283

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Project NPV KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 73. Garden-Grow Products is considering a new investment whose data are shown below. The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some additional working capital that would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's life.

What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.)

WACC Net investment in fixed assets (basis) Required new working capital Straight-line deprec. rate Sales revenues, each year

10.0% $75,000 $15,000 33.333% $75,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Operating costs (excl. deprec.), each year Tax rate a. b. c. d. e.

$25,000 35.0%

$23,852 $25,045 $26,297 $27,612 $28,993

ANS: A Investment in fixed assets WACC = 10% Investment in net working capital Sales revenues − Operating costs (excl. deprec.)

Depreciation Rate = 33.333% Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow from operations Recovery of working capital Total cash flows NPV $23,852

t=0 −$75,000 −$15,000

t=1

t=2

t=3

−$90,000

$75,000 25,000 25,000 $25,000 8,750 $16,250 25,000 $41,250

$75,000 25,000 25,000 $25,000 8,750 $16,250 25,000 $41,250

−$90,000

$41,250

$41,250

$75,000 25,000 25,000 $25,000 8,750 $16,250 25,000 $41,250 15,000 $56,250

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Project NPV KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 74. Sheridan Films is considering some new equipment whose data are shown below. The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down.

Also, some new working capital would be required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? WACC Net investment in fixed assets (depreciable basis) Required new working capital Straight-line deprec. rate Sales revenues, each year Operating costs (excl. deprec.), each year Expected pretax salvage value Tax rate a. b. c. d. e.

10.0% $70,000 $10,000 33.333% $75,000 $30,000 $5,000 35.0%

$20,762 $21,854 $23,005 $24,155 $25,363

ANS: C t=0

t=1

t=2

t=3

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investment in fixed assets WACC = 10% Investment in net working capital Sales revenues − Operating costs (excl. deprec.)

Depreciation Rate = 33.333% Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow from operations Recovery of working capital Salvage value, pre-tax Rate = 35% − Tax on salvage value Total cash flows NPV $23,005

−$70,000 −10,000

−$80,000

$75,000 30,000 23,333 $21,667 7,583 $14,083 23,333 $37,417

$75,000 30,000 23,333 $21,667 7,583 $14,083 23,333 $37,417

−$80,000

$37,417

$37,417

$75,000 30,000 23,333 $21,667 7,583 $14,083 23,333 $37,417 10,000 5,000 1,750 $50,667

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Project NPV KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 75. Shultz Business Systems 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, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. What is the project's expected NPV? WACC Net investment cost (depreciable basis) Units sold Average price per unit, Year 1 Fixed op. cost excl. deprec. (constant) Variable op. cost/unit, Year 1 Annual depreciation rate Expected inflation rate per year Tax rate a. b. c. d. e.

10.0% $200,000 50,000 $25.00 $150,000 $20.20 33.333% 5.00% 40.0%

$15,925 $16,764 $17,646 $18,528 $19,455

ANS: C Base Case Calculations Investment cost Inflation Price per unit VC per unit Units sold Sales revenues

WACC = 10%

t=0 −$200,000

t=1

t=2

t=3

5.0% $25.00 $20.20 50,000

5.0% $26.25 $21.21 50,000

5.0% $27.56 $22.27 50,000

$1,250,000

$1,312,500

$1,378,125

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

− Fixed op. cost (excl. deprec.) − Variable op costs Rate = 33.333% − Depreciation Operating income (EBIT) Rate = 40% − Taxes After-tax EBIT + Depreciation Cash flow NPV $17,646

−$200,000

150,000 1,010,000 66,667 $ 23,333 9,333 $ 14,000 66,667 $ 80,667

150,000 1,060,500 66,667 $ 35,333 14,133 $ 21,200 66,667 $ 87,867

150,000 1,113,525 66,667 $ 47,933 19,173 $ 28,760 66,667 $ 95,427

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: NPV including inflation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 76. Sylvester Media 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, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses 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 adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made vs. if it is not made?

WACC Net investment cost (depreciable basis) Units sold Average price per unit, Year 1 Fixed op. cost excl. deprec. (constant) Variable op. cost/unit, Year 1 Annual depreciation rate Expected inflation Tax rate a. b. c. d. e.

10.0% $200,000 50,000 $25.00 $150,000 $20.20 33.333% 4.00% 35.0%

$13,286 $13,985 $14,721 $15,457 $16,230

ANS: C NPV with no adjustment Investment cost Inflation (set to 0%) Price per unit VC per unit Units sold

WACC=10%

t=0 −$200,000

Sales revenues − Fixed op. cost (excl. deprec.) per unit = $20.20 − Variable op costs Rate = 33.3% − Depreciation Operating income (EBIT)

t=1

t=2

t=3

0.0% $25.00 $20.20 50,000

0.0% $25.00 $20.20 50,000

0.0% $25.00 $20.20 50,000

$1,250,000 150,000 1,010,000 66,667 $ 23,333

$1,250,000 150,000 1,010,000 66,667 $ 23,333

$1,250,000 150,000 1,010,000 66,667 $ 23,333

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

− Taxes After-tax EBIT + Depreciation Cash flow NPV w/o infl. adjustment

Rate = 35% $ −$200,000

$

8,167 15,167 66,667 81,833

$ $

8,167 15,167 66,667 81,833

$ $

8,167 15,167 66,667 81,833

$3,507

NPV with adjustment Investment cost Inflation Price per unit VC per unit Units sold

WACC=10%

t=0 −$200,000

Sales revenues − Fixed op. cost (excl. deprec.) per unit = $20.20 − Variable op costs Rate = 33.3% − Depreciation Operating income (EBIT) Rate = 35% − Taxes After-tax EBIT + Depreciation Cash flow −$200,000 NPV w/infl. adjustment $18,228 Increase w/infl. adjustment $14,721

t=1

t=2

t=3

4.0% $25.00 $20.20 50,000

4.0% $26.00 $21.01 50,000

4.0% $27.04 $21.85 50,000

$1,250,000 150,000 1,010,000 66,667 $ 23,333 8,167 $ 15,167 66,667 $ 81,833

$1,300,000 150,000 1,050,400 66,667 $ 32,933 11,527 $ 21,407 66,667 $ 88,073

$1,352,000 150,000 1,092,416 66,667 $ 42,917 15,021 $ 27,896 66,667 $ 94,563

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 11-2 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: NPV including inflation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 77. Spot-Free Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value after Year 3. No new working capital would be required.

Revenues and other operating costs will be constant over the project's life, and this 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 decline?

(Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.)

WACC Net investment cost (depreciable basis) Number of cars washed Average price per car Fixed op. cost (excl. deprec.)

Variable op. cost/unit (i.e., VC per car washed) Annual depreciation Tax rate a. b. c. d. e.

10.0% $60,000 2,800 $25.00 $10,000 $5.375 $20,000 35.0%

$28,939 $30,462 $32,066 $33,753 $35,530

ANS: E © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Base Case Calculations Investment cost Cars washed Price per car Variable cost/unit Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow Base-Case NPV

WACC: 10% 2,800 $25.00 $5.375

$10,000 $5.375 Rate = 33.333%

t=0 −$60,000

10,000

Rate = 35% −$60,000

t=1

t=2

t=3

2,800 $25.00 $5.375

2,800 $25.00 $5.375

2,800 $25.00 $5.375

$70,000 10,000 15,050 20,000 $24,950 8,733 $16,218 20,000 $36,218

$70,000 10,000 15,050 20,000 $24,950 8,733 $16,218 20,000 $36,218

$70,000

t=1

t=2

t=3

1,680 $25.00 $5.375

1,680 $25.00 $5.375

1,680 $25.00 $5.375

$42,000 10,000 9,030 20,000 $ 2,970 1,040 $1,931 20,000 $21,931

$42,000 10,000 9,030 20,000 $ 2,970 1,040 $1,931 20,000 $21,931

$42,000 10,000 9,030 20,000 $ 2,970 1,040 $1,931 20,000 $21,931

15,050 20,000 $24,950 8,733 $16,218 20,000 $36,218

$30,068

Bad Case Calculations Investment cost Cars washed Price per car Variable cost/unit Sales revenues − Fixed op. cost (excl. deprec.) − Variable op costs − Depreciation Operating income (EBIT) − Taxes After-tax EBIT + Depreciation Cash flow Bad-Case NPV Decline in NPV

t=0 −$60,000 Declines by: 40%

−$60,000 −$5,462 $35,530

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 11-5 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital | Tier 2: Financial statements, analysis, forecasting, © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

and cash flows KEY: Bloom’s: Analysis

LOC:

TBA TOP: Sensitivity analysis MSC: TYPE: Multiple Choice: Problem

78. Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth to the firm?

a. b. c. d. e.

$55.08 $57.98 $61.03 $64.08 $67.29

ANS: C

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 11-11 NAT: BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital LOC: TBA TOP: Phased decision KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 12—CORPORATE VALUATION AND FINANCIAL PLANNING TRUE/FALSE 1. 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, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Spontaneous liabilities KEY: Bloom’s: Knowledge 2. Firms pay a low interest rate on spontaneous liabilities so these funds are its cheapest source of capital.

Consequently, the firm should make arrangements with its suppliers to use as much of this credit as possible.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Spontaneous liabilities KEY: Bloom’s: Knowledge 3. A firm will use spontaneous funds to the extent possible; however, due to credit terms, contracts with workers, and tax laws there is little flexibility in their usage.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Spontaneous liabilities KEY: Bloom’s: Knowledge 4. As long as a firm does not pay out 100% of its earnings, the firm's annual profit that is retained in the business (i.e., the addition to retained earnings) is another source of funds for a firm's expansion.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Addition to ret. earnings KEY: Bloom’s: Knowledge 5. A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally large decrease in some other asset.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Asset increase KEY: Bloom’s: Knowledge 6. A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA

TOP: Additional funds needed

KEY: Bloom’s: Knowledge

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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Knowledge 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Knowledge 9. The capital intensity ratio is the amount of assets required per dollar of sales and it has a major impact on a firm's capital requirements.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Capital intensity ratio KEY: Bloom’s: Knowledge 10. One of the first steps in arriving at a firm's forecasted financial statements is a review of industry-average operating ratios relative to these same ratios for the firm to determine whether changes to the ratios need to be made.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Forecasted statements KEY: Bloom’s: Knowledge 11. Operating plans sketch out broad approaches for realization of the firm's strategic vision. These plans usually are developed for a period no longer than a 1-year time horizon because detail is "lost" by extending out the time horizon by more than 1 year.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Operating plans KEY: Bloom’s: Comprehension 12. One of the necessary steps in the financial planning process is a forecast of financial statements under each alternative version of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial plans KEY: Bloom’s: Comprehension © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Comprehension 14. A firm's profit margin is 5%, its debt/assets 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Comprehension 15. Companies with relatively high assets-to-sales ratios require a relatively large amount of new assets for any given increase in sales; hence, they have a greater need for external financing. There are currently no alternatives for these types of firms to lower their asset requirements.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Capital intensity ratio KEY: Bloom’s: Comprehension 16. Firms with high capital intensity ratios have found ways to lower this ratio permitting them to achieve a given level of growth with fewer assets and consequently less external capital. For example, just-in-time inventory systems, multiple shifts for labor, and outsourcing production are all feasible ways for firms to reduce their capital intensity ratios.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Capital intensity ratio KEY: Bloom’s: Comprehension 17. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Capital intensity ratio KEY: Bloom’s: Comprehension 18. If a firm's capital intensity ratio (A0*/S0) decreases as sales increase, use of the AFN formula is likely to understate the amount of additional funds required, other things held constant.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA

TOP: Capital intensity ratio

KEY: Bloom’s: Comprehension

19. The minimum growth rate that a firm can achieve with no access to external capital is called the firm's sustainable growth rate. It can be calculated by using the AFN equation with AFN equal to zero and solving for g.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Sustainable growth rate KEY: Bloom’s: Comprehension 20. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial forecasting KEY: Bloom’s: Comprehension 21. The AFN equation assumes that the ratios of assets and liabilities to sales remain constant over time.

However, this assumption can be relaxed when we use the forecasted financial statement method.

Three conditions where constant ratios cannot be assumed are economies of scale, lumpy assets, and excess capacity.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Forecasting when ratios chg.

KEY: Bloom’s: Comprehension MULTIPLE CHOICE 22. Which of the following assumptions is embodied in the AFN equation? a. Accounts payable and accruals are tied directly to sales. b. Common stock and long-term debt are tied directly to sales. c. Fixed assets, but not current assets, are tied directly to sales. d. Last year's total assets were not optimal for last year's sales. e. None of the firm's ratios will change.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: AFN equation KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 23. F. Marston, Inc. 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 switch to a just-in-time inventory system and outsourcing production. b. The company reduces its dividend payout ratio. c. 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. d. The company discovers that it has excess capacity in its fixed assets. e. A sharp increase in its forecasted sales. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: E Answer e is obviously correct. A switch to a just-in-time inventory system and outsourcing production would lower the firm's capital intensity ratio, which would lower AFN. Note that with purchase terms of 1/5 net 90, the nominal cost of non-free trade credit is only 4.34%, whereas with 3/15, net 35, the nominal cost of trade credit is over 56%. Therefore, the firm should have been taking discounts originally, hence should have had few accounts payable, whereas it would probably not take discounts and thus have more accounts payable with the new supplier. That change would lower its AFN. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 24. The term "additional funds needed (AFN)" is generally defined as follows: a. Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations. b. The amount of assets required per dollar of sales. c. 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. d. A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant. e. Funds that are obtained automatically from routine business transactions.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 25. The capital intensity ratio is generally defined as follows: a. The percentage of liabilities that increase spontaneously as a percentage of sales. b. The ratio of sales to current assets. c. The ratio of current assets to sales. d. The amount of assets required per dollar of sales, or A0*/S0. e. Sales divided by total assets, i.e., the total assets turnover ratio.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Capital intensity ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 26. Which of the following is NOT one of the steps taken in the financial planning process? a. Monitor operations after implementing the plan to spot any deviations and then take corrective actions. b. Determine the amount of capital that will be needed to support the plan. c. Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. d. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors. e. Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

capital can be raised.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-1 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Financial planning KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 27. Spontaneous funds are generally defined as follows: a. A forecasting approach in which the forecasted percentage of sales for each item is held constant. b. Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. c. Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes. d. 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. e. Assets required per dollar of sales.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Spontaneous funds KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 28. 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 increases its dividend payout ratio. b. The company begins to pay employees monthly rather than weekly. c. The company's profit margin increases. d. The company decides to stop taking discounts on purchased materials. e. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 29. Which of the following statements is CORRECT? a. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales. b. 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. c. The capital intensity ratio gives us an idea of the physical condition of the firm's fixed assets. d. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists. e. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

earnings.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Forecasting concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 30. Which of the following statements is CORRECT? a. 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. b. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth. c. 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. d. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 31. Which of the following statements is CORRECT? a. 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. b. Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy does not affect the AFN forecast. c. A negative AFN indicates that retained earnings and spontaneous liabilities are far more than sufficient to finance the additional assets needed. d. If the ratios of assets to sales and spontaneous liabilities to sales do not remain constant, then the AFN equation will provide more accurate forecasts than the forecasted financial statements method. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Additional funds needed KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 32. Which of the following statements is CORRECT? a. 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. b. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 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. d. Dividend policy does not affect the requirement for external funds based on the AFN equation. e. 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.

ANS: E PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: AFN equation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 33. Which of the following statements is CORRECT? a. 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. b. Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the financial forecasting process. c. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. d. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. The Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. e. 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.

ANS: B PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 12-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Forecasting financial reqs.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 34. The Besnier Company had $250 million of sales last year, 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. $312.5 b. $328.1 c. $344.5 d. $361.8 e. $379.8 ANS: A Sales Fixed assets % of capacity utilized

$250 $75.0 80.0%

Full capacity sales = Actual sales/% of capacity used = $312.5 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 12-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: Excess capacity MSC: TYPE: Multiple Choice: Problem

KEY: Bloom’s: Application

35. Last year Baron Enterprises had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity last year. In millions, by how much could Baron's sales increase before it is required to increase its fixed assets? a. $170.09 b. $179.04 c. $188.46 d. $197.88 e. $207.78 ANS: C Sales Fixed assets (not used in calculations) % of capacity utilized Sales at full capacity = Actual sales/% of capacity used =

$350 $270 65% $538.46

Additional sales without adding FA = Full capacity sales − Actual sales = $188.46 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Excess capacity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 36. North Construction had $850 million of sales last year, and it had $425 million of fixed assets that were used at only 60% of capacity. What is the maximum sales growth rate North could achieve before it had to increase its fixed assets? a. 54.30% b. 57.16% c. 60.17% d. 63.33% e. 66.67% ANS: E Sales Fixed assets (not used in calculations) % of capacity utilized Sales at full capacity = Actual sales/% of capacity used = Additional sales without adding FA = Full capacity sales − Actual sales =

$850 $425 60% $1,416.67 $566.67

Percent growth in sales = Additional sales/Old sales = 66.67% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Excess capacity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

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37. Last year National Aeronautics had a FA/Sales ratio of 40%, comprised of $250 million of sales and $100 million of fixed assets. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set? a. 28.5% b. 30.0% c. 31.5% d. 33.1% e. 34.7% ANS: B Sales Fixed assets % of capacity utilized Sales at full capacity = Actual sales/% of capacity used =

$250 $100 75% $333.33

Target FA/Sales ratio = Full capacity FA/Sales = FA Capacity sales = 30.0% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 12-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Finding target FA/S ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 38. Daniel Sawyer, the CEO of the Sawyer Group, is initiating planning for the company's operations next year, and he wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions.

Last year's sales = S0 Sales growth rate = g Last year's total assets = A0* Last year's profit margin = PM a. b. c. d. e.

$350 30% $500 5%

Last year's accounts payable Last year's notes payable Last year's accruals Target payout ratio

$40 $50 $30 60%

$102.8 $108.2 $113.9 $119.9 $125.9

ANS: D Last year's sales = S0 Sales growth rate = g Forecasted sales = S0  (1 + g) S = change in sales = S1 − S0 = S0  g Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, so does not enter AFN calculation Last year's accruals L0* = payables + accruals Profit margin = M Target payout ratio

$350 30% $455 $105 $500 $40 $50 $30 $70 5.0% 60.0%

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AFN = (A0*/S0)S − (L0*/S0)S − Profit margin  S1  (1 − Payout) AFN = $150.0 − $21.0 − $9.1 = $119.9 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Positive AFN KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 39. In your internship with Lewis, Lee, & Taylor Inc. you have been asked to forecast the firm's additional funds needed (AFN) for next year. The firm is operating at full capacity. 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 a. b. c. d. e.

$200,000 40% $135,000 20.0%

Last year's accounts payable Last year's notes payable Last year's accruals Target payout ratio

$50,000 $15,000 $20,000 25.0%

−$14,440 −$15,200 −$16,000 −$16,800 −$17,640

ANS: C Last year's sales = S0 Sales growth rate = g Forecasted sales = S0  (1 + g) S = change in sales = S1 − S0 = S0  g Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, so does not enter AFN calculation Last year's accruals L0* = payables + accruals Profit margin = M Target payout ratio

$200,000 40% $280,000 $80,000 $135,000 $50,000 $15,000 $20,000 $70,000 20.0% 25.0%

AFN = (A0*/S0)S − (L0*/S0)S − Profit margin  S1  (1 − Payout) AFN = $54,000 − $28,000 − $42,000 = −$16,000 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Negative AFN KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

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40. You have been asked to forecast the additional funds needed (AFN) for Houston, Hargrove, & Worthington (HHW), which is planning its operation for the coming year. The firm is operating at full capacity. 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 50%, 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 a. b. c. d. e.

$300.0 40% $500.0 20.0%

Last year's accounts payable Last year's notes payable Last year's accruals Initial payout ratio

$50.0 $15.0 $20.0 10.0%

$31.9 $33.6 $35.3 $37.0 $38.9

ANS: B Last year's sales = S0 Sales growth rate = g Forecasted sales = S0  (1 + g) S = change in sales = S1 − S0 = S0  g Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, so does not enter AFN calculation Last year's accruals L0* = payables + accruals Profit margin = M Initial payout ratio New payout ratio

$300 40% $420 $120 $500 $50 $15 $20 $70 20% 10% 50%

AFN = (A0*/S0)S − (L0*/S0)S − Profit margin  S1  (1 − Payout) Old AFN = $200.0 − $28.0 − $75.6 = $96.4 New AFN = $200.0 − $28.0 − $42.0 = $130.0 Change in AFN = $33.6 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 12-6 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: AFN–changing div. payout KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 41. Weber Interstate Paving Co. had $450 million of sales and $225 million of fixed assets last year, so its FA/Sales ratio was 50%. However, its fixed assets were used at only 65% 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. $74.81 b. $78.75 c. $82.69 d. $86.82 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. $91.16 ANS: B Sales Fixed assets % of capacity utilized Sales at full capacity = Actual sales/% of capacity used = Target FA/Sales ratio = Full capacity FA/Sales = FA/Capacity sales = Optimal FA = Sales  Target FA/Sales ratio = Cash generated = Actual FA − Optimal FA =

$450 $225 65% $692.31 32.50% $146.25 $78.75

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 12-7 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Finding target FA/S ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 13—AGENCY CONFLICTS AND CORPORATE GOVERNANCE TRUE/FALSE 1. Two important issues in corporate governance are (1) the rules that cover the board's ability to fire the CEO and (2) the rules that cover the CEO's ability to remove members of the board.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 13-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate governance KEY: Bloom’s: Knowledge 2. A poison pill is also known as a corporate restructuring.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 13-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate governance KEY: Bloom’s: Comprehension 3. The CEO of D'Amico Motors has been granted some stock options that have provisions similar to most other executive stock options. If D'Amico's stock underperforms the market, these options will necessarily be worthless.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 13-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Stock options KEY: Bloom’s: Comprehension 4. ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 13-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: ESOP KEY: Bloom’s: Comprehension MULTIPLE CHOICE 5. Which of the following is NOT normally regarded as being a barrier to hostile takeovers? a. Targeted share repurchases. b. Shareholder rights provisions. c. Restricted voting rights. d. Poison pills. e. Abnormally high executive compensation.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 13-2 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: Corporate governance KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 6. Which of the following is NOT normally regarded as being a good reason to establish an ESOP? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

To enable the firm to borrow at a below-market interest rate.

To make it easier to grant stock options to employees.

To help prevent a hostile takeover.

To help retain valued employees.

To increase worker productivity.

ANS: B Statement b is the correct answer, because firms can easily grant stock options to employees without an ESOP. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 13-3 NAT: BUSPROG: Analytic STA: DISC: Financial statements, analysis, forecasting, and cash flows LOC: TBA TOP: ESOP KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 14—DISTRIBUTIONS TO SHAREHOLDERS: DIVIDENDS AND REPURCHASES TRUE/FALSE 1. The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price.

ANS: T OBJ: LO: 14-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Optimal distribution policy KEY: Bloom’s: Knowledge

2. The dividend irrelevance theory, proposed by Miller and Modigliani, says that provided a firm pays at least some dividends, how much it pays does not affect either its cost of capital or its stock price.

ANS: F OBJ: LO: 14-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Dividend irrelevance KEY: Bloom’s: Knowledge

3. MM's dividend irrelevance theory says that while dividend policy does not affect a firm's value, it can affect the cost of capital.

ANS: F OBJ: LO: 14-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Dividend irrelevance KEY: Bloom’s: Knowledge

4. 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.

ANS: T OBJ: LO: 14-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Investors' dividend preferences KEY: Bloom’s: Knowledge

5. 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.

ANS: F OBJ: LO: 14-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Dividends and stock prices KEY: Bloom’s: Knowledge

6. If a firm adopts a residual distribution policy, distributions are determined as a residual after funding the capital budget. Therefore, the better the firm's investment opportunities, the lower its payout ratio should be.

ANS: T OBJ: LO: 14-7 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Residual distribution policy KEY: Bloom’s: Knowledge

7. Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders' wealth.

ANS: T

PTS: 1

DIF: Difficulty: Easy

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 14-13 LOC: TBA

NAT: BUSPROG: Reflective Thinking TOP: Stock dividends and stock splits

STA: DISC: Dividend policy KEY: Bloom’s: Knowledge

8. A reverse split reduces the number of shares outstanding.

ANS: T OBJ: LO: 14-13 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Reverse split KEY: Bloom’s: Knowledge

9. 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.

ANS: T OBJ: LO: 14-3 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Dividend irrelevance KEY: Bloom’s: Comprehension

10. 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.

ANS: T OBJ: LO: 14-3 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Dividend-growth tradeoff KEY: Bloom’s: Comprehension

11. If the information content, or signaling, hypothesis is correct, then changes in dividend policy can have an important effect on the firm's value and capital costs.

ANS: T OBJ: LO: 14-5 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Signaling hypothesis KEY: Bloom’s: Comprehension

12. If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual distribution policy.

ANS: F OBJ: LO: 14-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Residual distribution policy KEY: Bloom’s: Comprehension

13. If the shape of the curve depicting a firm's WACC versus its debt ratio is more like a sharp "V", as opposed to a shallow "U", it will be easier for the firm to maintain a steady dividend in the face of varying investment opportunities or earnings from year to year.

ANS: F OBJ: LO: 14-7 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: WACC and dividend policy KEY: Bloom’s: Comprehension

14. Even if a stock split has no information content, and even if the dividend per share adjusted for the split is not increased, there can still be a real benefit (i.e., a higher value for shareholders) from such a split, but any such benefit is probably small.

ANS: T OBJ: LO: 14-13 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Dividend policy TOP: Stock splits KEY: Bloom’s: Comprehension

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MULTIPLE CHOICE 15. In the real world, dividends a. are usually more stable than earnings. b. fluctuate more widely than earnings. 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 or 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 will equal $0.80. Once the percentage is set, then dividend policy is on "automatic pilot" and the actual dividend depends strictly on earnings.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-6 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividend payout KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 16. Poff Industries' stock currently sells for $120 a share. You own 100 shares of the stock. The company is contemplating a 2-for-1 stock split. Which of the following best describes what your position will be after such a split takes place? a. You will have 200 shares of stock, and the stock will trade at or near $60 a share. b. You will have 100 shares of stock, and the stock will trade at or near $60 a share. c. You will have 50 shares of stock, and the stock will trade at or near $120 a share. d. You will have 50 shares of stock, and the stock will trade at or near $60 a share. e. You will have 200 shares of stock, and the stock will trade at or near $120 a share.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock splits KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 17. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that a. investors require that the dividend yield and capital gains yield equal a constant. b. capital gains are taxed at a higher rate than dividends. c. investors view dividends as being less risky than potential future capital gains. d. investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains. e. investors are indifferent between dividends and capital gains.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividends versus capital gains KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 18. Which of the following should not influence a firm's dividend policy decision? a. A strong preference by most shareholders for current cash income versus capital gains. b. Constraints imposed by the firm's bond indenture. c. The fact that much of the firm's equipment has been leased rather than bought and owned. d. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains. e. The firm's ability to accelerate or delay investment projects. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-3 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Optimal dividend policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 19. Which of the following statements about dividend policies is correct? a. One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases. b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest. c. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy. d. The clientele effect suggests that companies should follow a stable dividend policy. e. Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the "bird-in-the hand" effect.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-5 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividend theories KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 20. Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio? a. Its access to the capital markets increases. b. Its R&D efforts pay off, and it now has more high-return investment opportunities. c. Its accounts receivable decrease due to a change in its credit policy. d. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages. e. Its earnings become more stable.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividend payout KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 21. Reynolds Paper Products Corporation follows a strict residual dividend policy. 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 company increases the percentage of equity in its target capital structure. b. The number of profitable potential projects increases. c. Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed. d. Earnings are unchanged, but the firm issues new shares of common stock. e. The firm's net income increases.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 22. If a firm adheres strictly to the residual dividend policy, then if its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio), then the firm should pay a. no dividends to common stockholders. b. dividends only out of funds raised by the sale of new common stock. c. dividends only out of funds raised by borrowing money (i.e., issue debt). d. dividends only out of funds raised by selling off fixed assets. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. no dividends except out of past retained earnings.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-8 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 23. If a firm adheres strictly to the residual dividend policy, the issuance of new common stock would suggest that a. the dividend payout ratio is increasing. b. no dividends were paid during the year. c. the dividend payout ratio is decreasing. d. the dollar amount of investments has decreased. e. the dividend payout ratio has remained constant.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-8 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 24. Which of the following statements is correct? a. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account. b. Stock repurchases can be used by a firm that wants to increase its debt ratio. c. 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. d. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding. e. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock repurchases and DRIPs KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 25. Which of the following statements is correct? a. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends. b. Empirical research indicates that, in general, companies send a negative signal to the marketplace when they announce an increase in the dividend, and as a result share prices fall when dividend increases are announced. The reason is that investors interpret the increase as a signal that the firm has relatively few good investment opportunities. c. If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend reinvestment plan would probably make more sense. d. Dividend reinvestment plans have not caught on in most industries, and today about 99% of all companies with DRIPs are utilities. e. Under the tax laws as they existed in 2008, a dollar received for repurchased stock must be taxed at the same rate as a dollar received as dividends.

ANS: C OBJ: LO: 14-1

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic STA: DISC: Dividend policy

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: Dividends, DRIPs, and repurchases KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 26. Which of the following statements is correct? a. If a company uses the residual dividend model to determine its dividend payments, dividends payout will tend to increase whenever its profitable investment opportunities increase. b. The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the residual dividend model. c. Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm's financial risk. d. A dollar paid out to repurchase stock is taxed at the same rate as a dollar paid out in dividends. Thus, both companies and investors are indifferent between distributing cash through dividends and stock repurchase programs. e. The tax code encourages companies to pay dividends rather than retain earnings.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividend policy and stock repurchases KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 27. Which of the following statements is correct? a. Capital gains earned in a share repurchase are taxed less favorably than dividends; this explains why companies typically pay dividends and avoid share repurchases. b. 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. c. Stock repurchases increase the number of outstanding shares. d. The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter. e. If a company has a 2-for-1 stock split, its stock price should roughly double.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Miscellaneous dividend concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 28. Which of the following statements is correct? a. One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like. b. An increase in the stock price when a company decreases its dividend is consistent with signaling theory as postulated by MM. c. 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 the stock price. d. Stock repurchases make the most sense at times when a company believes its stock is undervalued. e. Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above average payout ratios.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-12 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividend theories KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 29. Which of the following statements is correct? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. 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 follow the strict residual dividend policy. b. If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever the firm's investment opportunities improve. c. 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. d. Despite its drawbacks, following the residual dividend policy will tend to stabilize actual cash dividends, and this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees. e. One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-12 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividend policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 30. Consider two very different firms, M and N. Firm M is a mature firm in a mature industry. Its annual net income and net cash flows are both consistently high and stable. However, M's growth prospects are quite limited, so its capital budget is small relative to its net income. Firm N is a relatively new firm in a new and growing industry. Its markets and products have not stabilized, so its annual operating income fluctuates considerably. However, N has substantial growth opportunities, and its capital budget is expected to be large relative to its net income for the foreseeable future. Which of the following statements is correct? a. Firm M probably has a higher dividend payout ratio than Firm N. b. If the corporate tax rate increases, the debt ratio of both firms is likely to decline. c. The two firms are equally likely to pay high dividends. d. Firm N is likely to have a clientele of shareholders who want to receive consistent, stable dividend income. e. Firm M probably has a lower debt ratio than Firm N. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-12 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Miscellaneous dividend concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 31. Which of the following statements is CORRECT? a. 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 it is illegal today. b. Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits. c. When a company declares a stock split, the price of the stock typically declines⎯by about 50% after a 2-for-1 split⎯and this necessarily reduces the total market value of the equity. d. If a firm's stock price is quite high relative to most stocks⎯say $500 per share⎯then it can declare a stock split of say 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low⎯say $2 per share⎯then it can declare a "reverse split" of say 1-for-25 so as to bring the price up to somewhere around $50 per share. e. 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 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

then the after-split price will be higher than if the 3-for-1 split had been used.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock dividends and stock splits KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 32. Which of the following statements is correct? a. 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. b. Stock repurchases tend to reduce financial leverage. c. If a company declares a 2-for-1 stock split, its stock price should roughly double. d. One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller's dividend clientele theory. e. 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.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Miscellaneous dividend concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 33. Which of the following actions will best enable a company to raise additional equity capital? a. Declare a stock split. b. Begin an open-market purchase dividend reinvestment plan. c. Initiate a stock repurchase program. d. Begin a new-stock dividend reinvestment plan. e. Refund long-term debt with lower cost short-term debt.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-14 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Miscellaneous dividend concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 34. Which of the following statements is NOT correct? a. After a 3-for-1 stock split, a company's price per share should fall, but the number of shares outstanding will rise. b. Investors can interpret a stock repurchase program as a signal that the firm's managers believe the stock is undervalued. c. Companies can repurchase shares to distribute large inflows of cash, say from the sale of a division, to stockholders without paying cash dividends. d. Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend reinvestment plan. e. Stock repurchases can be used by a firm as part of a plan to change its capital structure.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-14 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock repurchases and stock splits KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 35. Which of the following statements is correct? a. The clientele effect can explain why so many firms change their dividend policies so often. b. One advantage of adopting the residual dividend policy is that this policy makes it easier © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

for corporations to develop a specific and well-identified dividend clientele. c. 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. d. Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received. e. If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.

ANS: E PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-12 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividend policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 36. The projected capital budget of Kandell Corporation is $1,000,000, its target capital structure is 60% debt and 40% equity, and its forecasted net income is $550,000. If the company follows a residual dividend policy, what total dividends, if any, will it pay out? a. $122,176 b. $128,606 c. $135,375 d. $142,500 e. $150,000 ANS: E Capital budget % Equity Net income (NI) Dividends paid = NI − [% Equity(Capital budget)]

$1,000,000 40% $550,000 $150,000

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual model-divs paid, divs always positive KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

37. Grandin Inc. is evaluating its dividend policy. It has a capital budget of $625,000, and it wants to maintain a target capital structure of 60% debt and 40% equity. The company forecasts a net income of $475,000. If it follows the residual dividend policy, what is its forecasted dividend payout ratio? a. 40.61% b. 42.75% c. 45.00% d. 47.37% e. 49.74% ANS: D Capital budget Equity ratio Net income (NI) Dividends paid = NI − (Equity ratio)(Capital budget) Dividend payout ratio = Dividends paid/NI

$625,000 40% $475,000 $225,000 47.37%

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: Residual dividend model–dividend payout ratio KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

38. The capital budget of Creative Ventures Inc. is $1,000,000. The company wants to maintain a target capital structure that is 30% debt and 70% equity. The company forecasts that its net income this year will be $800,000. If the company follows a residual dividend policy, what will be its total dividend payment? a. $100,000 b. $200,000 c. $300,000 d. $400,000 e. $500,000 ANS: A The amount of new investment which must be financed with equity is: $1,000,000  70% = $700,000.

Since the firm has $800,000 of net income only $100,000 will be left for dividends.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy–nonalgorithmic KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

39. Rohter Galeano Inc. is considering how to set its dividend policy. It has a capital budget of $3,000,000. The company wants to maintain a target capital structure that is 15% debt and 85% equity.

The company forecasts that its net income this year will be $3,500,000. If the company follows a residual dividend policy, what will be its total dividend payment? a. $205,000 b. $500,000 c. $950,000 d. $2,550,000 e. $3,050,000 ANS: C The amount of new investment which must be financed with equity is: $3,000,000  85% = $2,550,000.

Since the firm has $3,500,000 of net income, $950,000 = $3,500,000 − $2,550,000 will be left for dividends.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy–nonalgorithmic KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

40. Sanchez Company has planned capital expenditures that total $2,000,000. The company wants to maintain a target capital structure that is 35% debt and 65% equity. The company forecasts that its net income this year will be $1,800,000. If the company follows a residual dividend policy, what will be its total dividend payment? a. $100,000 b. $200,000 c. $300,000 d. $400,000 e. $500,000 ANS: E The amount of new investment which must be financed with equity is: $2,000,000  65% = $1,300,000.

Since the firm has $1,800,000 of net income only $500,000 = $1,800,000 − $1,300,000 will be left for dividends.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy–nonalgorithmic KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

41. Yesterday, Berryman Investments was selling for $90 per share. Today, the company completed a 7-for-2 stock split. If the total market value was unchanged by the split, what is the price of the stock today? a. $23.21 b. $24.43 c. $25.71 d. $27.00 e. $28.35 ANS: C Number of new shares Number of old shares Old (pre-split) price New price = Old price  (Old shrs/New shrs)

7 2 $90 $25.71

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock splits–fractional splits KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

42. Last week, Weschler Paint Corp. completed a 3-for-1 stock split. Immediately prior to the split, its stock sold for $150 per share. The firm's total market value was unchanged by the split. Other things held constant, what is the best estimate of the stock's post-split price? a. $50.00 b. $52.50 c. $55.13 d. $57.88 e. $60.78 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: A Number of new shares Number of old shares Pre-split stock price Post-split stock price: P0/New per old =

3 1 $150 $50.00

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock splits–simple splits KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

43. McCann Publishing has a target capital structure of 35% debt and 65% equity. This year's capital budget is $850,000 and it wants to pay a dividend of $400,000. If the company follows a residual dividend policy, how much net income must it earn to meet its capital budgeting requirements and pay the dividend, all while keeping its capital structure in balance? a. $904,875 b. $952,500 c. $1,000,125 d. $1,050,131 e. $1,102,638 ANS: B Capital budget Equity ratio Dividends to be paid Required net income = Dividends + (Capital budget  % Equity)

$850,000 65% $400,000 $952,500

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend model–find net income KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

44. Harvey's Industrial Plumbing Supply's target capital structure consists of 40% debt and 60% equity. Its capital budget this year is forecast to be $650,000. It also wants to pay a dividend of $225,000. If the company follows the residual dividend policy, how much net income must it earn to meet its capital requirements, pay the dividend, and keep the capital structure in balance? a. $584,250 b. $615,000 c. $645,750 d. $678,038 e. $711,939 ANS: B Capital budget % Equity Dividends to be paid Required net income = Dividends + (Capital budget  % Equity) PTS: 1

DIF: Difficulty: Moderate

$650,000 60% $225,000 $615,000 OBJ: LO: 14-7

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend model–find net income KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

45. Victor Rumsfeld Inc.'s dividend policy is under review by its board. Its projected capital budget is $2,000,000, its target capital structure is 60% debt and 40% equity, and its forecasted net income is $600,000. If the company follows a residual dividend policy, what total dividends, if any, will it pay out? a. $240,000 b. $228,000 c. $216,600 d. $205,770 e. $0 ANS: E Capital budget % Equity Net income (NI) Dividends paid = NI − [% Equity(Capital Budget)]

$2,000,000 40% $600,000 $0

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual model–divs paid, divs are zero KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

46. The capital budget forecast for the Santano Company is $725,000. The CFO wants to maintain a target capital structure of 45% debt and 55% equity, and it also wants to pay dividends of $500,000. If the company follows the residual dividend policy, how much income must it earn, and what will its dividend payout ratio be?

a. b. c. d. e.

Net Income Payout $ 898,750 55.63% $ 943,688 58.41% $ 990,872 61.34% $1,040,415 64.40% $1,092,436 67.62%

ANS: A Capital budget Equity ratio Dividends paid NI = Divs + (Eq %  Cap Bud) Payout = Dividends/NI

$725,000 55% $500,000 $898,750 55.63%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual model–find NI, then divs and payout KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

47. United Builders wants to maintain a target capital structure with 30% debt and 70% equity. Its forecasted net income is $550,000, and because of market conditions, the company will not issue any new stock during the coming year. If the firm follows the residual dividend policy, what is the maximum capital budget that is consistent with maintaining the target capital structure? a. $673,652 b. $709,107 c. $746,429 d. $785,714 e. $825,000 ANS: D % Debt % Equity Net income Max capital budget = NI/% Equity Check: Is calculated max cap bud  %Equity = NI?

30% 70% $550,000 $785,714 $550,000 = net income

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

48. Silvana Inc. projects the following data for the coming year. If the firm follows the residual dividend policy and also maintains its target capital structure, what will its payout ratio be?

EBIT Interest rate Debt outstanding Shares outstanding

$2,000,000 10% $5,000,000 $5,000,000

Capital budget % Debt % Equity Tax rate

$850,000 40% 60% 40%

$2,000,000 10% $5,000,000 $5,000,000

Capital budget % Debt % Equity Tax rate

$850,000 40% 60% 40%

EBIT − Interest expense = interest rate  debt Taxable income − Taxes = Tax rate  income Net income (NI) − Equity needed for capital budget = % Equity(capital budget) = Dividends = NI − Equity needed Payout ratio = Dividends/NI

$2,000,000 500,000 $1,500,000 600,000 $ 900,000 510,000 $ 390,000 43.33%

a. b. c. d. e.

37.2% 39.1% 41.2% 43.3% 45.5%

ANS: D EBIT Interest rate Debt outstanding Shares outstanding

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

49. David Rose Inc. forecasts a capital budget of $500,000 next year with forecasted net income of $400,000. The company wants to maintain a target capital structure of 30% debt and 70% equity. If the company follows the residual dividend policy, how much in dividends, if any, will it pay? a. $42,869 b. $45,125 c. $47,500 d. $50,000 e. $52,500 ANS: D % Debt % Debt Capital budget Net income Equity requirement = Cap Bud  % Equity = Dividends = NI − Equity requirement =

30% 70% $500,000 $400,000 $350,000 $50,000

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend policy | Dividend may be zero KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

50. In recent years Constable Inc. has suffered losses, and its stock currently sells for only $0.50 per share.

Management wants to use a reverse split to get the price up to a more "reasonable" level, which it thinks is $25 per share. How many of the old shares must be given up for one new share to achieve the $25 price, assuming this transaction has no effect on total market value? a. 47.50 b. 49.88 c. 50.00 d. 52.50 e. 55.13 ANS: C Current price Target price Old shares surrendered per 1 new share = Target price/Old price

$0.50 $25.00 50.00

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock splits–reverse split KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

51. Brinkley Resources stock has increased significantly over the last five years, selling now for $175 per share. Management feels this price is too high for the average investor and wants to get the price down to a more typical level, which it thinks is $25 per share. What stock split would be required to get to this price, assuming the transaction has no effect on the total market value? Put another way, how many new shares should be given per one old share? a. 6.65 b. 6.98 c. 7.00 d. 7.35 e. 7.72 ANS: C Current price Target price No. of new shares per 1 old share = Current price/Target price

$175.00 $25.00 7.00

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock splits–optimal stock split KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

52. Downie Foods recently completed a 4-for-1 stock split. Prior to the split, its stock sold for $120 per share. If the firm's total market value increased by 5% as a result of increased liquidity caused by the split, what was the stock price following the split? a. $28.43 b. $29.93 c. $31.50 d. $33.08 e. $34.73 ANS: C New shares per 1 old share Pre-split stock price % value increase Post-split stock price = (P0/New per old)(% Value increase)

4 $120 5% $31.50

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock splits–positive market reaction KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

53. Warren Supply Inc. is evaluating its capital budget. The company finances with debt and common equity, but because of market conditions, wants to avoid issuing any new common stock during the coming year. It is forecasting an EPS of $3.00 for the coming year on its 500,000 outstanding shares of stock. Its capital budget is forecasted at $800,000, and it is committed to maintaining a $2.00 dividend per share. Given these constraints, what percentage of the capital budget must be financed with debt? a. 30.54% b. 32.15% c. 33.84% d. 35.63% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. 37.50% ANS: E EPS Shares outstanding DPS Capital budget Net income = EPS  Shares outstanding = Dividends paid = DPS  Shares outstanding = Retained earnings available Capital budget − Retained earnings = Debt needed Debt needed/Capital budget = % Debt financing

$3.00 500,000 $2.00 $800,000 $1,500,000 $1,000,000 $500,000 $300,000 37.5%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual dividend model–req'd debt ratio KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

54. The Meltzer Corporation is contemplating a 7-for-3 stock split. The current stock price is $75.00 per share, and the firm believes that its total market value would increase by 5% as a result of the improved liquidity that it thinks would follow the split. What is the stock's expected price following the split? a. $32.06 b. $33.75 c. $35.44 d. $37.21 e. $39.07 ANS: B Number of new shares Number of old shares Old (pre-split) price % Increase in value New price before value increase = Old price/(Old shares/New shares) New price after value increase = Prior  (1 + % Value increase)

7 3 $75.00 5% $32.14 $33.75

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-13 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Stock splits–positive market reaction KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

55. Getler Inc.'s projected capital budget is $2,000,000, its target capital structure is 40% debt and 60% equity, and its forecasted net income is $1,000,000. If the company follows a residual dividend policy, how much dividends will it pay or, alternatively, how much new stock must it issue?

a. b. c. d.

Dividends $514,425 $541,500 $570,000 $600,000

Stock Issued $162,901 $171,475 $180,500 $190,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. $

0

$200,000

ANS: E Capital budget % Equity Net income (NI) Dividends paid = NI − [% Equity(Cap. Bud)], stock issued if dividends zero or neg

$2,000,000 60% $1,000,000 Dividends: or new stock: $0 $200,000

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual model–divs paid or stock issued KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

56. Norton Electrical has quite a few positive NPV projects from which to choose. The problem is that it has more of these projects than it can finance without issuing new stock and the board of directors refuses to issue any new shares in the foreseeable future. Norton's projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts.

a. b. c. d. e.

Increase Debt to 75% $114.0 $120.0 $126.4 $133.0 $140.0

Increase in Capital Budget Lower Payout to 20% Do both $73.3 $333.9 $77.2 $351.5 $81.2 $370.0 $85.5 $389.5 $90.0 $410.0

ANS: E

NI %Debt %Equity % Payout Dividends Retained earnings Max. capital budget = RE/%Equity Increase over current: Changed amt − Current max.

Current maximum $150.0 25.0% 75.0% 65.0% $97.5 $52.5 $70.0 NA

New Maximums: If increase If lower If do debt payout both $150.0 $150.0 $150.0 75.0% 25.0% 75.0% 25.0% 75.0% 25.0% 65.0% 20.0% 20.0% $97.5 $30.0 $30.0 $52.5 $120.0 $120.0 $210.0 $160.0 $480.0 $140.0 $90.0 $410.0

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-7 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Residual model–divs paid or stock issued KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

57. The following data apply to Garber Industries, Inc. (GII): Value of operations Short-term investments Debt Number of shares

$1,000 $100 $300 100

The company plans on distributing $50 million as dividend payments. What will the intrinsic per share stock price be immediately after the distribution? a. $6.32 b. $6.65 c. $7.00 d. $7.35 e. $7.72 ANS: C

Value of operations + Value of nonoperating assets Total intrinsic value of firm −Debt Intrinsic value of equity  Number of shares Intrinsic price per share

Prior to Distribution $1,000.00 100.00 $1,100.00 300.00 $ 800.00 100.00 $ 8.00

After Distribution $1,000.00 0.00 $1,000.00 300.00 $ 700.00 100.00 $ 7.00

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Dividends and intrinsic stock price KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

58. The following data apply to Elizabeth's Electrical Equipment: Value of operations Short-term investments Debt Number of shares

$20,000 $1,000 $6,000 300

The company plans on distributing $50 million by repurchasing stock. What will the intrinsic per share stock price be immediately after the repurchase? a. $47.50 b. $50.00 c. $52.50 d. $55.13 e. $57.88 ANS: B

Value of operations + Value of nonoperating assets Total intrinsic value of firm

Prior to Distribution $20,000 $ 1,000 $21,000

After Distribution $20,000 $ 0 $20,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

− Debt Intrinsic value of equity ÷ Number of shares Intrinsic price per share # shares repurchased = Value of nonoperating assets / Price prior to distribution

$ 6,000 $15,000 300 $ 50.00

$ 6,000 $14,000 280 $ 50.00

$20.00

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 14-1 NAT: BUSPROG: Analytic STA: DISC: Dividend policy LOC: TBA TOP: Repurchases and intrinsic stock price KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem NOT: With some combinations of variables, the residual policy may result in zero dividends and a zero payout ratio. These outcomes are noted in the topic [TOP] field if applicable.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 15—CAPITAL STRUCTURE DECISIONS TRUE/FALSE 1. Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

ANS: T OBJ: LO: 15-1 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Bankruptcy costs KEY: Bloom’s: Knowledge

2. 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.

ANS: F OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Business risk KEY: Bloom’s: Knowledge

3. Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

ANS: T OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Financial risk KEY: Bloom’s: Knowledge

4. As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

ANS: F OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Financial risk KEY: Bloom’s: Knowledge

5. A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.

ANS: T OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Financial risk KEY: Bloom’s: Knowledge

6. Whenever a firm borrows money, it is using financial leverage.

ANS: T OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Financial leverage KEY: Bloom’s: Knowledge

7. 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.

ANS: F OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Use of financial leverage KEY: Bloom’s: Knowledge

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT. ANS: F OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Operating and financial leverage KEY: Bloom’s: Knowledge

9. The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

ANS: T OBJ: LO: 15-3 LOC: TBA

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Trade-off theory KEY: Bloom’s: Knowledge

10. If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X. ANS: T OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Use of debt in financing KEY: Bloom’s: Comprehension

11. Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical.

ANS: F OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Financial leverage KEY: Bloom’s: Comprehension

12. Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk.

ANS: F OBJ: LO: 15-2 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Business risk KEY: Bloom’s: Comprehension

13. It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS. ANS: T If one firm's sales and earnings were more volatile than those of the other, it could have greater EPS variability in spite of identical financial and operating leverage.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure LOC: TBA TOP: Operating and financial leverage KEY: Bloom’s: Comprehension 14. If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

ANS: T OBJ: LO: 15-3 LOC: TBA

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Reflective Thinking STA: DISC: Capital structure TOP: Bankruptcy costs KEY: Bloom’s: Comprehension

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MULTIPLE CHOICE 1. Which of these items will not generally be affected by an increase in the debt ratio? a. Total risk. b. Financial risk. c. Market risk. d. The firm's beta. e. Business risk.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Business risk KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 2. Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations. a. Sales price variability. b. The extent to which operating costs are fixed. c. The extent to which interest rates on the firm's debt fluctuate. d. Input price variability. e. Demand variability.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Business risk KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 3. 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 personal tax rate. b. An increase in the company's operating leverage. c. The Federal Reserve tightens interest rates in an effort to fight inflation. d. The company's stock price hits a new high. e. An increase in the corporate tax rate.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-3 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Target debt ratio KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 4. Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. The Federal Reserve tightens interest rates in an effort to fight inflation. d. The company's stock price hits a new low. e. An increase in costs incurred when filing for bankruptcy.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-3 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Leverage and capital structure KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. Which of the following statements is CORRECT? a. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. b. Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC. c. Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC. d. Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity. e. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC. ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Capital structure and WACC KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 6. Which of the following statements is CORRECT? a. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. b. The capital structure that minimizes the required return on equity also maximizes the stock price. c. The capital structure that minimizes the WACC also maximizes the price per share of common stock. d. The capital structure that gives the firm the best credit rating also maximizes the stock price. e. The capital structure that maximizes expected EPS also maximizes the price per share of common stock.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Optimal capital structure KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 7. Based on the information below for Benson Corporation, what is the optimal capital structure? a. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. b. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. c. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. d. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. e. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Optimal capital structure KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 8. Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____. a. stock price. b. cost of equity. c. cost of debt. d. cost of preferred stock. e. earnings per share (EPS).

ANS: A

PTS: 1

DIF: Difficulty: Easy

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 15-5 NAT: BUSPROG: Analytic LOC: TBA TOP: Optimal capital structure MSC: TYPE: Multiple Choice: Conceptual

STA: DISC: Capital structure KEY: Bloom’s: Comprehension

9. Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense. The company would issue new bonds and use the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS). Assuming the CFO's estimates are correct, which of the following statements is CORRECT? a. If the plan reduces the WACC, the stock price is also likely to decline. b. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. c. If the plan does increase the EPS, the stock price will automatically increase at the same rate. d. 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. e. Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Financial leverage and EPS KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 10. Which of the following statements is CORRECT? a. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. b. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. c. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. d. The optimal capital structure simultaneously maximizes stock price and minimizes the WACC. e. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Optimal capital structure KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 11. The firm's target capital structure should be consistent with which of the following statements? a. Minimize the cost of debt (rd). b. Obtain the highest possible bond rating. c. Minimize the cost of equity (rs). d. Minimize the weighted average cost of capital (WACC). e. Maximize the earnings per share (EPS).

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Target capital structure KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 12. Which of the following statements is CORRECT? a. The factors that affect a firm's business risk are affected by industry characteristics and economic conditions. Unfortunately, these factors are generally beyond the control of the © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

firm's management. b. One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy. c. A firm's financial risk can be minimized by diversification. d. The amount of debt in its capital structure can under no circumstances affect a company's business risk. e. A firm's business risk is determined solely by the financial characteristics of its industry.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Business & fin. risk & cap. struc.

KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 13. Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will a. normally lead to a decrease in its business risk. b. normally lead to a decrease in the standard deviation of its expected EBIT. c. normally lead to a decrease in the variability of its expected EPS. d. normally lead to a reduction in its fixed assets turnover ratio. e. normally lead to an increase in its fixed assets turnover ratio.

ANS: D More operating leverage generally means a greater use of automation, which means more fixed assets.

If fixed assets increase, but sales do not, then the fixed asset turnover (S/FA) will decline.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Operating leverage KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 14. If debt financing is used, which of the following is CORRECT? a. The percentage change in net operating income will be equal to a given percentage change in net income. b. The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt. c. The percentage change in net income will be greater than the percentage change in net operating income. d. The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income. e. The percentage change in net operating income will be greater than a given percentage change in net income.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Use of financial leverage KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 15. Which of the following statements is CORRECT, holding other things constant? a. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. b. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. c. An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure. d. An increase in the corporate tax rate is likely to encourage a company to use more debt in © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

its capital structure. e. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Leverage and capital structure KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 16. Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure? a. The costs that would be incurred in the event of bankruptcy increase. b. Management believes that the firm's stock has become overvalued. c. Its degree of operating leverage increases. d. The corporate tax rate increases. e. Its sales become less stable over time.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Leverage and capital structure KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 17. Blueline Publishers is considering a recapitalization plan. It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan? a. The company's earnings per share would decline. b. The company's cost of equity would increase. c. The company's ROA would increase. d. The company's ROE would decline. e. The company's net income would increase.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Leverage and capital structure KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 18. Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its basic earning power is 15%. The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged. Which of the following is most likely to occur as a result of the recapitalization? a. The ROA would remain unchanged. b. The basic earning power ratio would decline. c. The basic earning power ratio would increase. d. The ROE would increase. e. The ROA would increase.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Capital structure, ROA, and ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Which of the following statements is CORRECT? a. If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage. b. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. c. If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating income.) d. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio. e. Increasing financial leverage is one way to increase a firm's basic earning power (BEP).

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Financial leverage and EPS KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 20. Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. 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 lower ROA than Company LD. b. Company HD has a lower ROE than Company LD. c. The two companies have the same ROA. d. The two companies have the same ROE. e. Company HD has a higher net income than Company LD. ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Financial leverage and ratios KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 21. Firms U and L both have a basic earning power ratio of 20% and each has the same amount of assets.

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 a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT? a. Firm L has a lower ROA than Firm U. b. Firm L has a lower ROE than Firm U. c. Firm L has the higher times interest earned (TIE) ratio. d. Firm L has a higher EBIT than Firm U. e. The two companies have the same times interest earned (TIE) ratio.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Financial leverage and ratios KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 22. Two operationally similar companies, HD and LD, have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also HD's basic earning power (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT? a. HD should have a higher times interest earned (TIE) ratio than LD. b. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. Given that BEP > rd, HD's stock price must exceed that of LD. d. Given that BEP > rd, LD's stock price must exceed that of HD. e. HD should have a higher return on assets (ROA) than LD. ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Financial leverage and ratios KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 23. Which of the following statements is CORRECT? a. The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price. b. The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. c. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. d. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-3 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Capital structure and WACC KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 24. Which of the following statements is CORRECT? a. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. b. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TIE) ratio. c. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC. d. 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. e. The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC).

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Capital structure, WACC, TIE, and EPS KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 25. Which of the following statements is CORRECT? a. There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. b. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. c. 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. d. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity financing. e. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: E PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Miscellaneous capital structure concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 26. Which of the following statements is CORRECT? a. A change in the personal tax rate should not affect firms' capital structure decisions. b. "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. c. 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. d. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. e. If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

ANS: E PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Miscellaneous capital structure concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 27. Which of the following statements is CORRECT? a. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share. b. All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt ratio. c. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC. d. Since debt is cheaper than equity, increasing a company's debt ratio will always reduce its WACC. e. When a company increases its debt ratio, the costs of equity and debt both increase.

Therefore, the WACC must also increase.

ANS: B PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Leverage and capital structure KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 28. Two operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD's basic earning power ratio (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT? a. Company HD has a higher times interest earned (TIE) ratio than Company LD. b. Company HD has a 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. c. The two companies have the same ROE. d. Company HD's ROE would be higher if it had no debt. e. Company HD has a higher return on assets (ROA) than Company LD. ANS: B OBJ: LO: 15-5 LOC: TBA

PTS: 1 DIF: Difficulty: Challenging NAT: BUSPROG: Analytic STA: DISC: Capital structure TOP: Financial leverage and ratios KEY: Bloom’s: Analysis

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 29. Which of the following statements is CORRECT? a. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. b. Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels. c. 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. d. Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital. e. Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.

ANS: C PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-4 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Variations in capital structures KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 30. The world-famous discounter, Fernwood Booksellers, specializes in selling paperbacks for $7 each.

The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1. Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even? a. $600,000 b. $466,667 c. $333,333 d. $200,000 e. None of the above ANS: D $7(200,000) − $5(200,000) − F = 0; F = $400,000. $7(200,000) − $4(200,000) − F = 0; F = $600,000. $600,000 − $400,000 = $200,000.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Breakeven point–nonalgorithmic KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 31. Larsen Films' is analyzing its cost structure. Its fixed operating costs are $470,000, its variable costs of $2.80 per unit produced, and its products sell for $4.00 per unit. What is the company's breakeven point, i.e., at what unit sales volume would income equal costs? a. 391,667 b. 411,250 c. 431,813 d. 453,403 e. 476,073 ANS: A Fixed operating costs Variable costs per unit

$470,000 $2.80

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sales price per unit Breakeven volume (units) = FC/(P − VC) =

$4.00 391,667

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Breakeven analysis KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 32. A new company to produce state-of-the-art car stereo systems is being considered by Jagger Enterprises. The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is estimated to be $2.50; and fixed costs are estimated at $120,000. What sales volume would be required in order to break even, i.e., to have an EBIT of zero for the stereo business? a. 86,640 b. 91,200 c. 96,000 d. 100,800 e. 105,840 ANS: C VC/unit Price multiple over VC Price Fixed costs Breakeven volume (units) = FC/(P − VC) =

$2.50 1.50 $3.75 $120,000 96,000

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Breakeven analysis KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 33. Hernandez Corporation expects to have the following data during the coming year. What is Hernandez's expected ROE? Assets D/A EBIT a. b. c. d. e.

$200,000 Interest rate 65% Tax rate $25,000

8% 40%

12.51% 13.14% 13.80% 14.49% 15.21%

ANS: A Assets D/A EBIT Interest rate Tax rate

$200,000 65% $25,000 8% 40%

EBIT − Interest EBT − Tax

$25,000 10,400 $14,600 5,840

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NI

$ 8,760

ROE = NI avail to common/Common equity ROE = 12.51% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Debt's effect on ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 34. After an intensive research and development effort, two methods for producing playing cards have been identified by the Turner Company. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income (EBIT)? a. 5,000 decks b. 10,000 decks c. 15,000 decks d. 20,000 decks e. 25,000 decks ANS: B Total cost Method 1 = $1.00Q + $10,000.

Total cost Method 2 = $1.50Q + $5,000.

Set equal and solve for Q: Q + $10,000 = $1.50Q + $5,000; $5,000 = $0.5Q; 10,000 = Q. PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Net operating income–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 35. Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 40%. What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta? a. 0.64 b. 0.67 c. 0.71 d. 0.75 e. 0.79 ANS: E bL D/A Tax rate D/E = (D/A)/(1 − D/A) bU = bL/(1 + (D/E)  (1 − T))

1.10 0.40 40% 0.67 0.79

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Calculating the unlevered beta KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

36. The following information has been presented to you about the Gibson Corporation.

Total assets Operating income (EBIT) Interest expense Net income Share price

$3,000 million $800 million $0 million $480 million $32.00

Tax rate Debt ratio WACC M/B ratio EPS = DPS

40% 0% 10% 1.00 $3.20

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company makes this change, what would be the total market value (in millions) of the firm? a. $3,200 b. $3,600 c. $4,000 d. $4,200 e. $4,800 ANS: E Step 1:

Find the new WACC: WACC = wcrs + wd(1 − T)rd = (0.8(0.11)) + (0.2(1 − 0.4)0.10) = 0.10.

Step 2:

Find the free cash flow: Because there is no growth, there is no investment in capital, hence FCF is equal to NOPAT: FCF = NOPAT − Investment in capital = EBIT(1 − T) −0 = $800(1 − 0.4) = $480 million.

Step 3:

Find the new value of the firm: V = FCF/(WACC − g) = $480/0.10 = $4,800 million.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Capital structure and value–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 37. A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, fixed costs are estimated at $750,000, and 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 this profit goal? a. 4,513 b. 4,750 c. 5,000 d. 5,250 e. 5,513 ANS: C VC/unit Price multiple over VC Price Fixed costs Profit target Volume (units) to meet profit goal = (FC + Profit)/(P − VC) =

$250 2 $500 $750,000 $500,000 5,000

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Check: Op profit = (P − VC)  Units − FC =

$500,000

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: EBIT and setting the price KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 38. Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt⎯HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs? Applicable to Both Firms Firm HD's Data Assets $200 Debt ratio EBIT $40 Interest rate Tax rate 35% a. b. c. d. e.

Firm LD's Data 50% Debt ratio 12% Interest rate

30% 10%

Firm LD's Data 50% Debt ratio 12% Interest rate

30% 10%

2.18% 2.29% 2.41% 2.54% 2.66%

ANS: C Applicable to Both Firms Firm HD's Data Assets $200 Debt ratio EBIT $40 Interest rate Tax rate 35% Debt = Interest = I = Taxable income = EBIT − I = NI = (Taxable Income)(1 − T) = Equity = A − Debt = ROE = NI/Equity = Difference in ROEs = 2.41%

$100.0 $12.0 $28.0 $18.2 $100.0 18.20%

$60.0 $6.0 $34.0 $22.1 $140.0 15.79%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-2 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Differences in ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 39. Morales Publishing's tax rate is 40%, its beta is 1.10, and it uses no debt. However, the CFO is considering moving to a capital structure with 30% debt and 70% equity. If the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity? a. 1.53% b. 1.70% c. 1.87% d. 2.05% e. 2.26% ANS: B bU = Target % Debt =

1.10 30%

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Target D/E = T= bL = bU  (1+ (D/E)  (1 − T)) rRF = RPM = rsU = rRF + bU(RPM) = rsL = rRF + bL(RPM) = Change in equity cost =

0.43 40% 1.38 5.00% 6.00% 11.60% 13.30% 1.70%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Calculating levered beta and cost of equity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 40. Serendipity Inc. is re-evaluating its debt level. Its current capital structure consists of 80% debt and 20% common equity, its beta is 1.60, and its tax rate is 35%. However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity.

The risk-free rate is 5.0% and the market risk premium is 6.0%. By how much would the capital structure shift change the firm's cost of equity? a. −5.20% b. −5.78% c. −6.36% d. −6.99% e. −7.69% ANS: B bL = Current Debt% Target Debt% Current D/E = D%/(1 − D%) Target D/E = D%/(1 − D%) Tax rate = bU = bL/(1 + (D/E)(1 − T)) new bL = bU  (1 + (D/E)  (1 − T)) rRF = RPM rs 80% D = rRF + b80% D(RPM) = rs 40% D = rRF + b40% D (RPM) = Change in equity cost

1.60 80% 40% 4.00 0.67 35% 0.4444 0.6370 5.00% 6.00% 14.60% 8.82% −5.78%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Calculating levered beta and cost of equity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 41. Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.) a. 10.95% b. 11.91% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 12.94% d. 14.07% e. 15.29% ANS: E Original rs Current D/A rRF RPM Tax rate Target D/A Original b: Original D/E: Unlevered beta: Target D/E = New beta: rs New = rRF + bL New (RPM) =

11.5% 25% 5% 6% 40% 60% rs = rRF + bL(RPM); b = (rs − rRF)/RPM = D/A/(1 − D/A) = bU = bL/(1 + (D/E)(1 − T)) bL = bU (1+ (D/E)(1 − T))

1.083 0.3333 0.90 1.50 1.7153 15.29%

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Cost of equity–unlevering and relevering betas KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 42. An all-equity firm with 200,000 shares outstanding, Antwerther Inc., has $2,000,000 of EBIT, which is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS). Its tax rate is 40%.

The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.

Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization? a. $65.77 b. $69.23 c. $72.69 d. $76.33 e. $80.14 ANS: B Shares outstanding EBIT Dividend payout ratio Tax rate Bonds issued = stock repurchased Before the recapitalization rs = rRF + bold(RPM) DPS = EPS = (EBIT)(1 − T)/Shares P0 = DPS/rs Shares repurchased = Bonds issued/P0

200,000 $2,000,000 100% 40% $5,000,000

Interest rate Risk-free rate Market risk premium Beta − before recap Beta − after recap

10% 6.5% 5.0% 0.90 1.10

11.00% $6.00 $54.55 91,667

After the recapitalization © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

rs = rRF + bnew(RPM) DPS = EPS = (EBIT − rd  Bonds)(1 − T)/Shares P0 = DPS/rs

12.00% $8.31 $69.23

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Recapitalization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 43. Merriwether Building has operating income of $20 million, a tax rate of 40%, and no debt. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40% debt and 60% equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10%. What would its stock price be if it changes to the new capital structure? a. $40 b. $48 c. $52 d. $54 e. $60 ANS: B Step 1:

Find the new value of the firm after the recapitalization. Because growth is zero, free cash flow is equal to NOPAT: V = FCF/WACC = NOPAT/WACC = EBIT(1 − T)/WACC = $20(1 − 0.4)/0.1 = $120 million.

Step 2:

Find the new value of equity and debt after the recapitalization: S = wcV = 0.6($120) = $72 million.

D = wdV = 0.4($120) = $48 million.

Step 3:

Find the new price per share after the recapitalization: P = [S + (D − D0)]/n0 = [$72 + ($48 − 0)]/2.5 = $48.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Capital structure and stock price–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 44. Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value. Right now, Cartwright has a capital structure that consists of 20% debt and 80% equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, rM − rRF, is 5%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%. What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity? a. 13.00% b. 13.64% c. 14.35% d. 14.72% e. 15.60% ANS: C Facts given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 40%.

Step 1:

Find the firm's current levered beta using the CAPM:

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

rs = rRF + RPM(b) 12% = 6% + 5%(b) b = 1.2.

Step 2:

Find the firm's unlevered beta using the Hamada equation: b = bU[1 + (1 − T)(D/E)] 1.2 = bU[1 + (0.6)(0.25)] 1.2 = 1.15bU 1.0435 = bU.

Step 3:

Find the new levered beta given the new capital structure using the Hamada equation: b = bU[1 + (1 − T)(D/E)] = 1.0435[1 + (0.6)(1)] = 1.6696.

Step 4:

Find the firm's new cost of equity given its new beta and the CAPM: rs = rRF + RPM(b) = 6% + 5%(1.6696) = 14.35%.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Hamada equation and cost of equity–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 45. LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table: Percent financed with debt (wd) 0.10 0.20 0.30 0.40 0.50

Percent financed with equity (wc) 0.90 0.80 0.70 0.60 0.50

Debt-to-equity ratio (D/S) 0.10/0.90 = 0.11 0.20/0.80 = 0.25 0.30/0.70 = 0.43 0.40/0.60 = 0.67 0.50/0.50 = 1.00

Bond Rating AAA AA A BBB BB

Before-tax cost of debt 7.0% 7.2 8.0 8.8 9.6

The company uses the CAPM to estimate its cost of common equity, rs. The risk-free rate is 5% and the market risk premium is 6%. LeCompte estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.) The company's tax rate, T, is 40%.

On the basis of this information, what is LeCompte's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure? a. wc = 0.9; wd = 0.1; WACC = 14.96% b. wc = 0.8; wd = 0.2; WACC = 10.96% c. wc = 0.7; wd = 0.3; WACC = 7.83% d. wc = 0.6; wd = 0.4; WACC = 10.15% e. wc = 0.5; wd = 0.5; WACC = 10.18% ANS: D rRF = 5%; rM − rRF = 6%. rs = rRF + (rM − rRF)b. WACC = rd  wd  (1 − T) + rs  wc.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

You need to use the D/E ratio given for each capital structure to find the levered beta using the Hamada equation. Then, use each of these betas with the CAPM to find the rs for that capital structure.

Use this rs and rd for each capital structure to find the WACC. The optimal capital structure is the one that minimizes the WACC. (D/E) 0.11 0.25 0.43 0.67 1.00

b = bU[1 + (1 − T)(D/E)] 1.0667 1.1500 1.2571 1.4000 1.6000

For example, if the D/E is 0.11:

rs = rRF + (rM − rRF)b 11.4005% 11.9000 12.5429 13.4000 14.6000

wc 0.9 0.8 0.7 0.6 0.5

rd 7.0% 7.2 8.0 8.8 9.6

wd 0.1 0.2 0.3 0.4 0.5

WACC 10.68% 10.38 10.22 10.15 10.18

b = 1.0[1 + (1 − T)(D/E)] = 1.0[1 + (1 − 0.4)(0.1111)] = 1.0667. rs = rRF + (rM − rRF)b = 5% + 6%(1.0667) = 11.40%.

The weights are given at 0.9 and 0.1 for equity and debt, respectively, and the rd for that capital structure is given as 7%.

WACC = rd  wd  (1 − T) + rs  wc = 7%  0.1  (1 − 0.4) + 11.40%  0.9 = 10.68%.

Do the same calculation for each of the capital structures and find each WACC. The optimal capital structure is the one that minimizes the WACC, which is 10.15%. Therefore, the optimal capital structure is 40% debt and 60% equity.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Opt cap struc, Hamada equation–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 46. Refer to Exhibit 15.1. PP is considering changing its capital structure to one with 30% debt and 70% equity, based on market values. The debt would have an interest rate of 8%. The new funds would be used to repurchase stock. It is estimated that the increase in risk resulting from the added leverage would cause the required rate of return on equity to rise to 12%. If this plan were carried out, what would be PP's new value of operations? a. $484,359 b. $487,805 c. $521,173 d. $560,748 e. $584,653 ANS: B WACC

V V

= wcrs + wd(1 − T)rd = (0.7)(0.12) + (0.3)(1 − 0.4)(0.08) = 0.0984 = 9.84%.

= FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 − T). = $80,000(1 − 0.4)/0.0984 = $487,804.878  $487,805.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: WACC and recapitalization–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.1 MUST be kept together, and they cannot be changed © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

algorithmically.

47. Refer to Exhibit 15.1. Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 in new debt and purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase? a. $45.90 b. $48.12 c. $51.06 d. $53.33 e. $58.75 ANS: C Value of operations + value of T-bills Total value − value of debt Value of equity Divide by # shares Price per share

$510,638 178,723 $689,361 178,723 $510,638 10,000 $51.06

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Stock price, recapitalization–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.1 MUST be kept together, and they cannot be changed algorithmically.

48. Refer to Exhibit 15.1. Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 in new debt and purchases T-bills to hold until it makes the stock repurchase. PP then sells the T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase? a. 7,500; $71.49 b. 7,000; $59.57 c. 6,500; $51.06 d. 6,649; $53.33 e. 6,959; $58.78 ANS: C First, find the stock price after issuing debt but prior to repurchase: Value of operations + value of T-bills Total value − value of debt Value of equity Divide by # shares Price per share

$510,638 178,723 $689,361 178,723 $510,638 10,000 $51.06

The price per share does not change in the repurchase, so the number of shares repurchased is equal to the amount used to repurchase shares divided by the price per share: © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Number shares repurchased = $178,723/$51.06 = 3,500.

Number shares remaining = 10,000 − 3,500 = 6,500.

As a check, the price per share after repurchase is: Value of operations + value of T-bills Total value − repurchase Value of equity Divide by # shares Price per share

$510,638 0 $510,638 178,723 $331,915 6,500 $51.06

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Stock price, recapitalization–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.1 MUST be kept together, and they cannot be changed algorithmically.

49. Refer to Exhibit 15.2. If this plan were carried out, what would be VF's new WACC and its new value of operations?

a. b. c. d. e.

WACC Value 9.64% $497,925 9.83% $507,884 10.03% $518,041 10.23% $528,402 10.74% $538,970

ANS: A Debt/Value = Equity/Value = WACC V V V

20% Interest rate = rd = 80% New cost of equity = rs =

7.0% 11.0%

= wd(1 − T)rd + wcrs = 0.84% + 8.80% = 9.64%

= FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 − T). = NOPAT/WACC = $48,000/9.64% = $497,925

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: WACC and recapitalization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.2 MUST be kept together.

50. Refer to Exhibit 15.2. Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt. This results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations. Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Debt/Value = Equity/Value = a. b. c. d. e.

40% Value of new debt = 60% New WACC =

$213,333 9.0%

$50.67 $53.33 $56.00 $58.80 $61.74

ANS: B Value of operations = EBIT(1 − T)/WACC + value of T-bills Total value − value of debt Value of equity Divide by # shares Price per share

$533,333 213,333 $746,666 −213,333 $533,333 10,000 $53.33

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Stock price, recapitalization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.2 MUST be kept together.

51. Refer to Exhibit 15.2. What would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock? a. $49.43 b. $50.70 c. $52.00 d. $53.33 e. $56.00 ANS: D The price per share does not change in the repurchase.

As a check, consider the following data: Value of operations = EBIT(1 − T)/WACC + value of T-bills Total value − repurchase Value of equity New shares = old − Debt/Price = Stock price = Equity divided by # shares

$533,333 0 $533,333 −213,333 $320,000 6,000 $53.33

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Stock price, recapitalization KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.2 MUST be kept together.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

52. Refer to Exhibit 15.3. BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity, based on market values. The debt would have an interest rate of 7%. The new funds would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise to 14%. If this plan were carried out, what would BB's new value of operations be? a. $498,339 b. $512,188 c. $525,237 d. $540,239 e. $590,718 ANS: A WACC = wcrs + wd(1 − T)rd = (0.8)(0.14) + (0.2)(0.07)(1 − 0.4) = 0.1204 = 12.04%.

V V

= FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 − T). = $100,000(1 − 0.4)/0.1204 = $498,338.87  $498,339.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: WACC and recapitalization–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.3 MUST be kept together, and they cannot be changed algorithmically.

53. Refer to Exhibit 15.3. Now assume that BB is considering changing from its original capital structure to a new capital structure with 45% debt and 55% equity. This results in a weighted average cost of capital equal to 10.4% and a new value of operations of $576,923. Assume BB raises $259,615 in new debt and purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase? a. $14.42 b. $19.36 c. $23.91 d. $28.85 e. $35.62 ANS: D Value of operations + value of T-bills Total value − value of debt Value of equity Divide by # shares Price per share

$576,923 259,615 $836,538 259,615 $576,923 20,000 $28.85

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Stock price, recapitalization–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.3 MUST be kept together, and they cannot be changed algorithmically.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

54. Refer to Exhibit 15.3. Now assume that BB is considering changing from its original capital structure to a new capital structure with 45% debt and 55% equity. This results in a weighted average cost of capital equal to 10.4% and a new value of operations of $576,923. Assume BB raises $259,615 in new debt and purchases T-bills to hold until it makes the stock repurchase. BB then sells the T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase? a. 11,001; $28.85 b. 12,711; $35.62 c. 13,901; $42.57 d. 15,220; $54.31 e. 17,105; $89.67 ANS: A First, find the stock price after issuing debt but prior to repurchase: Value of operations + value of T-bills Total value − value of debt Value of equity Divide by # shares Price per share

$576,923 259,615 $836,538 259,615 $576,923 20,000 $28.85

The price per share does not change in the repurchase, so the number of shares repurchased is equal to the amount used to repurchase shares divided by the price per share: Number shares repurchased = $259,615/$28.85 = 8,999.

Number shares remaining = 20,000 − 8,999 = 11,001.

As a check, the price per share after repurchase is: Value of operations + value of T-bills Total value − repurchase Value of equity Divide by # shares Price per share

$576,923 0 $576,923 259,615 $317,308 11,001 $28.84

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Stock price, recapitalization–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.3 MUST be kept together, and they cannot be changed algorithmically.

55. Refer to Exhibit 15.4. What is AJC's current total market value and weighted average cost of capital? a. $600,000; 7.5% b. $600,000; 8.0% c. $800,000; 7.0% d. $800,000; 7.5% e. $800,000; 8.0% ANS: D © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

V

= Debt + Equity = $200,000 + $60(10,000) = $200,000 + $600,000 = $800,000.

WACC

= wcrs + wd(1 − T)rd = (($600,000/$800,000)(0.088)) + ($200,000/$800,000)(1 − 0.4)(0.06) = (0.75)(0.088) + (0.25)(0.036) = 0.075 = 7.5%.

As a check, V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 − T).

V = $100,000(1 − 0.4)/0.075 = $800,000.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Market value and WACC–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.4 MUST be kept together, and they cannot be changed algorithmically.

56. Refer to Exhibit 15.4. The firm is considering moving to a capital structure that is comprised of 40% debt and 60% equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 7%, while the required rate of return on equity would rise to 9.5%. If this plan were carried out, what would be AJC's new WACC and total value? a. 7.38%; $800,008 b. 7.38%; $813,008 c. 7.50%; $813,008 d. 7.50%; $790,008 e. 7.80%; $790,008 ANS: B WACC

V V

= wcrs + wd(1 − T)rd = (0.6)(0.095) + (0.4)(1 − 0.4)(0.07) = 0.0738 = 7.38%.

= FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 − T). = $100,000(1 − 0.4)/0.0738 = $813,008.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-5 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: WACC and recapitalization–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.4 MUST be kept together, and they cannot be changed algorithmically.

57. Refer to Exhibit 15.4. Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50% debt and 50% equity. If it makes this change, its resulting market value would be $820,000. What would be its new stock price per share? a. $58 b. $59 c. $60 d. $61 e. $62 ANS: E Step 1.

Find the new value of equity and debt after the recapitalization: S = wcV = 0.5($820,000) = $410,000.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

D = wdV = 0.5($820,000) = $410,000.

Step 2.

Find the new price per share after the recapitalization: P = [S+ (D − D0)]/n0 = [$410,000 + ($410,000 − $200,000)]/10,000 = $62.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: Stock price, recapitalization–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.4 MUST be kept together, and they cannot be changed algorithmically.

58. Refer to Exhibit 15.4. Now assume that AJC is considering changing from its original capital structure to a new capital structure that results in a stock price of $64 per share. The resulting capital structure would have a $336,000 total market value of equity and a $504,000 market value of debt. How many shares would AJC repurchase in the recapitalization? a. 4,250 b. 4,500 c. 4,750 d. 5,000 e. 5,250 ANS: C First, find the number of shares remaining: n = S/P = $336,000/$64 = 5,250.

The number of repurchased shares is the original number of shares minus the resulting number of shares: # repurchased = 10,000 − 5,250 = 4,750.

Alternatively, number of shares repurchased is equal to the debt used to repurchase stock divided by the price per share: # repurchased = ($504,000 − $200,000)/$64 = 4,750.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 15-6 NAT: BUSPROG: Analytic STA: DISC: Capital structure LOC: TBA TOP: No. shares repurchased–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part NOT: The problems referring to Exhibit 15.4 MUST be kept together, and they cannot be changed algorithmically.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 16—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT TRUE/FALSE 1. Net working capital, defined as current assets minus the sum of payables and accruals, is equal to the current ratio minus the quick ratio.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Net working capital KEY: Bloom’s: Knowledge 2. Net working capital is defined as current assets divided by current liabilities.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Net working capital KEY: Bloom’s: Knowledge 3. Net operating working capital is defined as operating current assets minus operating current liabilities..

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Net operating working capital KEY: Bloom’s: Knowledge 4. Determining a firm's optimal investment in working capital and deciding how that investment should be financed are critical to working capital management.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Working capital management KEY: Bloom’s: Knowledge 5. An increase in any current asset must be accompanied by an equal increase in some current liability.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Working capital financing KEY: Bloom’s: Knowledge 6. The concept of permanent current operating 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 operating assets represent a minimum level of current assets that must be financed.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Permanent curr. oper. assets KEY: Bloom’s: Knowledge 7. A conservative current operating asset financing approach will result in permanent current assets and some seasonal current assets being financed using long-term securities. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Conservative fin. approach KEY: Bloom’s: Knowledge 8. 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 operating asset financing strategy because of the inherent risks of using short-term financing.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Aggressive fin. approach KEY: Bloom’s: Knowledge 9. 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).

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Knowledge 10. Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts payable, this will lengthen its cash conversion cycle (CCC).

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Knowledge 11. Shorter-term cash budgets⎯say a daily cash budget for the next month⎯are generally used for actual cash control while longer-term cash budgets⎯say monthly cash budgets for the next year⎯are generally used for planning purposes.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Knowledge 12. Cash is often referred to as a "non-earning" asset. Thus, one goal of cash management is to minimize the amount of cash necessary for conducting a firm's normal business activities.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-5 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Goal of cash management KEY: Bloom’s: Knowledge 13. Firms hold cash balances in order to complete transactions (both routine and precautionary) that are necessary in business operations and as compensation to banks for providing loans and services.

ANS: T OBJ: LO: 16-5

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

STA: DISC: Working capital management LOC: TBA TOP: Motives for holding cash KEY: Bloom’s: Knowledge 14. For a firm that makes heavy use of net float, being able to forecast collections and disbursement check clearings is essential.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Float KEY: Bloom’s: Knowledge 15. Setting up a lockbox arrangement is one way for a firm to speed up the collection of payments from its customers.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Lockbox KEY: Bloom’s: Knowledge 16. The overriding goal of inventory management is to ensure that the firm never suffers a stock-out, i.e., never runs out of an inventory item.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Goal of inventory management KEY: Bloom’s: Knowledge 17. The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-7 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Goal of inventory management KEY: Bloom’s: Knowledge 18. The average accounts receivable balance is a function of both the volume of credit sales and the days sales outstanding.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Receivables balance KEY: Bloom’s: Knowledge 19. If a firm has a large percentage of accounts over 30 days old, this is proof positive that its receivables manager is not doing a good job.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Receivables aging KEY: Bloom’s: Knowledge 20. The aging schedule is a commonly used method for monitoring receivables. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Monitoring receivables KEY: Bloom’s: Knowledge 21. The four primary elements in a firm's credit policy are (1) credit standards, (2) discounts offered, (3) credit period, and (4) collection policy.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Credit policy KEY: Bloom’s: Knowledge 22. Changes in a firm's collection policy can affect sales, working capital, and profits.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Collection policy KEY: Bloom’s: Knowledge 23. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Taking discounts KEY: Bloom’s: Knowledge 24. Suppose a firm changes its credit policy from 2/10 net 30 to 3/10 net 30. The change is meant to meet competition, so no increase in sales is expected. The average accounts receivable balance will probably decline as a result of this change.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Change in credit policy KEY: Bloom’s: Knowledge 25. If a firm busy on terms of 2/10 net 30, it should pay as early as possible during the discount period.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Trade credit KEY: Bloom’s: Knowledge 26. 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Trade credit KEY: Bloom’s: Knowledge 27. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Trade credit KEY: Bloom’s: Knowledge 28. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Trade credit KEY: Bloom’s: Knowledge 29. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Trade credit KEY: Bloom’s: Knowledge 30. The calculated cost of trade credit can be reduced by paying late.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cost of trade credit KEY: Bloom’s: Knowledge 31. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cost of trade credit KEY: Bloom’s: Knowledge 32. One of the effects of ceasing to take trade credit discounts is that the firm's accounts payable will rise, other things held constant.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cost of trade credit KEY: Bloom’s: Knowledge 33. "Stretching" accounts payable is a widely accepted, entirely ethical, and costless financing technique.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Stretching accounts payable KEY: Bloom’s: Knowledge 34. Accruals are "free" capital in the sense that no explicit interest must normally be paid on accrued liabilities. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Accruals KEY: Bloom’s: Knowledge 35. Accruals are "spontaneous," but unfortunately, due to law and economic forces, firms have little control over the level of these accounts.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Accruals KEY: Bloom’s: Knowledge 36. The facts (1) that no explicit interest is paid on accruals and (2) that the firm can control the level of these accounts at will makes them an attractive source of funding to meet working capital needs.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Accruals KEY: Bloom’s: Knowledge 37. Short-term marketable securities are held for two separate and distinct purposes: (1) to provide liquidity as a substitute for cash and (2) as a non-operating investment. Marketable securities held while awaiting reinvestment are not available for liquidity purposes.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Short-term mkt. securities KEY: Bloom’s: Knowledge 38. Short-term financing is riskier than long-term financing since, during periods of tight credit, the firm may not be able to rollover (renew) its debt. This is especially true if the funds are used to finance long-term assets rather than short-term assets.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Short-term financing KEY: Bloom’s: Knowledge 39. One of the advantages of short-term debt financing is that firms can obtain short-term credit more quickly than long-term credit.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Short-term financing KEY: Bloom’s: Knowledge 40. Funds from short-term loans can generally be obtained faster than from long-term loans for two reasons: (1) when lenders consider long-term loans they must make a more thorough evaluation of the borrower's financial health, and (2) long-term loan agreements are more complex.

ANS: T OBJ: LO: 16-11

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

STA: DISC: Working capital management LOC: TBA TOP: Short-term financing KEY: Bloom’s: Knowledge 41. 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.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-12 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Bank loans KEY: Bloom’s: Knowledge 42. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-12 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Bank loans KEY: Bloom’s: Knowledge 43. Loans from commercial banks generally appear on balance sheets as notes payable. A bank's importance is actually greater than it appears from the dollar amounts shown on balance sheets because banks provide nonspontaneous funds to firms.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-12 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Bank loans KEY: Bloom’s: Knowledge 44. A promissory note is the document signed when a bank loan is executed, and it specifies financial aspects of the loan.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-12 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Promissory note KEY: Bloom’s: Knowledge 45. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-12 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Line of credit KEY: Bloom’s: Knowledge 46. 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.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-12 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Revolving credit KEY: Bloom’s: Knowledge © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

47. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Maturity matching KEY: Bloom’s: Comprehension 48. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Maturity matching KEY: Bloom’s: Comprehension 49. A firm that follows an aggressive current asset 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Aggressive financing KEY: Bloom’s: Comprehension 50. The relative profitability of a firm that employs an aggressive current asset financing policy will improve if the yield curve changes from upward sloping to downward sloping.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-2 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Aggressive financing KEY: Bloom’s: Comprehension 51. 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. ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Comprehension 52. The cash conversion cycle (CCC) combines three factors: The inventory conversion period, the average 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Comprehension © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

53. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Comprehension 54. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Comprehension 55. The cash budget and the capital budget are handled separately, and although they are both important, they are developed completely independently of one another.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash and capital budgets KEY: Bloom’s: Comprehension 56. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash budget and depreciation KEY: Bloom’s: Comprehension 57. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-6 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Cash flow synchronization KEY: Bloom’s: Comprehension 58. On average, a firm collects checks totaling $250,000 per day. It takes the firm approximately 4 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 2 1/2 days and (2) the firm could invest any additional cash generated at 6% after taxes. The lockbox system would be a good buy if it costs $25,000 annually.

ANS: F Funds generated = Days saved  Checks per day = $375,000 Return on funds generated = Funds generated  Rate of return = $22,500 < $25,000 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-6 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Lockbox KEY: Bloom’s: Comprehension 59. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Receivables balance KEY: Bloom’s: Comprehension 60. 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.

ANS: F Accounts receivable will increase by 10%. That percentage increase would occur regardless of the level of the cash sales. Even if cash sales were 90%, receivables would still increase by 10% under the assumptions in the question.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Receivables and growth KEY: Bloom’s: Comprehension 61. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Receivables and growth KEY: Bloom’s: Comprehension 62. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Collection policy KEY: Bloom’s: Comprehension 63. Because money has time value, a cash sale is always more profitable than a credit sale.

ANS: F Department stores, auto dealers, and many others sell on credit, using interest bearing notes payable.

The interest rate on this credit can exceed the firm's cost of capital, making credit sales more profitable than cash sales.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-8 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA

TOP: Cash vs. credit sales

KEY: Bloom’s: Comprehension

64. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: DSO and past-due accounts KEY: Bloom’s: Comprehension 65. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Trade credit KEY: Bloom’s: Comprehension 66. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Stretching accounts payable KEY: Bloom’s: Comprehension 67. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Stretching accounts payable KEY: Bloom’s: Comprehension 68. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Short-term financing KEY: Bloom’s: Comprehension 69. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

TOP: Short-term financing

KEY: Bloom’s: Comprehension

70. Long-term loan agreements always contain provisions, or covenants, that constrain the firm's future actions. Short-term credit agreements are just as restrictive in order to protect the interest of the lender.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-11 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Short-term financing KEY: Bloom’s: Comprehension 71. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-11 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Short-term financing KEY: Bloom’s: Comprehension 72. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-12 NAT: BUSPROG: Reflective Thinking STA: DISC: Working capital management LOC: TBA TOP: Revolving credit KEY: Bloom’s: Comprehension MULTIPLE CHOICE 73. Which of the following will cause an increase in net working capital, other things held constant? a. A cash dividend is declared and paid. b. Merchandise is sold at a profit, but the sale is on credit. c. Long-term bonds are retired with the proceeds of a preferred stock issue. d. Missing inventory is written off against retained earnings. e. Cash is used to buy marketable securities.

ANS: B PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-0 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Working capital KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 74. Firms generally choose to finance temporary current operating assets with short-term debt because a. short-term interest rates have traditionally been more stable than long-term interest rates. b. 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. c. the yield curve is normally downward sloping. d. short-term debt has a higher cost than equity capital. e. matching the maturities of assets and liabilities reduces risk under some circumstances, and also because short-term debt is often less expensive than long-term capital.

ANS: E

PTS: 1

DIF: Difficulty: Easy

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 16-2 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Current asset financing KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 75. Which of the following actions should Reece Windows take if it wants to reduce its cash conversion cycle? a. Take steps to reduce the DSO. b. Start paying its bills sooner, which would reduce the average accounts payable but not affect sales. c. Sell common stock to retire long-term bonds. d. Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock. e. Increase average inventory without increasing sales.

ANS: A PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 76. A lockbox plan is a. used to identify inventory safety stocks. b. used to slow down the collection of checks our firm writes. c. used to speed up the collection of checks received. d. 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. e. used to protect cash, i.e., to keep it from being stolen.

ANS: C PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-6 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Lockbox KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 77. A lockbox plan is most beneficial to firms that a. have widely dispersed manufacturing facilities. b. have a large marketable securities portfolio and cash to protect. c. receive payments in the form of currency, such as fast food restaurants, rather than in the form of checks. d. have customers who operate in many different parts of the country. e. have suppliers who operate in many different parts of the country.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-6 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Lockbox KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 78. Which of the following is NOT commonly regarded as being a credit policy variable? a. Collection policy. b. Credit standards. c. Cash discounts. d. Payments deferral period. e. Credit period. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Credit policy KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 79. Summary balance sheet data for Greener Gardens Co. is shown below (in thousands of dollars). The company is in a highly seasonal business, and the data show its assets and liabilities at peak and off-peak seasons:

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. Greener Gardens' current asset financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt. b. Greener Gardens follows a relatively conservative approach to current asset financing; that is, some of its short-term needs are met by permanent capital. c. Without income statement data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy. d. Without cash flow data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy. e. Greener Gardens' current asset financing policy calls for exactly matching asset and liability maturities.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-2 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Current asset financing KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 80. Which of the following statements is CORRECT? a. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive strategy because of the inherent risks associated with using short-term financing. b. 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. c. Net working capital is defined as current assets minus the sum of payables and accruals, and any decrease in the current ratio automatically indicates that net working capital has decreased. d. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. Net working capital is defined as current assets minus the sum of payables and accruals, and any increase in the current ratio automatically indicates that net working capital has increased.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-2 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Current asset financing KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 81. Other things held constant, which of the following would tend to reduce the cash conversion cycle? a. Place larger orders for raw materials to take advantage of price breaks. b. Take all discounts that are offered. c. Continue to take all discounts that are offered and pay on the net date. d. Offer longer payment terms to customers. e. Carry a constant amount of receivables as sales decline.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 82. Which of the following actions would be likely to shorten the cash conversion cycle? a. Change the credit terms offered to customers from 3/10 net 30 to 1/10 net 50. b. Begin to take discounts on inventory purchases; we buy on terms of 2/10 net 30. c. 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. d. Change the credit terms offered to customers from 2/10 net 30 to 1/10 net 60. e. Adopt a new manufacturing process that speeds up the conversion of raw materials to finished goods from 20 days to 10 days.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 83. Which of the following is NOT directly reflected in the cash budget of a firm that is in the zero tax bracket? a. Depreciation. b. Cumulative cash. c. Repurchases of common stock. d. Payment for plant construction. e. Payments lags.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 84. Which of the following statements concerning the cash budget is CORRECT? a. Cash budgets do not include financial items such as interest and dividend payments. b. Cash budgets do not include cash inflows from long-term sources such as the issuance of © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

bonds. c. Changes that affect the DSO do not affect the cash budget. d. Capital budgeting decisions have no effect on the cash budget until projects go into operation and start producing revenues. e. Depreciation expense is not explicitly included, but depreciation's effects are reflected in the estimated tax payments.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 85. Which of the following items should a company report directly in its monthly cash budget? a. Cash proceeds from selling one of its divisions. b. Accrued interest on zero coupon bonds that it issued. c. New shares issued in a stock split. d. New shares issued in a stock dividend. e. Its monthly depreciation expense.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 86. Which of the following statements is CORRECT? a. 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. b. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. c. 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. d. 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. e. Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control.

ANS: D PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 87. Which of the following statements is most consistent with efficient inventory management? The firm has a a. low incidence of production schedule disruptions. b. below average total assets turnover ratio. c. relatively high current ratio. d. relatively low DSO. e. below average inventory turnover ratio.

ANS: A

PTS: 1

DIF: Difficulty: Moderate

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

OBJ: LO: 16-7 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Inventory management KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 88. Which of the following statements is CORRECT? a. 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. b. Because of the costs of granting credit, it is not possible for credit sales to be more profitable than cash sales. c. 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. d. Other things held constant, if a firm can shorten its DSO, this will lead to a higher current ratio. e. 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.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Receivables management KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 89. Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. 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. e. Other things held constant, the higher a firm's days sales outstanding (DSO), the better its credit department.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Days sales outstanding (DSO) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 90. 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 is going from its peak sales season to its slack season, so its receivables and inventories will experience a seasonal decline. b. The firm is going from its slack season to its peak sales season, so its receivables and inventories will experience seasonal increases. c. The firm has just sold long-term securities and has not yet invested the proceeds in operating assets. d. The firm just won a product liability suit one of its customers had brought against it. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

e. The firm must make a known future payment, such as paying for a new plant that is under construction.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-2 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Marketable securities KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 91. 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 short-term securities because they pay higher rates. b. consist mainly of U.S. Treasury securities to minimize interest rate risk. c. consist mainly of short-term securities to minimize interest rate risk. d. be balanced between long- and short-term securities to minimize the adverse effects of either an upward or a downward trend in interest rates. e. consist mainly of long-term securities because they pay higher rates.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-10 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Marketable securities KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 92. Which of the following statements is CORRECT? a. Commercial paper is a form of short-term financing that is primarily used by large, strong, financially stable companies. b. 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. c. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. d. Commercial paper is typically offered at a long-term maturity of at least five years. e. Trade credit is provided only to relatively large, strong firms.

ANS: A PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-13 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Current asset financing KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 93. Which of the following statements is NOT CORRECT? a. Accruals are "free" in the sense that no explicit interest is paid on these funds. b. A conservative approach to working capital management will result in most, if not all, permanent current operating assets being financed with long-term capital. c. 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. d. Bank loans generally carry a higher interest rate than commercial paper. e. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-13 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Current asset financing KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 94. Which of the following statements is CORRECT? a. Conservative firms generally use no short-term debt and thus have zero current liabilities. b. 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. c. 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. d. 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. e. 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.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-12 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Short-term financing KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 95. Which of the following statements is NOT CORRECT? a. Credit policy has an impact on working capital because it influences both sales and the time before receivables are collected. b. The cash budget is useful to help estimate future financing needs, especially the need for short-term working capital loans. c. 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. d. Managing working capital is important because it influences financing decisions and the firm's profitability. e. 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.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-10 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Working capital policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 96. Which of the following statements is CORRECT? a. 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. b. Sound working capital policy is designed to maximize the time between cash expenditures on materials and the collection of cash on sales. c. 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. d. 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. e. Depreciation is included in the estimate of cash flows (Cash flow = Net income = Depreciation); hence depreciation is set forth on a separate line in the cash budget.

ANS: A

PTS: 1

DIF: Difficulty: Moderate

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OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Working capital concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 97. Which of the following statements is CORRECT? a. 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. b. 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. c. One cannot tell if a firm has a conservative, aggressive, or moderate current asset financing policy without an examination of its cash budget. d. If a firm has a relatively aggressive current asset financing policy vis-á-vis other firms in its industry, then its current ratio will probably be relatively high. e. Accruals are an expensive but commonly used way to finance working capital.

ANS: B PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Working capital concepts KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 98. Albrecht Inc. is a no-growth firm whose sales fluctuate seasonally, causing total assets to vary from $320,000 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. $260,642 b. $274,360 c. $288,800 d. $304,000 e. $320,000 ANS: E Lower total asset range Upper total asset range

$320,000 $410,000

Minimum total assets = FA + Min. CA = $320,000 = LT Debt + Equity A maturity matching policy implies that fixed assets and permanent current assets are financed with long-term sources. This is its most likely level of long-term financing.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-2 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Maturity matching KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 99. Brothers Breads has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = Average collection period = Payables deferral period =

50 days 17 days 25 days

a. 31 days b. 34 days © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 38 days d. 42 days e. 46 days ANS: D Inventory conversion period = Average collection period = Payables deferral period =

50 days 17 days 25 days

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 42 days PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 100. Fireside Inc. has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = Average collection period = Payables deferral period = a. b. c. d. e.

38 days 19 days 20 days

33 days 37 days 41 days 45 days 49 days

ANS: B Inventory conversion period = Average collection period = Payables deferral period =

38 days 19 days 20 days

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 37 days PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 101. Whaley & Whaley has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = Average collection period = Payables deferral period = a. b. c. d. e.

41 days 31 days 38 days

31 days 34 days 37 days 41 days 45 days

ANS: B Inventory conversion period = Average collection period =

41 days 31 days

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Payables deferral period =

38 days

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 34 days PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 102. Mark's Manufacturing's average age of accounts receivable is 45 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. 63 days b. 67 days c. 70 days d. 74 days e. 78 days ANS: D CCC = Inv. conv. period + Avg. coll. period − Pay. deferral period Age of receivables = Avg. coll. period = 45 days Age of inventory = Inv. conv. period = 69 days Age of payables = Pay. def. period = 40 days CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 74 days PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 103. Baltimore Baking is preparing its cash budget and expects to have sales of $30,000 in January, $35,000 in February, and $35,000 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. $24,057 b. $26,730 c. $29,700 d. $33,000 e. $36,300 ANS: D Cash Pay 2nd month Pay 3rd month

January February March Total collections for month:

Payments: 20% 40% 40%

Sales for Mos. $30,000 35,000 35,000

January $6,000 _____ $6,000

Collections February $12,000 7,000 ______ $19,000

March $12,000 14,000 7,000 $33,000

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PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-4 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 104. Krackle Korn Inc. had credit sales of $3,500,000 last year and its days sales outstanding was DSO = 35 days. What was its average receivables balance, based on a 365-day year? a. $335,616 b. $352,397 c. $370,017 d. $388,518 e. $407,944 ANS: A Sales DSO

$3,500,000 35

Receivables = (Sales per day)(DSO) = Sales/365  DSO = $335,616 PTS: 1 DIF: Difficulty: Easy OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Accounts receivable balance KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 105. Buchholz Corporation 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 $35,000; the interest rate on its debt is 10%; and its tax rate is 40%. With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies? a. 4.25% b. 4.73% c. 5.25% d. 5.78% e. 6.35% ANS: C Sales Fixed assets CA/Sales, restricted

$400,000 Debt ratio $100,000 EBIT 15% CA/Sales, relaxed

50% Interest rate $35,000 Tax rate 25%

CA FA Total assets

Restricted $ 60,000 100,000 $160,000

Relaxed $100,000 100,000 $200,000

Debt Equity Total liab. & capital

$ 80,000 80,000 $160,000

$100,000 100,000 $200,000

EBIT Interest EBT Taxes

$ 35,000 8,000 $ 27,000 10,800

$ 35,000 10,000 $ 25,000 10,000

10% 40%

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NI

$ 16,200

$ 15,000

ROE

20.25%

15.00%

Difference in ROE = 5.25% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-1 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: ROE and WC policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 106. Data on Nathan Enterprises for the most recent 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.

Sales Accounts receivable Days sales outstanding (DSO) Benchmark days sales outstanding (DSO) a. b. c. d. e.

$110,000 $16,000 53.09 20.00

$8,078 $8,975 $9,973 $10,970 $12,067

ANS: C Original Benchmark Data Related DSO DSO Sales $110,000 Receivables and DSO $16,000 53.09 20.00 New receivables = DSO  (Sales/365) = Reduction in receivables = Original receivables − New receivables = Alternative solution: (Change in DSO/Original DSO)  Orig. receivables =

Receivables at Benchmark Level

$6,027 $9,973

$9,973

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Days sales outstanding (DSO) KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 107. Thornton Universal Sales' cost of goods sold (COGS) average $2,000,000 per month, and it keeps inventory equal to 50% of its monthly COGS on hand at all times. Using a 365-day year, what is its inventory conversion period? a. 11.7 days b. 13.0 days c. 14.4 days d. 15.2 days e. 16.7 days ANS: D Monthly COGS =

$2,000,000

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Inventory/COGS = Annual COGS = Avg. inventory =

50.0% $24,000,000 $1,000,000

Inv. conv. period = Inv./COGS per day = Inv./(Annual COGS/365) = 15.2 days PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Inventory conv. period KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 108. Data on Liu Inc. for the most recent 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.

Cost of goods sold = Inventory = Inventory conversion period (ICP) = Benchmark inventory conversion period (ICP) = a. b. c. d. e.

$85,000 $20,000 85.88 38.00

$7,316 $8,129 $9,032 $10,036 $11,151

ANS: E Original Data Related ICP Cost of goods sold $85,000 Inventory and ICP $20,000 85.88 New inventory = ICP  (COGS/365) = Reduction in inventories = Original Inv. − New Inv. =

Benchmark ICP

ICP at Benchmark Level

38.00 $8,849 $11,151

Alternative solution: (Change in ICP/Original ICP)  Orig. Inv. =

$11,151

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Inventory conv. period KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 109. Data on Mertz Co. for the most recent 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.

Cost of goods sold = Payables = Payables deferral period (PDP) = Benchmark payables deferral period =

$75,000 $5,000 24.33 30.00

a. $764 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

$849 $943 $1,048 $1,164

ANS: E Original Data Related PDP Cost of goods sold $75,000 Inventory and PDP $5,000 24.33 New payables = PDP  (COGS/365) = Increase in payables = New Payables − Original Payables =

Benchmark PDP

Payables at Benchmark Level

30.00

Alternative solution: (Change in PDP/Original PDP)  Orig. Payables =

$6,164 $1,164

$1,164

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Payables deferral period KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 110. Marshall Inc. recently hired your consulting firm to improve the company's performance. It has been 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?

Average inventory = Annual sales = Annual cost of goods sold = Average accounts receivable = Average accounts payable = a. b. c. d. e.

$75,000 $600,000 $360,000 $160,000 $25,000

120.6 days 126.9 days 133.6 days 140.6 days 148.0 days

ANS: E Avg. inventory = Avg. receivables = Avg. payables =

$75,000 Annual sales = $160,000 Annual COGS = $25,000 Days in year =

Inv. conv. period = Inv./(COGS/365) + DSO = Receivables/(Sales/365) − Payables deferral = Payables/(COGS/365) Cash conversion cycle (CCC)

$600,000 $360,000 365

76.0 97.3 −25.3 148.0

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

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111. Frosty Corporation has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle?

Annual sales = Annual cost of goods sold = Inventory = Accounts receivable = Accounts payable = a. b. c. d. e.

$45,000 $31,500 $4,000 $2,000 $2,400

25 days 28 days 31 days 35 days 38 days

ANS: D Annual sales Annual cost of goods sold (COGS) Inventory Accounts receivable Accounts payable Days in year Sales per day = COGS per day = Inv. conv. period = Inv./COGS per day = Avg. coll. period = Receivables/Sales per day = Pay. def. period = Accounts payable/COGS per day =

$45,000 $31,500 $4,000 $2,000 $2,400 365 $123.29 $86.30 46.35 16.22 27.81

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 34.76 days PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 112. Shulman Inc. has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle?

Annual sales = Annual cost of goods sold = Inventory = Accounts receivable = Accounts payable = a. b. c. d. e.

$45,000 $30,000 $4,500 $1,800 $2,500

28 days 32 days 35 days 39 days 43 days

ANS: D Annual sales Annual cost of goods sold (COGS) Inventory

$45,000 $30,000 $4,500

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Accounts receivable Accounts payable Days in year Sales per day = COGS per day = Inv. conv. period = Inv./COGS per day = Avg. coll. period = Receivables/Sales per day = Pay. def. period = Accounts payable/COGS per day =

$1,800 $2,500 365 $123.29 $82.19 54.75 14.60 30.42

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 38.93 days PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 113. Kiley Corporation had the following data for the most recent 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, she thinks 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?

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 a. b. c. d. e.

Original $110,000 $80,000 $20,000 $16,000 $10,000 365

Revised $110,000 $80,000 $16,000 $14,000 $12,000 365

Original $110,000 $80,000 $20,000 $16,000 $10,000 365 91.25 53.09 45.63 98.72

Revised $110,000 $80,000 $16,000 $14,000 $12,000 365 73.00 46.45 54.75 64.70

34.0 37.4 41.2 45.3 49.8

ANS: A 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 Inv. conv. period = Inv./(COGS/365) = DSO = Receivables/(Sales/365) = Payables deferral = Payables/(COGS/365) = CCC = Inv. conv. + DSO − Pay. def. period = Change = 34.01 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: Cash conversion cycle MSC: TYPE: Multiple Choice: Problem

KEY: Bloom’s: Analysis

114. Whitson Co. is looking for ways to shorten its cash conversion cycle. It has annual sales of $36,500,000, or $100,000 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. 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? Round to the nearest whole day. a. −26 days b. −22 days c. −18 days d. −14 days e. −11 days ANS: B Annual sales Days in year Sales per day COGS/Sales COGS per day Inventory Accounts receivable Pay. deferral period % Reduction in Inv. % Reduction in Rec. % Reduction in Sales

Original $36,500,000 365 $100,000 75% $75,000 $9,000,000 $8,000,000 35

New $32,850,000 365 $90,000 75% $67,500 $7,200,000 $6,400,000 35 20% 20% 10%

Cash conversion cycle = Inv. conversion period + Avg. collection period − Pay. deferral period CCCOrig = 120.00 + 80.00 − 35.00 = 165.00 CCCNew = 106.67 + 71.11 − 35.00 = 142.78 CCCNew − CCCOrig = 142.78 − 165.00 = −22.22 days PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 115. Pascarella Inc. is revising its payables policy. It has annual sales of $50,735,000, 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? a. −26.6 days b. −29.5 days c. −32.8 days d. −36.4 days e. −40.5 days © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: E Original $50,735,000 365 $139,000 85% $118,150 $15,012,000 $10,008,000 30

Annual sales Days in year Sales per day COGS/Sales COGS per day Inventory Accounts receivable Pay. deferral period $ Reduction in Inv. $ Reduction in Rec.

New $50,735,000 365 $139,000 85% $118,150 $13,062,000 $8,062,000 40 $1,946,000 $1,946,000

Cash conversion cycle = Inv. conversion period + Avg. collection period − Pay. deferral period CCCOrig = 127.06 + 72.00 − 30.00 = 169.06 CCCNew = 110.59 + 58.00 − 40.00 = 128.59 CCCNew − CCCOrig = 128.59 − 169.06 = −40.47 days PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 116. Tierney Enterprises is constructing its cash budget. Its budgeted monthly sales are $5,000, 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 net cash flow during the month. a. $1,092 b. $1,150 c. $1,210 d. $1,271 e. $1,334 ANS: C Monthly sales Monthly purchase % Other payments:

Payment pattern: Discount:

$5,000 50% 25% Sales Month 40% 2%

Cash budget: Sales Collections, same month's sales (% of Sales)(Sales)(1 − Discount) Collections (last month's sales) Total collections Purchases payments

Next Month 60%

Last Month $5,000

Current Month $5,000

Next Month $5,000

$1,960 3,000 $4,960 2,500

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Other payments Total payments Net cash flow

1,250 $3,750 $1,210

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash budget KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 117. Carter & Carter is considering setting up a regional lockbox system to speed up collections. The company sells to customers all over the U.S., and all receipts come in to its headquarters in San Francisco. The firm's average accounts receivable balance is $2.5 million, and they are financed by a bank loan at an 11% annual interest rate. The firm believes this new lockbox system 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. $29,160 b. $32,400 c. $36,000 d. $40,000 e. $44,000 ANS: D Average accounts receivable balance Annual interest rate to finance A/R % Reduction in A/R Annual lockbox cost

$2,500,000 11.00% 20.00% $15,000

Reduction in A/R Reduction in A/R Reduction in A/R

= % Reduction in A/R  Avg. A/R balance = 20.00%  $2,500,000 = $500,000

Annual int. savings Annual int. savings Annual int. savings

= Reduction in A/R  Annual interest rate = $500,000  11.00% = $55,000

Pre-tax net annual savings Pre-tax net annual savings Pre-tax net annual savings

= Annual interest savings − Annual lockbox cost = $55,000 − $15,000 = $40,000

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-6 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Lockbox KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 118. Newsome Inc. buys on terms of 3/15, net 45. It does not take the discount, and it generally pays after 60 days. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year? a. 25.09% b. 27.59% c. 30.35% d. 33.39% e. 36.73% ANS: A © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Discount % Discount days

3% Net days 15 Actual days to payment

45 60

Nom. % cost = Disc. %/(100 − Disc. %)  (365/(Actual days − Disc. days) Nom. % cost = 3.09%  8.11 = 25.09% The effective discount % is earned N times per year; the product is the nominal annual cost rate.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Trade credit: nom. cost KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 119. Freeman Builders, Inc. buys on terms of 2/15, net 30. It does not take discounts, and it typically pays 60 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year? a. 10.86% b. 12.07% c. 13.41% d. 14.90% e. 16.55% ANS: E Discount % Discount days

2% Net days 15 Actual days to payment

30 60

Nom. % cost = Disc. %/(100 − Disc. %)  (365/(Actual days − Disc. days) Nom. % cost = 2.04%  8.11 = 16.55% The effective discount % is earned N times per year; the product is the nominal annual cost rate.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Trade credit: nom. cost KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 120. The company you just started 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 120 days after the purchase?

(Assume a 365-day year.) a. 16.05% b. 16.90% c. 17.74% d. 18.63% e. 19.56% ANS: B Discount % Discount days

4% Net days 30 Actual days to payment

90 120

Nom. % cost = Disc. %/(100 − Disc. %)  (365/(Actual days − Disc. days) = 16.90% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Trade credit: nom. cost KEY: Bloom’s: Analysis © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Problem 121. Howes Inc. purchases $4,562,500 in goods per year from its sole supplier on terms of 2/15, net 50. If the firm chooses to pay on time but does not take the discount, what is the effective annual percentage cost of its non-free trade credit? (Assume a 365-day year.) a. 20.11% b. 21.17% c. 22.28% d. 23.45% e. 24.63% ANS: D Discount % Discount days

2% Net days 15 Actual days to payment

50 50

EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] −1 = 23.45% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Trade credit: EAR cost KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 122. Andrews Corporation buys on terms of 2/8, net 45 days, it does not take discounts, and it actually pays after 58 days. What is the effective annual percentage cost of its non-free trade credit? (Use a 365-day year.) a. 14.34% b. 15.10% c. 15.89% d. 16.69% e. 17.52% ANS: C Discount % Discount days

2% Net days 8 Actual days to payment

45 58

EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] − 1 = 15.89% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Trade credit: EAR cost KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 123. Safety Window and Door Co. 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 $450,000 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. $18,493 b. $19,418 c. $20,389 d. $21,408 e. $22,479 ANS: A Purchases Discount %

$450,000 Net days 2% Days to payment

60 60

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Discount days

15 Days/Year

365

Purchases/day = $450,000/365 = $1,233 Free credit = Disc. days  Purchases/day = $18,493 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Free trade credit KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 124. Taylor Textbooks 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 $450,000 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.) a. $43,151 b. $45,308 c. $47,574 d. $49,952 e. $52,450 ANS: A Purchases Discount % Discount days

$450,000 Net days 2% Days to payment 15 Days/Year

50 50 365

Purchases/day = $450,000/365 = $1,233 Avg. trade credit = Average A/P = Days to payment  Net purchases/day = $61,644 Free trade credit = Discount days  Purchases/day = $18,493 Costly trade credit = Total credit − Free credit = $43,151 Alternatively, Costly TC = (Days to pmt. − Disc. days)  (Purchases/day) = $43,151 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Costly trade credit KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 125. Fairweather Corporation purchases merchandise on terms of 2/15, net 40, and its gross purchases (i.e., purchases before taking off the discount) are $800,000 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.) a. $53,699 b. $56,384 c. $59,203 d. $62,163 e. $65,271 ANS: A Discount Discount days Net days

2% Gross purchases 15 Days in year 40

$800,000 365

Net purchases = Gross(1 − Disc. %) = $784,000 Net per day = Net/365 = $2,148 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Total trade credit = Net days  Net per day = $85,918 Free credit = Net per day  Discount days = $32,219 Costly credit = Total credit − Free credit = $53,699 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Costly trade credit KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 126. Hinkle Corporation 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 $550,000 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 365-day year, and note that purchases are net of discounts.) a. $90,411 b. $94,932 c. $99,678 d. $104,662 e. $109,895 ANS: A Purchases Discount % Discount days

$550,000 Net days 2% Days to payment 15 Days/Year

60 60 365

Purchases/day = $550,000/365 = $1,507 Average trade credit = Average A/P = Days to payment  Net purchases/day = $90,411 PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Total trade credit KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 127. Noddings Inc. needs to raise more capital because its business is booming. The company purchases supplies on terms of 1/10 net 20, and it currently takes the discount. One way of getting the needed funds would be to forgo the discount, and the firm's owner believes she could delay payment to 40 days without adverse effects. What would be the effective annual percentage cost of funds raised by this action? (Assume a 365-day year.) a. 10.59% b. 11.15% c. 11.74% d. 12.36% e. 13.01% ANS: E Discount % Discount days

1% Net days 10 Actual days to payment

20 40

EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] − 1 = 13.01% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Stretching accounts payable KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

128. Sanders Enterprises arranged a revolving credit agreement of $9,000,000 with a group of banks. The firm paid an annual commitment fee of 0.5% of the unused balance of the loan commitment. On the used portion of the revolver, it paid 1.5% above prime for the funds actually borrowed on a simple interest basis. The prime rate was 3.25% 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? a. $285,000 b. $300,000 c. $315,000 d. $330,750 e. $347,288 ANS: B Total commitment Fee on unused balance Prime rate Premium over prime Amount borrowed

$9,000,000 0.50% 3.25% 1.50% $6,000,000

Interest rate on borrowed funds = Prime + Premium = Cost of used portion = Amount borrowed  Rate = Cost of unused portion: Unused balance  Fee = Total annual cost of loan agreement =

4.75% $285,000 $15,000 $300,000

Alternative solution: Rate per day = 4.75%/365 = Interest per day = (Rate per day)(Amount borrowed) = Interest per year = (Interest per day)(365) = Cost of unused portion: Unused balance  Fee = Total annual cost of loan agreement =

0.0130137% $781 $285,000 $15,000 $300,000

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-12 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Revolving credit agreement KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 129. Fontana Painting had the following data for the most recent year (in millions). The new CFO believes that the company could improve its working capital management sufficiently to bring its NWC and CCC up to the benchmark companies' level without affecting either sales or the costs of goods sold.

Fontana 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?

Sales Cost of goods sold Inventory (ICP) Receivables (DSO) Payables (PDP)

Original Data Related CCC $100,000 $ 80,000 $ 20,000 91.25 $ 16,000 58.40 $ 5,000 22.81 126.84

Benchmark CCC

38.00 20.00 30.00 28.00

a. 1,901 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

2,092 2,301 2,531 2,784

ANS: A

Sales Cost of goods sold Inventory = ICP(COGS/365) = Receivables = DSO(Sales/365) = Payables = PDP(COGS/365) = New and old NWC

Original Data Related CCC $100,000 $ 80,000 $ 20,000 91.25 $ 16,000 58.40 $ 5,000 22.81 $ 31,000 126.84

Reduction in NWC = Old − New = $23,767 Interest rate = 8% Savings = Interest rate  Reduction in NWC =

Benchmark CCC

Benchmark Levels

38.00 20.00 30.00 28.00

$8,329 $5,479 $6,575 $7,233

$1,901

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 130. Monar Inc.'s CFO would like to decrease its cash conversion cycle by 10 days (based on a 365 day year). The company carries average inventory of $750,000. Its annual sales are $10 million, its cost of goods sold is 75% of annual sales, and its average 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. The CFO believes he can reduce the average inventory to $647,260 with no effect on sales. By how much must the firm also reduce its accounts receivable to meet its goal in the reduction of the cash conversion cycle? a. $123,630 b. $130,137 c. $136,986 d. $143,836 e. $151,027 ANS: C Inventory Annual sales Days/year COGS/Sales Payables deferral period (PDP) Avg. collection period (DSO) = Cost of goods sold Inv. conv. period (ICP) DSO (calculated) Receivables (A/R) CCC = DSO + ICP − PDP = Decrease in CCC New CCC

Original $750,000 $10,000,000 365 75.00% 30.00 2  ICP $7,500,000 36.50 73.00 $2,000,000 79.50 10

New $647,260 $10,000,000 365 75.00% 30.00 $7,500,000 31.50 68.00 $1,863,014 69.50 CHECK on CCC 69.50

Reduction in A/R = Orig. A/R − New A/R = $136,986 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 16-3 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Cash conversion cycle KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 131. Suppose the suppliers of your firm offered you credit terms of 2/10 net 30 days. Your firm is not taking discounts, but is paying after 25 days instead of waiting until Day 30. You point out that the nominal cost of not taking the discount and paying on Day 30 is approximately 37%. But since your firm is 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. 60.3% b. 63.5% c. 66.7% d. 70.0% e. 73.5% ANS: B Discount % Discount days

2% Net days 10 Actual days to payment

30 25

EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] − 1 = 63.49% PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Trade credit: EAR cost KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 132. Arnold Inc. purchases merchandise on terms of 2/10 net 30, and it always pays on the 30th day. The CFO calculates that the average amount of costly trade credit carried is $375,000. What is the firm's average accounts payable balance? (Assume a 365-day year.) a. $458,160 b. $482,273 c. $507,656 d. $534,375 e. $562,500 ANS: E Discount % Discount days Costly trade credit

2% Net days 10 Actual days to payment $375,000 Years/day

30 30 365

Costly trade credit = Purchases per day  (Days credit is outstanding − Discount period) $375,000 = Purchases per day  20 Purchases per day = $18,750 Free trade credit = Purchases per day  Discount period Free trade credit = $18,750  10 Free trade credit = $187,500 Total trade credit = Costly trade credit + Free trade credit Total trade credit = $375,000 + $187,500 Total trade credit = $562,500 PTS: 1

DIF: Difficulty: Challenging

OBJ: LO: 16-9

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Accounts payable balance KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 133. Blueroot Inc. is considering a change in its financing policy. Currently, it uses maximum trade credit by not taking discounts on its purchases. The standard industry credit terms offered by all its suppliers are 2/10 net 30 days, and the firm pays 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? a. $32,964 b. $34,699 c. $36,526 d. $38,448 e. $40,370 ANS: D Discount % Discount days Net purchases/day Annual interest rate

2% 10 $11,760 10.00%

Net days Actual days to payment Days/year Tax rate

30 30 365 40.00%

A/PNo disc. = Net purchases/day  Actual days to payment A/PNo disc. = $11,760  30 = $352,800 A/PDisc. = Net purchases/day  Discount days A/PDisc. = $11,760  10 = $117,600 Amount needed to be financed = A/PNo disc. − A/PDisc.

Amount needed to be financed = $352,800 − $117,600 = $235,200 Additional interest cost = Amount needed to be financed  Annual interest rate Additional interest cost = $235,200  10.00% = $23,520 Gross purchases = (Net purchases/day  365)/(1 − Disc. %) Gross purchases = $11,760  365/98.00% = $4,380,000 Discounts lost = Gross purchases  Discount % Discounts lost = $4,380,000  2.00% = $87,600 Pre-tax savings = Discounts lost − Additional interest Pre-tax savings = $87,600 − $23,520 = $64,080 After-tax savings = Pre-tax savings  (1 − T) After-tax savings = $64,080  60.00% = $38,448 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Fin. stmts. and trade credit KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

134. Famous Farm's payables deferral period (PDP) is 50 days (on a 365-day basis), accounts payable are $100 million, and its balance sheet shows inventory of $125 million. What is the inventory turnover ratio? a. 4.73 b. 5.26 c. 5.84 d. 6.42 e. 7.07 ANS: C PDP Payables

50 Days/year $100 Inventory

365 $125

Use PDP equation to find sales: PDP = Receivables/(COGS/365) COGS = 365(Payables)/DSO = $730 Inventory turnover = COGS/Inventory = 5.84 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 16-8 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Inventory turnover and DSO KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 135. During the coming year, Gold & Gold wants to increase its free cash flow by $180 million, 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 $850 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 working capital (in millions of dollars) would enable the firm to meet its target increase in FCF? a. $72 b. $90 c. $108 d. $130 e. $156 ANS: B EBIT Gross capital expenditures Depreciation Tax rate Target increase in FCF FCF $180 $180 −$90

$850 $360 $120 40% $180

= EBIT(1 − T) + Deprec. − Capex. −NWC = $510 + $120 − $360 − NWC = $270 − NWC = − NWC

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NWC = $90 PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 16-9 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: Working capital, FCF KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 136. Refer to Exhibit 21.1. If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy? a. $8,418 b. $8,861 c. $9,327 d. $9,818 e. $10,309 ANS: D Annual sales Fixed assets turnover (FATO) Debt/TA Equity/TA EBIT Interest rate Tax rate Total assets turnover (restricted) Total assets turnover (relaxed)

$3,600,000 4.0 50.00% 50.00% $150,000 10.00% 40.00% 2.5 2.2

FA turnover = Sales/Net FA 4.0 = $3,600,000/Net FA Net FA = $900,000 Restricted: TATO = Sales/Total assets 2.5 = $3,600,000/Total assets Total assets = $1,440,000 Relaxed: TATO = Sales/Total assets 2.2 = $3,600,000/Total assets Total assets = $1,636,364 Balance Sheets: Current assets Fixed assets Total assets

Restricted 540,000 900,000 $1,440,000

Debt Equity Total liab. & equity

Relaxed 736,364 900,000 $1,636,364

$

$

$

$

720,000 720,000 $1,440,000

Interest:

$72,000

818,182 818,182 $1,636,364 $81,818

Difference in interest = $9,818 PTS: 1

DIF: Difficulty: Moderate

OBJ: LO: 16-1

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: WC investment policy KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part 137. Refer to Exhibit 21.1. What's the difference in the projected ROEs under the restricted and relaxed policies? a. 1.20% b. 1.50% c. 1.80% d. 2.16% e. 2.59% ANS: B EBIT Interest EBT Taxes Net income

Restricted $150,000 72,000 $ 78,000 31,200 $ 46,800

Relaxed $150,000 81,818 $ 68,182 27,273 $ 40,909

6.50%

5.00%

ROE = Net income/Equity Difference in ROEs = 1.50%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-1 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: WC investment, ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part 138. Refer to Exhibit 21.1. 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? a. 2.24% b. 2.46% c. 2.70% d. 2.98% e. 3.27% ANS: A % Change in sales % Change in EBIT New sales New EBIT

−15.00% −10.00% $3,060,000 $135,000

Restricted: TATO = Sales/Total assets 2.5 = $3,060,000/Total assets Total assets = $1,224,000 Balance Sheet:

Restricted

Total assets

$1,224,000

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Debt Equity Total liab. & equity

$

612,000 612,000 $1,224,000

Income Statement: EBIT Interest EBT Taxes Net income

Restricted 135,000 61,200 $ 73,800 29,520 $ 44,280 $

ROE = Net income/Equity = 7.24% Relaxed ROE from above: 5.00% Difference in ROE = 2.24% PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-1 NAT: BUSPROG: Analytic STA: DISC: Working capital management LOC: TBA TOP: WC investment, ROE KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Multi-part

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CHAPTER 17—MULTINATIONAL FINANCIAL MANAGEMENT TRUE/FALSE 1. Multinational financial management requires that financial analysts consider the effects of changing currency values.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-3 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Multinational financial management KEY: Bloom’s: Knowledge 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 of subsidiaries.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-3 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Multinational financial management KEY: Bloom’s: Knowledge 3. Exchange rate quotations consist solely of direct quotations.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-3 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Exchange rates KEY: Bloom’s: Knowledge 4. Calculating a currency cross rate involves determining the exchange rate for two currencies by using a third currency as a base.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-3 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Cross rates KEY: Bloom’s: Knowledge 5. When the value of the U.S. dollar appreciates against another country's currency, we may purchase more of the foreign currency with a dollar.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-3 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Currency appreciation KEY: Bloom’s: Knowledge 6. If the United States is running a deficit trade balance with China, then in a free market we would expect the value of the Chinese yuan to depreciate against the U.S. dollar.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-4 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Trade deficit and depreciation KEY: Bloom’s: Knowledge © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. The United States and most other major industrialized nations currently operate under a system of floating exchange rates.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-5 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Floating exchange rates KEY: Bloom’s: Knowledge 8. Exchange rate risk is the risk that the cash flows from a foreign project, when converted to the parent company's currency, will be worth less than was originally projected because of exchange rate changes.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-5 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Exchange rate risk KEY: Bloom’s: Knowledge 9. A Eurodollar is a U.S. dollar deposited in a bank outside the United States.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-1 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Eurodollars KEY: Bloom’s: Knowledge 10. The Eurodollar market is essentially a long-term market; most loans and deposits in this market have maturities longer than one year.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-1 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Eurodollar market KEY: Bloom’s: Knowledge 11. LIBOR is an acronym for London Interbank Offer Rate, which is an average of interest rates offered

by London banks to smaller U.S. corporations.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-1 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: LIBOR KEY: Bloom’s: Knowledge 12. Because political risk is seldom negotiable, it cannot be explicitly addressed in multinational corporate financial analysis.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-11 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Political risk KEY: Bloom’s: Knowledge 13. Credit policy for multinational firms is generally more risky due in part to the additional consideration of exchange rates and also due to uncertainty regarding the credit worthiness of many foreign customers.

ANS: T OBJ: LO: 17-13

PTS: 1 DIF: Difficulty: Easy NAT: BUSPROG: Reflective Thinking

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

STA: DISC: International financial management LOC: TBA TOP: International credit management KEY: Bloom’s: Knowledge 14. Due to advanced communications technology and the standardization of general procedures, working capital management for multinational firms is no more complex than it is for large domestic firms.

ANS: F PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-13 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: International working capital management KEY: Bloom’s: Knowledge 15. Exchange rates influence a multinational firm's inventory policy because changing currency values can affect the value of inventory.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-13 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Multinational inventory management KEY: Bloom’s: Knowledge 16. The threat of expropriation creates an incentive for the multinational firm to minimize inventory holdings in certain countries and to bring in goods only as needed.

ANS: T PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-13 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Expropriation and inventory KEY: Bloom’s: Knowledge 17. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-5 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Forward market hedging transactions KEY: Bloom’s: Comprehension 18. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-6 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Discount on forward rate KEY: Bloom’s: Comprehension 19. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-6 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Premium on forward rate KEY: Bloom’s: Comprehension 20. 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. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-9 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Currency value and inflation KEY: Bloom’s: Comprehension 21. The interest rate paid on Eurodollar deposits depends on the particular bank's lending rate and on rates available on U.S. money market instruments.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-1 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Eurodollar interest rates KEY: Bloom’s: Comprehension 22. 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.

ANS: F PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-11 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Relevant investment cash flows KEY: Bloom’s: Comprehension 23. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-11 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Foreign project's cost of capital KEY: Bloom’s: Comprehension 24. 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.

ANS: T PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-11 NAT: BUSPROG: Reflective Thinking STA: DISC: International financial management LOC: TBA TOP: Risk and international investment KEY: Bloom’s: Comprehension MULTIPLE CHOICE 25. Which of the following is NOT a reason why companies move into international operations? a. To develop new markets for the firm's products. b. To better serve their primary customers. c. Because important raw materials are located abroad. d. To increase their inventory levels. e. To take advantage of lower production costs in regions where labor costs are relatively low.

ANS: D PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-1 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Motivation for going global KEY: Bloom’s: Comprehension © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

MSC: TYPE: Multiple Choice: Conceptual 26. 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. Depreciate against the U.S. dollar. b. Remain unchanged against the U.S. dollar. c. Appreciate against other major currencies. d. Appreciate against the dollar and other major currencies. e. Appreciate against the U.S. dollar.

ANS: E PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-5 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Currency depreciation KEY: Bloom’s: Comprehension MSC: TYPE: Multiple Choice: Conceptual 27. 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 180-day forward market. b. The yen-dollar exchange rate in the 90-day forward market equals the yen-dollar exchange rate in the 180-day forward market. c. The spot rate equals the 90-day forward rate. d. The spot rate equals the 180-day forward rate. e. The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 90-day forward market.

ANS: E PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-7 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Interest rate parity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 28. Which of the following statements is NOT CORRECT? a. Foreign bonds and Eurobonds are two important types of international bonds. b. Foreign bonds are bonds sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. c. The term Eurobond applies only to foreign bonds denominated in U.S. currency. d. A foreign bond might pay a higher nominal interest rate than a U.S. bond. e. Any bond sold outside the country of the borrower is called an international bond.

ANS: C PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-1 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: International bond markets KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Conceptual 29. If it takes $0.71 U.S. dollars to purchase one Swiss franc, how many Swiss francs can one U.S. dollar buy? a. 0.50 b. 0.71 c. 1.00 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. 1.41 e. 2.81 ANS: D Dollars should sell for 1/0.71, or 1.41 Swiss francs per dollar.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-3 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Exchange rates KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 30. If 1.64 Canadian dollars can purchase one U.S. dollar, how many U.S. dollars can you purchase for one Canadian dollar? a. 0.37 b. 0.61 c. 1.00 d. 1.64 e. 3.28 ANS: B You can get 1/1.64, or 0.61 U.S. dollars for one Canadian dollar.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-3 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Exchange rates KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 31. Suppose one U.S. dollar can purchase 144 yen today in the foreign exchange market. If the yen depreciates by 8.0% tomorrow, how many yen could one U.S. dollar buy tomorrow? a. 155.5 yen b. 144.0 yen c. 133.5 yen d. 78.0 yen e. 72.0 yen ANS: A If the yen depreciates by 8% we would get more yen per dollar. One U.S. dollar will equal 144  1.08 = 155.5 yen.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-4 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Currency appreciation KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 32. Suppose a foreign investor who holds tax-exempt Eurobonds paying 9% is considering investing in an equivalent-risk domestic bond in a country with a 28% withholding tax on interest paid to foreigners.

If 9% after-tax is the investor's required return, what before-tax rate would the domestic bond need to pay to provide the required after-tax return? a. 9.00% b. 10.20% c. 11.28% d. 12.50% e. 13.57% ANS: D © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Gross up the interest rate on the domestic bond: rd(pretax) = 0.09/(1 − 0.28) = 12.5%.

Solution check: After-tax return: 12.5% − 0.28(12.5%) = 12.5% − 3.5% = 9.0%.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-1 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Eurobonds versus domestic bonds KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 33. Suppose Yates Inc., a U.S. exporter, sold a consignment of antique American muscle-cars to a Japanese customer at a price of 143.5 million yen, when the exchange rate was 140 yen per dollar. In order to close the sale, Yates 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 Yates actually receive after it exchanged yen for U.S. dollars? a. $1,075,958 b. $1,025,000 c. $1,000,000 d. $975,610 e. $929,404 ANS: E Time line:

Calculate the amount received in U.S. dollars after the 143,500,000 yen are exchanged for dollars at the spot rate of 154.4 yen, when the invoice is paid.

143,500,000/154.4 = $929,404.15  $929,404.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 17-13 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Credit and exchange rate risk KEY: Bloom’s: Application MSC: TYPE: Multiple Choice: Problem 34. Suppose the exchange rate between U.S. dollars and Swiss francs is SF 1.41 = $1.00, and the exchange rate between the U.S. dollar and the euro is $1.00 = 1.64 euros. What is the cross-rate of Swiss francs to euros? a. 0.43 b. 0.86 c. 1.41 d. 1.64 e. 2.27 ANS: B SF/euro = (1.41/1)  (1/1.64) = 1.41/1.64 = 0.86 SF/euro.

PTS: 1

DIF: Difficulty: Moderate

OBJ: LO: 17-3

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

NAT: BUSPROG: Analytic LOC: TBA TOP: Cross rates MSC: TYPE: Multiple Choice: Problem

STA: DISC: International financial management KEY: Bloom’s: Analysis

35. Suppose that 1 British pound currently equals 1.62 U.S. dollars and 1 U.S. dollar equals 1.62 Swiss francs. What is the cross exchange rate between the pound and the franc? a. 1 British pound equals 3.2400 Swiss francs b. 1 British pound equals 2.6244 Swiss francs c. 1 British pound equals 1.8588 Swiss francs d. 1 British pound equals 1.0000 Swiss francs e. 1 British pound equals 0.3810 Swiss francs ANS: B 1 British pound can be exchanged for 1.62 U.S. dollars. 1.62 U.S. dollars can then be exchanged for 2.6244[(1.62)(1.62)] Swiss francs. It follows that 1 pound is worth 2.6244 francs.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-3 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Cross rates–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 36. If the spot rate of the Israeli shekel is 5.51 shekels per dollar and the 180-day forward rate is 5.97 shekels per dollar, then the forward rate for the Israeli shekel is selling at a ____ to the spot rate. a. premium of 8% b. premium of 18% c. discount of 18% d. discount of 8% e. premium of 16% ANS: D (5.97 − 5.51)/5.51 = 0.083  8%. Because one can obtain more Israel shekels for a dollar in the forward market, the forward currency is selling at an 8% discount to the spot rate.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-3 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Forward exchange rates–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 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 144 yen per dollar, what would the car be selling for today in U.S. dollars? a. $5.964 b. $8,200 c. $10,250 d. $12,628 e. $13,525 ANS: C Exchange rate in 1985 = 1,476,000/$8,200 = 180 yen per dollar.

Today's exchange rate = 144 yen per dollar; 144/180 = 0.80.

Today's price = $8,200/0.8 = $10,250.

Alternatively, 1,476,000/144 = $10,250.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-3 NAT: BUSPROG: Analytic STA: DISC: International financial management © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LOC: TBA TOP: Exchange rates and asset value MSC: TYPE: Multiple Choice: Problem

KEY: Bloom’s: Analysis

38. Suppose it takes 1.82 U.S. dollars today to purchase one British pound in the foreign exchange market, and currency forecasters predict that the U.S. dollar will depreciate by 12.0% against the pound over the next 30 days. How many dollars will a pound buy in 30 days? a. 1.12 b. 1.63 c. 1.82 d. 2.04 e. 3.64 ANS: D The British pound will appreciate against the dollar by 12%.

1£ = 1.82 US$  1.12 = 2.04 US$.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-5 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Currency depreciation KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 39. A U.S.-based importer, Zarb Inc., makes a purchase of crystal glassware from a firm in Switzerland for 39,960 Swiss francs, or $24,000, at the spot rate of 1.665 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 francs. If the spot rate in 90 days is actually 1.638 francs, how much will the U.S. firm have saved or lost in U.S. dollars by hedging its exchange rate exposure? a. −$396 b. −$243 c. $0 d. $243 e. $638 ANS: E Time line:

Calculate the cost of the forward contract at the forward rate: 39,960 SFr/(1.682 SFr/US$) = $23,757.43.

Calculate the cost of purchasing exchange currency at the spot rate in 90 days to satisfy the payable: 39,960 SFr/1.638 SFr/US$ = $24,395.60.

Calculate the savings from the forward market hedge: $24,395.60 − $23,757.43 = $638.17  $638.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-6 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Forward market hedge KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

40. Suppose 90-day investments in Britain have a 6% annualized return and a 1.5% quarterly (90-day) return. In the U.S., 90-day investments of similar risk have a 4% annualized return and a 1% quarterly (90-day) return. In the 90-day forward market, 1 British pound equals $1.65. If interest rate parity holds, what is the spot exchange rate? a. 1 pound = $1.8000 b. 1 pound = $1.6582 c. 1 pound = $1.0000 d. 1 pound = $0.8500 e. 1 pound = $0.6031 ANS: B From the interest rate parity formula it follows that e0 = (ft)(1 + rf)/(1 + rh) = (1.65 dollars/pound)(1.015)/(1.01) = 1.6582 dollars/pound.

Another way to think of this is $1 invested today in the United States yields $1.01 90 days from now.

Alternatively, investors could put their money in British securities. In this case, the investor would exchange today $1 for (1/1.6582) or 0.6031 pounds in the spot market. This money could be invested in Britain and after 90 days this investment would be worth 0.6031(1.015) = 0.6121 pounds. Given the forward exchange rate, 0.6121 pounds is worth $1.01 90 days from now (0.6121  1.65 = $1.01).

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-7 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Interest rate parity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 41. Suppose 1 U.S. dollar equals 1.60 Canadian dollars in the spot market. 6-month Canadian securities have an annualized return of 6% (and thus a 6-month periodic return of 3%). 6-month U.S. securities have an annualized return of 6.5% and a periodic return of 3.25%. If interest rate parity holds, what is the U.S. dollar-Canadian dollar exchange rate in the 180-day forward market? a. 1 U.S. dollar = 0.6235 Canadian dollars b. 1 U.S. dollar = 0.6265 Canadian dollars c. 1 U.S. dollar = 1.0000 Canadian dollars d. 1 U.S. dollar = 1.5961 Canadian dollars e. 1 U.S. dollar = 1.6039 Canadian dollars ANS: D From the interest rate parity formula it follows that ft = (eo)(1 + rh)/(1 + rf) = (0.6250 U.S. dollars/Canadian dollar)(1.0325)/(1.03) = 0.6265 U.S. dollars/Canadian dollar, or 1.5961 Canadian dollars per U.S. dollar.

Another way to think of this is $1 invested today in the United States yields $1.0325 six months from now. Alternatively, investors could put their money in Canadian securities. In this case, the investor would exchange $1 today for 1.6 Canadian dollars. This money could be invested in Canada and after 6 months this investment would be worth 1.6480 Canadian dollars[(1.6)(1.03)]. At a forward exchange rate of 1 U.S. dollar equals 1.5961 Canadian dollars, 1.6480 Canadian dollars would be worth $1.0325 in the U.S. Since the 2 investments produce the same return, interest rate parity holds.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-7 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Interest rate parity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 42. A product sells for $750 in the United States. The exchange rate is $1 to 1.65 Swiss francs. If purchasing power parity (PPP) holds, what is the price of the product in Switzerland? © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

a. b. c. d. e.

123.75 Swiss francs 454.55 Swiss francs 750.00 Swiss francs 1,237.50 Swiss francs 1,650.00 Swiss francs

ANS: D $750 equals 1,237.50 [(750)(1.65)] Swiss francs. If PPP holds, the product should cost the same in both markets.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-8 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Purchasing power parity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 43. Suppose a carton of hockey pucks sell in Canada for 105 Canadian dollars, and 1 Canadian dollar equals 0.71 U.S. dollars. If purchasing power parity (PPP) holds, what is the price of hockey pucks in the United States? a. $14.79 b. $63.00 c. $74.55 d. $85.88 e. $147.88 ANS: C 105 Canadian dollars equals 74.55 [(105)(0.71)] U.S. dollars. If PPP holds, the pucks should cost the same in both markets.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-8 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Purchasing power parity KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 44. A box of chocolate candy costs 28.80 Swiss francs in Switzerland and $20 in the United States.

Assuming that purchasing power parity (PPP) holds, what is the current exchange rate? a. 1 U.S. dollar equals 0.69 Swiss francs b. 1 U.S. dollar equals 0.85 Swiss francs c. 1 U.S. dollar equals 1.21 Swiss francs d. 1 U.S. dollar equals 1.29 Swiss francs e. 1 U.S. dollar equals 1.44 Swiss francs ANS: E If PPP holds, the chocolate should cost the same in each country, so that 28.80 Swiss francs equal 20 U.S. dollars. This relationship implies that 1 U.S. dollar equals 1.44 Swiss francs (28.80 SF/20).

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-8 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Purchasing power parity–nonalgorithmic KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 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. The exchange rate at that time was 1.420 Swiss francs 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? a. −7.92% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. c. d. e.

−4.13% 6.00% 8.25% 12.00%

ANS: A Time line:

Financial calculator solution: Calculate the 6-month return to the Swiss investor after she has exchanged US$ for Swiss francs.

Inputs: N = 1; PV = −13,786.41; FV = 13,240.

Output: I/YR = −3.96%.

Annualized nominal rate of return = −3.96(2) = −7.92%.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-9 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Exchange fluctuations and T-bills KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 46. Suppose Stackpool Inc. had inventory in Britain valued at 240,000 pounds one year ago. The exchange rate for dollars to pounds was 1£ = 2 U.S. dollars. This year the exchange rate is 1£ = 1.82 U.S. dollars. The inventory in Britain is still valued at 240,000 pounds. What is the gain or loss in inventory value in U.S. dollars as a result of the change in exchange rates? a. −$240,000 b. −$43,200 c. $0 d. $43,200 e. $47,473 ANS: B Inventory, this year = 240,000£  $1.82 = Inventory, last year = 240,000£  $2.00 = Loss =

$436,800 480,000 ($ 43,200)

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 17-13 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Inventory value and exchange rates KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 47. A U.S.-based company, Stewart, Inc., arranged a 2-year, $1,000,000 loan to fund a project in Mexico.

The loan is denominated in Mexican pesos, carries a 10.0% nominal rate, and requires equal semiannual payments. The exchange rate at the time of the loan was 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, Stewart 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 interest rate will Stewart end up paying on the loan? a. 10.36% b. 11.50% © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. 17.44% d. 20.00% e. 21.79% ANS: E

Financial calculator solution: Calculate the required payments in Mexican pesos: Inputs: N = 4; I/YR = 5; PV = −5,750,000; FV = 0.

Output: PMT = 1,621,568 MP. 1,621,568 Mexican pesos are needed on each payment date. At the initial exchange rate of 5.75 pesos/US$, the payments are approximately US $282,012. Payment in U.S. dollars after conversion = 1,621,568 pesos/(5.75 FF/US$) = $282,011.83. However, at an exchange rate of 5.10 pesos/US$, the cost to the firm in US$ increases to 1,621,568/5.10 = $317,954.51  $317,955.

Calculate nominal annual interest rate on loan: Inputs: N = 4; PV = −1,000,000; PMT = 317,955; FV = 0.

Output: I/YR = 10.36% semiannual rate.

Annual nominal rate = 10.36(2) = 20.72%.

Calculate effective annual rate: Inputs: P/YR = 2; NOM% = 20.72.

Output: EFF% = 21.79%.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 17-1 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: EAR on foreign debt KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 48. Tashakori Trucking, a U.S.-based company, is considering expanding its operations into a foreign country. The required investment at Time = 0 is $10 million. The firm forecasts total cash inflows of $4 million per year for 2 years, $6 million for the next 2 years, and then a possible terminal value of $8 million. In addition, due to political risk factors, Tashakori believes that there is a 50% chance that the gross terminal value will be only $2 million and a 50% chance that it will be $8 million. However, the government of the host country will block 20% of all cash flows. Thus, cash flows that can be repatriated are 80% of those projected. Tashakori's cost of capital is 15%, but it adds one percentage point to all foreign projects to account for exchange rate risk. Under these conditions, what is the project's NPV? a. $1.01 million b. $2.77 million c. $3.09 million d. $5.96 million e. $7.39 million ANS: B Time line: (In millions)

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

*Calculate the expected terminal value cash flow: Expected terminal cash flow (CF5) = 0.5(8) + 0.5(2) = 4 + 1 = 5.

Calculate the unrestricted cash flows that can be repatriated to the parent firm: Unrestricted cash flows = Projected cash inflows  0.80.

Tabular solution (In millions):

Year 1 2 3 4 5

Projected Cash Flow $4 4 6 6 5

Percent Unrestricted 0.80 0.80 0.80 0.80 0.80

Unrestricted Repatriable Cash Flows $3.2 3.2 4.8 4.8 4.0

NPV = $3.2/1.16 + $3.2/1.162 + $4.8/1.163 + $4.8/1.164 + $4.0/1.165 − $10.0 = $3.2(0.8621) + $3.2(0.7432) + $4.8(0.6407) + $4.8(0.5523) + $4.0(0.4761) − $10.0 = $2.759 + $2.378 + $3.075 + $2.651 + $1.904 − $10.0 = $2.768  $2.77 million.

Financial calculator solution (In millions): Inputs: CF0 = −10.0; CF1 = 3.2; Nj = 2; CF2 = 4.8; Nj = 2; CF3 = 4.0; I/YR = 16.

Output: NPV = $2.767  $2.77 million.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 17-11 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Foreign investment cash flows KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem 49. Suppose a U.S. firm buys $200,000 worth of stereo speaker wire 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 5.50 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? a. $0 b. $1,834.86 c. $4,517.26 d. $5,712.31 e. $7,547.17 ANS: D Obligation is for 200,000  5.50 = 1,100,000 pesos.

1,100,000/5.45 = cost of forward contract = $201,834.86.

Spot rate in 90 days = 5.30 pesos per U.S. dollar. © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

1,100,000/5.30 = cost of spot rate in 90 days = $207,547.17.

Spot cost − forward cost = $207,547.17 − $201,834.86 = $5,712.31.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 17-13 NAT: BUSPROG: Analytic STA: DISC: International financial management LOC: TBA TOP: Forward market hedge KEY: Bloom’s: Analysis MSC: TYPE: Multiple Choice: Problem

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.