Intermediate Financial Management 14th Edition Brigham . All 31 Chapters | TEST BANK

1. Overview of Financial Management & the Financial Environment

Indicate whether the statement is true or 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 5. One key value of limited liability is that it lowers owners' risks and thereby enhances a firm's value. a. True b. False 6. 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. a. True b. False 7. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

8. 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

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1. Overview of Financial Management & the Financial Environment ones. e. Corporations of all types are subject to the corporate income tax.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

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1. Overview of Financial Management & the Financial Environment 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.

14. 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.

15. 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.

16. 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. 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.

17. 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

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1. Overview of Financial Management & the Financial Environment 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.

18. 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.

19. 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? a. Proprietorship, because of ease of entry. b. S corporation, to gain some tax advantages and also to obtain limited liability. c. Partnership, but only if she needs additional capital. d. Regular corporation, because of the limited liability. e. In this situation, the various forms of organization seem equally desirable.

20. 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.

Indicate whether the statement is true or false.

21. 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

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1. Overview of Financial Management & the Financial Environment and thus shareholders' wealth. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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

23. 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.

24. 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.

25. 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

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1. Overview of Financial Management & the Financial Environment 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.

26. 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.

27. 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 makes raising capital easier for corporations.

Indicate whether the statement is true or false.

28. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

29. 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

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1. Overview of Financial Management & the Financial Environment

Indicate whether the statement is true or false.

30. Debt is a less risky than equity because a debtholder's claim has priority to an equity holder's claim. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

31. 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.

32. 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. b. Prices would rise and interest rates would decline. c. Prices and interest rates would both decline. d. There would be no changes in either prices or interest rates. e. Prices would decline and interest rates would rise.

33. 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.

34. 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.

Indicate whether the statement is true or false.

35. If an individual investor buys or sells a currently outstanding stock through a broker, this is a primary market transaction.

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1. Overview of Financial Management & the Financial Environment a. True b. False 36. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

37. 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. 38. 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.

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

40. 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

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1. Overview of Financial Management & the Financial Environment "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.

41. 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.

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1. Overview of Financial Management & the Financial Environment Answer Key 1. False 2. False 3. True 4. True 5. True 6. False 7. True 8. d 9. a 10. d 11. c 12. a 13. c 14. a 15. c 16. b 17. d 18. c 19. b 20. e 21. False 22. c 23. a 24. d 25. c

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1. Overview of Financial Management & the Financial Environment 26. e 27. d 28. True 29. c 30. True 31. a 32. e 33. d 34. e 35. False 36. True 37. b 38. a 39. c 40. b 41. d

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2. Risk & Return: Part I

Indicate whether the statement is true or 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. a. True b. False 2. Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse. a. True b. False 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. a. True b. False 4. Diversification will normally reduce the riskiness of a portfolio of stocks. a. True b. False 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. a. True b. False 6. The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 10. One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering

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2. Risk & Return: Part I both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM. a. True b. False 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 welldiversified portfolio. a. True b. False 12. If investors become less averse to risk, the slope of the Security Market Line (SML) will increase. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 18. "Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities. a. True b. False

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2. Risk & Return: Part I 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. a. True b. False 20. Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk. a. True b. False 21. A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms. a. True b. False 22. A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. a. True b. False 23. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False 24. A stock with a beta equal to −1.0 has zero systematic (or market) risk. a. True b. False 25. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative. a. True b. False 26. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky. a. True b. False 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. a. True b. False 28. A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is

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2. Risk & Return: Part I this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios. a. True b. False 29. The distributions of rates of return for Companies AA and BB are given below: State of the Economy Boom Normal Recession

Probability of This State Occurring 0.2 0.6 0.2

AA 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. a. True b. False 30. Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone. a. True b. False 31. Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away. a. True b. False 32. We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio. a. True b. False 33. We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security. a. True b. False 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. a. True b. False 35. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM. a. True b. False

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2. Risk & Return: Part I 36. Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return. a. True b. False 37. A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions. a. True b. False 38. Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant. a. True b. False 39. The slope of the SML is determined by the value of beta. a. True b. False 40. The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML. a. True b. False 41. If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a welldiversified investor, assuming that the observed relationship is expected to continue in the future. a. True b. False 42. If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the riskfree rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future. a. True b. False 43. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate. a. True b. False 44. The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions. a. True b. False 45. The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on

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2. Risk & Return: Part I an average (b = 1) stock is zero. a. True b. False 46. If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM − rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation. a. True b. False 47. Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk. a. True b. False 48. Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A's portfolio has a beta of minus 2.0, while Investor B's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0. a. True b. False 49. The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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.

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 held as part of a well-diversified portfolio.

if it is to be held in isolation and Stock

if it is to be

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2. Risk & Return: Part I a. A; B. b. B; A. c. C; A. d. C; B. e. A; A. 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.

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.

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. 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.

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2. Risk & Return: Part I 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 5year 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 lowbeta 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 Paidin-Full Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.

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.

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. 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.

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2. Risk & Return: Part I 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.

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 Market 1 0.03 2 −0.05 3 0.01 4 −0.10 5 0.06 a. bA > +1; bB = 0.

Stock A 0.16 0.20 0.18 0.25 0.14

Stock B 0.05 0.05 0.05 0.05 0.05

b. bA = 0; bB = −1. c. bA < 0; bB = 0. d. bA < −1; bB = 1. e. bA > 0; bB = 1.

61.61.

Which of the following statements is CORRECT? a. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. b. An investor can eliminate almost all risk if he or she holds a very large and well diversified portfolio of stocks. c. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. d. An investor can eliminate almost all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks. e. An investor can eliminate almost all market risk if he or she holds a very large and well diversified portfolio of stocks.

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 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.

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.

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2. Risk & Return: Part I 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.

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.

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 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.

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.

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

Expected Return 10%

Standard Deviation 20%

Beta 1.0

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2. Risk & Return: Part I B C

10% 12%

10% 12%

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%.

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. 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.

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.

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.

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%.

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2. Risk & Return: Part I 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%. 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%.

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%.

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.

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.

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%.

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2. Risk & Return: Part I d. Portfolio P has a beta that is less than 1.2. e. Portfolio P has a beta that is greater than 1.2.

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%.

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.

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? a. Portfolio P's expected return is equal to the expected return on Stock A. b. Portfolio P's expected return is less than the expected return on Stock B. c. Portfolio P's expected return is equal to the expected return on Stock B. d. Portfolio P's expected return is greater than the expected return on Stock C. e. Portfolio P's expected return is greater than the expected return on Stock B. 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.

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.

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2. Risk & Return: Part I 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.

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%.

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%.

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.

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, largecompany stocks.

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2. Risk & Return: Part I 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.

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.

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.

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.

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%. 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%.

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?

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2. Risk & Return: Part I 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.

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.

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. 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.

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%.

93. Which of the following statements is CORRECT? a. Lower beta stocks have higher required returns.

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2. Risk & Return: Part I 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.

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.

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. b. Portfolio P has a standard deviation of 22.5%. c. More information is needed to determine the portfolio's beta. d. Portfolio P has a beta of 1.0. e. Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns.

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.

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.

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2. Risk & Return: Part I 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. 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. 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%.

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.

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.

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.

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2. Risk & Return: Part I 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.

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.

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.

105. Which of the following statements is CORRECT? a. The slope of the Security Market Line is beta. 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.

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.

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2. Risk & Return: Part I 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.

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 = . 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.

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.

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. 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%

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2. Risk & Return: Part I 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. e. Portfolio P has a standard deviation of 25% and a beta of 1.0.

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.

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.

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%.

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.

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2. Risk & Return: Part I 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. 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 averagerisk 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 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.

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% 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% 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 b. 0.72

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2. Risk & Return: Part I c. 0.80 d. 0.89 e. 0.98 121. 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. 1.42 122. 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%; 1.42 123. 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% 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% 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% c. 6.09% d. 6.25%

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2. Risk & Return: Part I e. 6.40% 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. 1.143 127. Sherrie Hymes holds a $200,000 portfolio consisting of the following stocks. The portfolio's beta is 0.875.

Stock A B C D Total

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

Beta 0.50 0.80 1.00 1.20

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. 1.30 128. Megan Ross holds the following portfolio: Stock A B C D Total

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

What is the portfolio's beta? a. 1.06 b. 1.17 c. 1.29 d. 1.42 e. 1.56

Beta 1.40 0.80 1.00 1.20

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2. Risk & Return: Part I 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. −0.286 130. 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 e. 1.165 131. 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% 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% 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.)

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2. Risk & Return: Part I a. 8.76% b. 8.98% c. 9.21% d. 9.44% e. 9.68% 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% 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? a. 13.51% b. 13.86% c. 14.21% d. 14.58% e. 14.95% 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% 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 Investment A $ 200,000 B $ 300,000 C $ 500,000 D $1,000,000 a. 9.58% b. 10.09% c. 10.62% d. 11.18% e. 11.77%

Beta 1.50 −0.50 1.25 0.75

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2. Risk & Return: Part I 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. 14.00% b. 14.70% c. 15.44% d. 16.21% e. 17.02%

1.00 10.20% 6.00% 30.00% 2.00%

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% 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. 1.43 141. 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. 20.08% b. 20.59% c. 21.11% d. 21.64% e. 22.18%

Return 21.00% −12.50% 25.00%

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

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2. Risk & Return: Part I the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.)

Economic Conditions Strong Normal Weak a. 17.69% b. 18.62% c. 19.55% d. 20.52% e. 21.55%

Prob.

30% 40% 30%

Return 32.0% 10.0% −16.0%

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 2011 2012 2013 2014 2015 Average return = Standard deviation = a. 3.29% b. 3.46% c. 3.65% d. 3.84% e. 4.03%

15.00% 22.64%

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%

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% 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%.

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2. Risk & Return: Part I 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 e. 2.04 146. 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

Amount $1,075,000 675,000 750,000 500,000 $3,000,000 a. 10.56% b. 10.83% c. 11.11% d. 11.38% e. 11.67%

Beta 1.20 0.50 1.40 0.75

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%

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2. Risk & Return: Part I Answer Key 1. False 2. True 3. True 4. True 5. True 6. False 7. True 8. False 9. False 10. True 11. True 12. False 13. True 14. True 15. True 16. False 17. True 18. True 19. True 20. True 21. False 22. False 23. True 24. False 25. True

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2. Risk & Return: Part I 26. True 27. False 28. False 29. False 30. False 31. True 32. False 33. False 34. False 35. False 36. False 37. True 38. True 39. False 40. True 41. True 42. False 43. True 44. False 45. False 46. True 47. True 48. True 49. False 50. a 51. b

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2. Risk & Return: Part I 52. b 53. b 54. c 55. b 56. a 57. d 58. d 59. b 60. c 61. d 62. b 63. b 64. d 65. a 66. a 67. c 68. a 69. c 70. e 71. a 72. b 73. e 74. b 75. c 76. d

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2. Risk & Return: Part I 77. a 78. c 79. b 80. a 81. a 82. d 83. c 84. b 85. b 86. b 87. a 88. e 89. a 90. a 91. d 92. e 93. e 94. d 95. d 96. c 97. c 98. e 99. e 100. d 101. b 102. e

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2. Risk & Return: Part I 103. c 104. c 105. d 106. e 107. d 108. c 109. c 110. a 111. b 112. d 113. e 114. c 115. e 116. b 117. d 118. c 119. d 120. e 121. a 122. b 123. d 124. c 125. a 126. b 127. b

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2. Risk & Return: Part I 128. b 129. d 130. e 131. a 132. e 133. c 134. d 135. e 136. b 137. e 138. a 139. a 140. c 141. b 142. b 143. d 144. a 145. b 146. c 147. c

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3. Risk & Return: Part II

Indicate whether the statement is true or false.

1. The slope of the SML is determined by the value of beta. a. True b. False 2. If you plotted the returns of Selleck & 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 Selleck's 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. a. True b. False 3. The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions. a. True b. False 4. The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero. a. True b. False 5. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False 6. A stock with a beta equal to −1.0 has zero systematic (or market) risk. a. True b. False 7. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative. a. True b. False 8. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data. a. True b. False 9. We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security. a. True b. False 10. 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

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3. Risk & Return: Part II stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock. a. True b. False 11. The CAPM is a multi-period model which takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk. a. True b. False 12. Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

13. Which of the following statements is CORRECT? a. The slope of the CML is ( M − rRF)/bM. b. All portfolios that lie on the CML to the right of σM are inefficient. c. All portfolios that lie on the CML to the left of σM are inefficient. d. The slope of the CML is ( M − rRF)/σM. e. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.

14. You have the following data on three stocks: Stock A B C

Standard Deviation 0.15 0.25 0.20

Beta 0.79 0.61 1.29

As a risk minimizer, you would choose Stock of a well-diversified portfolio. a. A; B. b. B; C. c. C; A. d. C; B. e. A; A.

if it is to be held in isolation and Stock

if it is to be held as part

15. Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio? a. Standard deviation; correlation coefficient. b. Beta; variance. c. Coefficient of variation; beta. d. Beta; beta. e. Variance; correlation coefficient.

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3. Risk & Return: Part II 16. Which of the following is NOT a potential problem with beta and its estimation? 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 than the "true" or "expected future" beta. b. The beta of "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. There is a wide confidence interval around a typical stock's estimated beta. e. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

17. Stock A's beta is 1.5 and Stock B's beta is 0.5. 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 Stock A. b. Stock A must be a more desirable addition to a portfolio than Stock B. c. The expected return on Stock A should be greater than that on Stock B. d. The expected return on Stock B should be greater than that on Stock A. e. When held in isolation, Stock A has greater risk than Stock B. 18. In a portfolio of three different stocks, which of the following could NOT be true? a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. b. The beta of the portfolio is less than the betas of each of the individual stocks. c. The beta of the portfolio is greater than the beta of one or two of the individual stocks' betas. d. The beta of the portfolio cannot be equal to 1. e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.

19. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B? Years Market 1 0.03 2 −0.05 3 0.01 4 −0.10 5 0.06 a. bA > +1; bB = 0.

Stock A 0.16 0.20 0.18 0.25 0.14

Stock B 0.05 0.05 0.05 0.05 0.05

b. bA = 0; bB = −1. c. bA < 0; bB = 0. d. bA < −1; bB = 1. e. bA > 0; bB = 1.

20. Which of the following statements is CORRECT? a. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6. b. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94. c. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94. d. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.

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3. Risk & Return: Part II e. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.

21. Which of the following statements is CORRECT? a. The characteristic line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry. b. The slope of the characteristic line is the stock's standard deviation. c. The distance of the plot points from the characteristic line is a measure of the stock's market risk. d. The distance of the plot points from the characteristic line is a measure of the stock's diversifiable risk. e. "Characteristic line" is another name for the Security Market Line.

22. You hold a portfolio consisting of a $5,000 investment in each of 20 different stocks. The portfolio beta is equal to 1.12. You have decided to sell a coal mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a mineral rights company stock (b = 2.00). What is the new beta of the portfolio? a. 1.1139 b. 1.1700 c. 1.2311 d. 1.2927 e. 1.3573 23. Your mother's well-diversified portfolio has an expected return of 12.0% and a beta of 1.20. She is in the process of buying 100 shares of Safety Corp. at $10 a share and adding it to her portfolio. Safety has an expected return of 15.0% and a beta of 2.00. The total value of your current portfolio is $9,000. What will the expected return and beta on the portfolio be after the purchase of the Safety stock? rp bp a. 11.69%; 1.22 b. 12.30%; 1.28 c. 12.92%; 1.34 d. 13.56%; 1.41 e. 14.24%; 1.48 24. Suppose 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) Talcott Inc.'s beta is 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. Calculate the required rate of return for Talcot Inc. a. 10.29% b. 10.83% c. 11.40% d. 12.00% e. 12.60% 25. A stock you are holding has a beta of 2.0 and the stock is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event? a. 36.10%

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3. Risk & Return: Part II b. 38.00% c. 40.00% d. 42.00% e. 44.10% 26. Calculate the required rate of return for the Wagner Assets Management Group, which holds 4 stocks. The market's required rate of return is 15.0%, the risk-free rate is 7.0%, and the Fund's assets are as follows: Stock Investment A $ 200,000 B 300,000 C 500,000 D 1,000,000 a. 10.67% b. 11.23% c. 11.82% d. 12.45% e. 13.10%

Beta 1.50 −0.50 1.25 0.75

27. Consider the information below for Postman Builders Inc. Suppose that the expected inflation rate and thus the inflation premium increase by 2.0 percentage points, and Postman acquires risky assets that increase its beta by the indicated percentage. What is the firm's new required rate of return?

Beta: Required return (rs) RPM: Percentage increase in beta: a. 14.00% b. 14.70% c. 15.44% d. 16.21% e. 17.02%

1.50 10.20% 6.00% 20%

28. Assume that the market is in equilibrium and that stock betas can be estimated with historical data. The returns on the market, the returns on United Fund (UF), the risk-free rate, and the required return on the United Fund are shown below.

Based on this information, what is the required return on the market, rM? Year 2011 2012 2013 2014 2015 rRF: 7.00%; a. 10.57% b. 11.13%

Market −9% 11% 15% 5% −1%

UF −14% 16% 22% 7% −2%

rUnited: 15.00%

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3. Risk & Return: Part II c. 11.72% d. 12.33% e. 12.95% 29. You are given the following returns on "the market" and Stock F during the last three years. We could calculate beta using data for Years 1 and 2 and then, after Year 3, calculate a new beta for Years 2 and 3. How different are those two betas, i.e., what's the value of beta 2 − beta 1? (Hint: You can find betas using the Rise-Over-Run method, or using your calculator's regression function.)

Year 1 2 3 a. 7.89 b. 8.30 c. 8.74 d. 9.20 e. 9.66

Market 6.10% 12.90% 16.20%

Stock F 6.50% −3.70% 21.71%

30. 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 rate of return; that is, . b. The required rate of return must equal the realized rate of return; that is, r = . c. All companies must pay dividends. d. No companies can be in danger of declaring bankruptcy. e. The expected rate of return must be equal to the required rate of return; that is, = r.

31. Assume an economy in which there are three securities: Stock A with rA = 10% and σA = 10%; Stock B with rB = 15% and σB = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0). Which of the following statements is most CORRECT? a. The expected return on the investor's portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%. b. The expected return on the investor's portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%. c. The investor's risk/return indifference curve will be tangent to the CML at a point where the expected return is in the range of 7% to 10%. d. Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%. e. The expected return on the investor's portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.

32. Which of the following statements is CORRECT? a. Richard Roll has argued that it is possible to test the CAPM to see if it is correct. b. Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is greater than that predicted by the CAPM. c. Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios

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3. Risk & Return: Part II are much less stable. d. The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller. e. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

33. Stock A has an expected return rA = 10% and σA = 10%. Stock B has rB = 14% and σB = 15%. rAB = 0. The rate of return on riskless assets is 6%.

Construct a graph that shows the feasible and efficient sets, giving consideration to the a. existence of the riskless asset. what would happen to the CML if the two stocks had (a) a positive correlation b. Explain coefficient or (b) a negative correlation coefficient.

Suppose these were the only three securities (A, B, and riskless) in the economy, and everyone's indifference curves were such that they were tangent to the CML to the right of c. the point where the CML was tangent to the efficient set of risky assets. Would this represent a stable equilibrium? If not, how would an equilibrium be produced?

34. You plan to invest in Stock X, Stock Y, or some combination of the two. The expected return for X is 10% and σ X = 5%. The expected return for Y is 12% and σY = 6%. The correlation coefficient, rXY, is 0.75. a. Calculate rp and σp for 100%, 75%, 50%, 25%, and 0% in Stock X. Use the values you calculated for rp and σp to graph the attainable set of portfolios. Which b. part of the attainable set is efficient? Also, draw in a set of hypothetical indifference curves to show how an investor might select a portfolio comprised of Stocks X and Y. Let an indifference curve be tangent to the efficient set at the point where rp = 11%. c. Now suppose we add a riskless asset to the investment possibilities. What effects will this have on the construction of portfolios? d. Suppose rM = 12%, σM = 4%, and rRF = 6%. What would be the required and expected return on a portfolio with σP = 10%?

Suppose the correlation of Stock X with the market, rXM, is 0.8, while rYM = 0.9. Use this e. information, along with data given previously, to determine Stock X's and Stock Y's beta coefficients. f. What is the required rate of return on Stocks X and Y? Do these stocks appear to be in equilibrium? If not, what would happen to bring about an equilibrium?

35. Security A has an expected return of 12.4% with a standard deviation of 15%, and a correlation with the market of 0.85. Security B has an expected return of −0.73% with a standard deviation of 20%, and a correlation with the market of −0.67. The standard deviation of rM is 12%.

To someone who acts in accordance with the CAPM, which security is more risky, A or B? a. Why? (Hint: No calculations are necessary to answer this question; it is easy.)

What are the beta coefficients of A and B? Calculations are necessary. b.

If the risk-free rate is 6%, what is the value of rM? c.

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3. Risk & Return: Part II Answer Key 1. False 2. True 3. False 4. False 5. True 6. False 7. True 8. True 9. False 10. True 11. False 12. False 13. d 14. a 15. c 16. b 17. c 18. b 19. c 20. b 21. d 22. b 23. b 24. d 25. c

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3. Risk & Return: Part II 26. e 27. a 28. d 29. d 30. e 31. b 32. e

33.33.

ABCDE = feasible set.

BCDE = efficient set of risky assets. rRFD = efficient set including riskless asset. a.

The table below shows the returns and standard deviations for various portfolios of Securities A and B. Percent of Portfolio in Percent of Portfolio in Security A Security B (x) (1 − x) 100 0 75 25 50 50 25 75 0 100

Expected Portfolio Return rr (%) 10.0 11.0 12.0 13.0 14.0

Standard Deviation of Portfolio Return σp (%) 10.00 8.39 9.01 11.52 15.00

Calculations: rp = xrA + (1 − x)rB. . rA = 10%; σA = 10%; rB = 14%; σB = 15%; rAB = 0%.

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3. Risk & Return: Part II For x = 0.5: rp = 0.5(10%) + 0.5(14%) = 0.05 + 0.07 = 0.12 = 12%.

rp and σp for other combinations of Securities A and B in the portfolio were similarly calculated.

If the correlation coefficient were positive, then the CML would have a less steep slope. The riskiness of the portfolio would increase. If the correlation coefficient were negative, then the CML would be steeper.

b.

This would not represent a stable equilibrium, because no one would want to hold the riskless asset. In a stable equilibrium, all securities must be priced so that they will be held in portfolios. Therefore, the price of the riskless asset will fall, and its rate of return, rRF, will rise. This will produce a new tangency point and cause a new CML to be created. However, at the new tangency point we have a new market portfolio. This will probably lead to a repricing of stocks, hence to a change in the efficient set.

c.

The final results will include (1) a higher rRF, (2) a CML that is less steep than the present one, (3) some change in the efficient set, (4) a rebalancing of portfolios, with some investors (those who are most risk averse) holding portfolios that contain some of the riskless asset and some of the market portfolio, and (5) an equilibrium situation in which all securities were held in portfolios and there was no general desire to change portfolio compositions.

34.34. rp = X(rX) + (1 − X)(rY)

a.

X 1.00 0.75

×

rX 10% 10

+

(1 − X) 0.00 0.25

×

rY 12% 12

=

rp 10.0% 10.5

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3. Risk & Return: Part II 0.50 0.25 0.00

10 10 10

0.50 0.75 1.00

12 12 12

11.0 11.5 12.0

covXY = rXYσXσY = (0.75)(0.05)(0.06) = 0.00225.

At 100% Stock X: .

At 75% Stock X:

At 50% Stock X:

At 25% Stock X:

At 0% Stock X:

b.

Portfolio A B C D E

Percent inPercent in X Y 100% 0% 75 25 50 50 25 75 0 100

rp

σp

10.0% 10.5 11.0 11.5 12.0

5.00% 4.98 5.15 5.50 6.00 The segment BCDE is efficient. The segment BAE is not efficient.

c.

d.

With the addition of a riskless asset, a new portfolio can be created which combines risk-free and risky assets. Now investors will choose combinations of the market portfolio and the riskless asset. If borrowing is permitted, then less risk-averse investors will move out the CML beyond P.

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3. Risk & Return: Part II

e.

rX = rRF + (rM − rRF)bX = 6% + (11% − 6%)1.0 = 11%. rY = 6% + (11% − 6%)1.35 = 12.75%.

f.

Since the expected return on X, X = 10% < 11%, and Y = 12% < 12.75%, both stocks are out of equilibrium. They are both overvalued. Their prices would decline, and their expected returns would rise, until an equilibrium was restored.

35.3 5 The very fact that rA > rB indicates that Security A is regarded by investors as the more risky . one. This occurs because Security B has a negative covariance with the market⎯holding B in a diversified portfolio lowers the riskiness of the portfolio. Although it is not necessary for a. answering the question, one could use the data to calculate covariances for A and B: Cov(rA, rM) = ρA,M σAσM, where ρA,M = Correlation of A's return with the market return = 0.85. σA,M = Standard deviations of returns of A and the market, respectively.

Cov(rA, rM) = 0.85(0.15)(0.12) = 0.0153.

Cov(rB, rM) = ρB,MσBσM = −0.67(0.20)(0.12) = −0.01608.

Security A's contribution to the portfolio risk is, therefore, higher than that of B. In a single-asset portfolio, the security's risk is measured by the variance of its returns.

VarianceA =

= (0.15)2 = 0.0225, and VarianceB =

= (0.20)2 = 0.04.

Thus, in a single-asset portfolio, B is riskier than A, but in a diversified (CAPM) portfolio, A is riskier. b.

Beta coefficients of A and B are calculated as follows: .

.

c.

The value of rM is calculated from the CAPM equation: rsA = rRF + (rM − rRF)bA. 12.4% = 6% + (rM − 6%)1.0625.

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3. Risk & Return: Part II Therefore, 1.0625rM = 12.4% − 6% + 6.375% = 12.775%. rM = 12.775%/1.0625 = 12.02%.

A similar solution could be obtained by applying the CAPM equation to Security B.

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4. Bond Valuation

Indicate whether the statement is true or 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 5. The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds. a. True b. False 6. A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond. a. True b. False 7. Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds. a. True b. False 8. 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. a. True

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4. Bond Valuation b. False 9. Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floatingrate debt shifts interest rate risk to companies, it offers no advantages to issuers. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

10. 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.

11. 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.

12. 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%.

Indicate whether the statement is true or false.

13. 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. a. True b. False

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4. Bond Valuation 14. For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures. a. True b. False 15. 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%. a. True b. False 16. 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%. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

17. 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.

18. 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.

19. 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

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4. Bond Valuation 20. 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 21. 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 d. $1,162.00 e. $1,191.79

Indicate whether the statement is true or false.

22. If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain above that rate, then the market value of the bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.) a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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. 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.

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.

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4. Bond Valuation c. The company's financial situation deteriorates significantly. d. Inflation increases significantly. e. The company's bonds are downgraded.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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

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4. Bond Valuation c. $882.90 d. $904.97 e. $927.60 30. 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 31. 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 32. 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 Total debt and equity

$10,000,000 2,000,000 10,000,000 4,000,000 $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 33. 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

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4. Bond Valuation 34. 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 35. 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.

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.

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.

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.

39. A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following

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4. Bond Valuation 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%.

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.

41. 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.

42. 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.

43. 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.

44. Which of the following statements is CORRECT?

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4. Bond Valuation 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.

45. 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 rate. e. If a coupon bond is selling at par, its current yield equals its yield to maturity.

46. 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.

47. 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.

48. 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.

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4. Bond Valuation e. Bond A's capital gains yield is greater than Bond B's capital gains yield.

49. 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.

50. 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. 51. 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.

52. 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.

53. 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?

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4. Bond Valuation a. 6.20% b. 6.53% c. 6.87% d. 7.24% e. 7.62% 54. 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% 55. 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% 56. 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% 57. 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% 58. 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%

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4. Bond Valuation c. 2.55% d. 2.80% e. 3.09% 59. 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% 60. 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% 61. 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% 62. 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.

63. 5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5year bonds is 0.4%. What is the real risk-free rate, r*?

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4. Bond Valuation a. 2.59% b. 2.88% c. 3.20% d. 3.52% e. 3.87% 64. 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%

Indicate whether the statement is true or false.

65. As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured. a. True b. False 66. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds. a. True b. False 67. There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. a. True b. False 68. "Restrictive covenants" are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

69. 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

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4. Bond Valuation 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.

70. 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.

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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. 1, 4, 6 b. 1, 2, 3, 4, 6 c. 1, 2, 3, 4, 5, 6 d. 1, 3, 4, 5, 6 e. 1, 3, 4, 6

71. 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.

72. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond? a. 1.90% b. 2.09%

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4. Bond Valuation c. 2.30% d. 2.53% e. 2.78% 73. 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% 74. 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%

Indicate whether the statement is true or false.

75. 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.) a. True b. False 76. 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. a. True b. False 77. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

78. 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.

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4. Bond Valuation b. 20-year, 5% coupon bond. c. 1-year, 10% coupon bond. d. 20-year, zero coupon bond. e. 10-year, zero coupon bond.

79. 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.

80. 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.

81. 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.

82. 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.

83. 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.

84. Which of the following statements is NOT CORRECT?

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4. Bond Valuation 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.

85. 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.

86. 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.

87. 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 10%, 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.

88. 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

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4. Bond Valuation 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 bonds.

89. 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.

90. 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. 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.

91. 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 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.

92. 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.

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4. Bond Valuation 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.

93. 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.

94. 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.

95. 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.

Indicate whether the statement is true or false.

96. Junk bonds are high risk, high yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

97. 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.

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4. Bond Valuation 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.

98. 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.

99. 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.

100. 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 payments received.

101. 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.

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4. Bond Valuation Answer Key 1. True 2. False 3. True 4. False 5. True 6. False 7. False 8. False 9. False 10. c 11. e 12. a 13. True 14. True 15. True 16. True 17. a 18. c 19. a 20. d 21. e 22. True 23. e 24. b 25. b

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4. Bond Valuation 26. a 27. b 28. e 29. c 30. a 31. c 32. b 33. c 34. d 35. c 36. e 37. b 38. b 39. a 40. c 41. e 42. d 43. a 44. d 45. e 46. c 47. d 48. d 49. e 50. b 51. a

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4. Bond Valuation 52. c 53. e 54. b 55. b 56. d 57. a 58. a 59. e 60. e 61. b 62. b 63. c 64. b 65. True 66. True 67. True 68. True 69. a 70. e 71. b 72. a 73. b 74. e 75. False 76. False

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4. Bond Valuation 77. True 78. d 79. c 80. a 81. d 82. d 83. c 84. d 85. a 86. e 87. c 88. b 89. a 90. d 91. d 92. e 93. c 94. b 95. e 96. True 97. b 98. e 99. c 100. b 101. d

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5. Financial Options

Indicate whether the statement is true or 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. a. True b. False 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. a. True b. False 3. If a stock's price is above the strike price of a call option written on the stock, then the exercise value is equal to the stock price minus the strike price. If the stock price is below the strike price, the exercise value of the call option is zero. a. True b. False 4. The exercise value is also called the strike price, but this term is generally used when discussing convertibles rather than financial options. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False

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5. Financial Options 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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

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5. Financial Options goes ex dividend. e. Put options give investors the right to buy a stock at a certain strike price before a specified date.

16. 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 17. 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.

18. 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. 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.

19. 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. 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.

20. 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?

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5. Financial Options a. −$3.10 b. $16.90 c. $17.75 d. $22.50 e. $25.60 21. 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 pretax net profit be? a. −$5.10 b. $19.90 c. $20.90 d. $22.50 e. $27.60

Indicate whether the statement is true or false.

22. 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. a. True b. False 23. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

24. 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.

25. 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

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5. Financial Options c. $8.12 d. $8.55 e. $9.00 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 27. 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

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5. Financial Options Answer Key 1. True 2. True 3. True 4. False 5. True 6. False 7. False 8. False 9. False 10. False 11. a 12. d 13. e 14. a 15. d 16. c 17. d 18. c 19. c 20. b 21. b 22. False 23. False 24. e 25. e

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5. Financial Options 26. c 27. c

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6. Accounting for Financial Management

Indicate whether the statement is true or false.

1. The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of stockholders' equity. a. True b. False 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. a. True b. False 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 a. True b. False

$

50,000Accounts payable 200,000Accruals 250,000Total CL $ 500,000Debt $ 900,000Common stock Retained earnings $1,400,000Total L & E

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

4. On the balance sheet, total assets must always equal total liabilities and equity. a. True b. False 5. Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be higher or lower than the values at which these assets are carried on the books. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6. 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 is designed to give us an idea of what happened to the firm during that year. c. The balance sheet for a given year tells us how much money the company 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.

7. Other things held constant, which of the following actions would increase the amount of cash on a company's balance

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6. Accounting for Financial Management 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.

8. 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.

9. 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.

10. Below are the year-end balance sheets for Wolken Enterprises: Assets: Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets

2022 $ 200,000 864,000 2,000,000 $3,064,000 6,000,000 $9,064,000

2021 $ 170,000 700,000 1,400,000 $2,270,000 5,600,000 $7,870,000

Liabilities and equity: Accounts payable $1,400,000 $1,090,000 Notes payable 1,600,000 1,800,000 Total current liabilities $3,000,000 $2,890,000 Long-term debt 2,400,000 2,400,000 Common stock 3,000,000 2,000,000 Retained earnings 664,000 580,000 Total common equity $3,664,000 $2,580,000 Total liabilities and equity $9,064,000 $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 2021. As of the end of 2022, none of the principal on this debt had been repaid. Assume that the company's sales in 2021 and 2022 were the same. Which of the following statements must be CORRECT? a. Wolken increased its short-term bank debt in 2022. b. Wolken issued long-term debt in 2022. c. Wolken issued new common stock in 2022. d. Wolken repurchased some common stock in 2022.

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6. Accounting for Financial Management e. Wolken had negative net income in 2022.

11. On its 2021 balance sheet, Barngrover Books showed $510 million of retained earnings, and exactly that same amount was shown the following year in 2022. Assuming that no earnings restatements were issued, which of the following statements is CORRECT? a. Dividends could have been paid in 2022, but they would have had to equal the earnings for the year. b. If the company lost money in 2022, they must have paid dividends. c. The company must have had zero net income in 2022. d. The company must have paid out half of its earnings as dividends. e. The company must have paid no dividends in 2022.

12. Below is the common equity section (in millions) of Fethe Industries' last two year-end balance sheets: 2022 2021 Common stock $1,000 $2,000 Retained earnings 2,000 2,340 Total common equity $4,000 $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 2021 was higher than in 2022. b. The company issued common stock in 2022. c. The market price of the company's stock doubled in 2022. d. The company had positive net income in both 2021 and 2022, but the company's net income in 2021 was lower than it was in 2022. e. The company has more equity than debt on its balance sheet.

13. 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 14. Hunter Manufacturing Inc.'s December 31, 2021 balance sheet showed total common equity of $2,050,000 and 100,000 shares of stock outstanding. During 2022, Hunter had $250,000 of net income, and it paid out $100,000 as dividends. What was the book value per share at 12/31/2022, assuming that Hunter neither issued nor retired any common stock during 2022? a. $20.90 b. $22.00 c. $23.10 d. $24.26 e. $25.47

Indicate whether the statement is true or false.

15. The income statement shows the difference between a firm's income and its costs—i.e., its profits—during a specified

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6. Accounting for Financial Management 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. a. True b. False 16. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

17. Which of the following statements is CORRECT? a. The income statement for a given year 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 provided (used) by operating activities.

18. 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.

19. 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 25%. How much was Lindley's operating income, or EBIT? a. $3,462 b. $3,644 c. $3,836 d. $4,038 e. $4,250 20. 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

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6. Accounting for Financial Management outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 25%. 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 21. 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 25%. How much was the firm's net income after taxes? Meric uses the same depreciation expense for tax and stockholder reporting purposes. a. $3,789.87 b. $3,989.33 c. $4,199.30 d. $4,420.31 e. $4,641.33

Indicate whether the statement is true or false.

22. 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. a. True b. False 23. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

24. On 12/31/2022, 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 12/31/2021, the company had reported $555,000 of retained earnings. No shares were repurchased during 2022. How much in dividends did Heaton pay during 2022? a. $47,381 b. $49,875 c. $52,500 d. $55,125 e. $57,881 25. 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?

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6. Accounting for Financial Management a. $77,000 b. $80,850 c. $84,893 d. $89,137 e. $93,594

Indicate whether the statement is true or false.

26. 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. a. True b. False 27. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

28. 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.

29. Which of the following factors could explain why Regal Industrial Fixtures had a negative net cash provided (used) by operations 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 issued preferred stock.

30. Analysts following Armstrong Products recently noted that the company's net cash provided (used) by operations was positive 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.

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6. Accounting for Financial Management e. The company issued new common stock.

31. A security analyst obtained the following information from Prestopino Products' financial statements: Retained earnings at the end of the previous year were $700,000, but retained earnings at the ∙ end of the current year 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 provided (used) by operations for the current year was $150,000. ∙ On the basis of this information, which of the following statements is CORRECT? a. Prestopino had negative net income in the current year. b. Prestopino's depreciation expense in the current year was less than $150,000. c. Prestopino had positive net income in the current year, but its income was less than its previous year's income. d. Prestopino's net cash provided by operations in the current year must be higher than in the previous year. e. Prestopino's cash on the balance sheet at the end of the current year must be lower than the cash it had on the balance sheet at the previous year.

32. 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 shortterm 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 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.

33. 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.

34. Lucy’s Music Emporium purchased $50 million in fixed assets in January and their accountant told them that they would have to depreciate the assets over 20 years (they use the same depreciation calculations for shareholder reporting and income tax purposes). In December they learned that their accountant did not have a college degree and fired him.

They hired a new accountant with a college degree and she told them that they could depreciate the assets over 15 years.

How would the new depreciation assumption affect the company's financial statements relative to the old assumption? 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.

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6. Accounting for Financial Management d. The firm's reported earnings per share would increase. e. The firm's cash position would increase, all else held equal.

35. 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 25%. 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. -534.38 b. -562.50 c. -590.63 d. -620.16 e. -651.16 36. 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.

37. Jessie's Bobcat Rentals' cash flow from operations was negative 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.

38. Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its 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.

Indicate whether the statement is true or false.

39. 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.

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6. Accounting for Financial Management However, a secondary financial consideration is cash flow, because cash is needed to operate the business. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

40. 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 provided (used) by operations, 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 provided (used) by operations is often defined as follows: Net cash provided (used) by operations = Net Income + Noncash Adjustments + Working Capital Adjustments.

41. 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, operating costs other than depreciation, 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' free cash flows would increase. e. Companies' cash positions would decline.

42. JBS Inc. recently reported net income of $4,750 and depreciation of $885. How much was its net cash provided (used) by operations, assuming it had no amortization expense, added $200 to inventories, sold none of its fixed assets, and had a $200 increase in accounts payable? a. $4,831.31 b. $5,085.59 c. $5,353.25 d. $5,635.00 e. $5,916.75 43. 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 (25%)

$1,800.00 1,400.00 250.00 $ 150.00 70.00 $ 80.00 20.00

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6. Accounting for Financial Management Net income a. $101.53 b. $106.88 c. $112.50 d. $118.13 e. $124.03

$60.00

44. 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 (25%) Net income a. $427.62 b. $450.12 c. $473.81 d. $498.75 e. $525.00

$2,000.00 1,200.00 100.00 $ 700.00 200.00 $ 500.00 125.00 $375.00

Indicate whether the statement is true or false.

45. Total net operating capital is equal to net fixed assets. a. True b. False 46. 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. a. True b. False 47. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

48. 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

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6. Accounting for Financial Management 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.

e.

49. Which of the following statements is CORRECT? a. A shortcut to calculate free cash flow (FCF) is defined as follows: FCF = 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.

Net cash provided (used) by operations is the same as free cash flow (FCF).

50. Danielle's Sushi Shop last year had (1) a negative cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation? a. The company had a sharp increase in its 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.

51. 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 52. 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

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6. Accounting for Financial Management 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 53. 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 54. 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. $54.00 b. $60.00 c. $66.00 d. $72.60 e. $79.86

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

$ 20 20 50 $ 90 0 30 50 $230

55. Tibbs Inc. had the following data for the most recent year: 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% 56. Zumbahlen Inc. has the following balance sheet. How much total operating capital does the firm have?

Cash Short-term investments

$ 20.00Accounts payable 50.00Accruals

$ 30.00 50.00

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6. Accounting for Financial Management Accounts receivable Inventory Current assets Gross fixed assets Accumulated deprec.

Net fixed assets Total assets a. $114.00 b. $120.00 c. $126.00 d. $132.30 e. $138.92

20.00Notes payable 60.00 Current liabilities $150.00Long-term debt $140.00Common stock 40.00Retained earnings $100.00Total common equity $250.00Total liab. & equity

30.00 $110.00 70.00 30.00 40.00 $ 70.00 $250.00

57. 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 25%. 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. $2,050.00 b. $2,152.50 c. $2,260.13 d. $2,373.13 e. $2,491.79 58. 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 25%. 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 to change? Note that the company uses the same depreciation calculations for tax and stockholder reporting purposes. a. −$442.89 b. −$466.20 c. −$490.73 d. −$516.56 e. −$543.75 59. 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 25%. 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. $658.83 b. $693.50 c. $730.00 d. $766.50 e. $804.83

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6. Accounting for Financial Management 60. 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.

61. 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 from operations.

62. 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 63. Barnes' Brothers has the following data for the year ending 12/31/2022: 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 64. 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 25%. What was HHH's Economic Value Added (EVA), i.e., how much value did management add to stockholders' wealth during the year? a. $2,098.31 b. $2,208.75

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6. Accounting for Financial Management c. $2,325.00 d. $2,441.25 e. $2,563.31

Indicate whether the statement is true or false.

65. The fact that 50% 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. a. True b. False 66. 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 taxdeductible expense, this would probably encourage companies to use more debt financing than they presently do, other things held constant. a. True b. False 67. The interest and dividends paid by a corporation are considered to be deductible operating expenses, hence they decrease the firm's tax liability. a. True b. False 68. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

69. 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.

70. 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

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6. Accounting for Financial Management 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 free 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.

71. 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.

72. 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 provided (used) by operations would increase. e. The firm's tax payments would increase.

73. 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.

74. Which of the following statements is CORRECT? a. The maximum federal tax rate on personal income can exceed 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, but dividends received are taxed at a maximum rate of 20%. d. The maximum federal tax rate on corporate income is 50%.

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6. Accounting for Financial Management 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.

75. 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 25%. How much was its net operating profit after taxes (NOPAT)? a. $2,748.96 b. $2,893.64 c. $3,045.94 d. $3,206.25 e. $3,375.00 76. Dreebyshaw Industries has the following information from its financial statements ($millions). Calculate Dreebyshaw's federal income tax payment for the current year. Dreebyshaw has no prior year carryforwards or nonoperating income or expenses. Recall that the Tax Cuts and Jobs Act limits the allowable interest deduction to 30% of EBIT. The federal tax rate is 21%.

EBIT Interest expense

2023 $125.00 $50.00

a. $20.00 b. $17.46 c. $18.38 d. $19.29 e. $20.26 77. Apex, Inc. has the following information from its financial statements ($millions). Calculate Henry's federal income tax payment for the current year. Apex has no prior year carryforwards or non-operating income. Recall that the Tax Cuts and Jobs Act limits the allowable interest deduction to 30% of EBIT. The federal tax rate is 21%.

EBIT Interest expense Other expenses

2023 $215.00 $86.00 $22.00

a. $30.00 b. $33.36 c. $35.11 d. $36.87 e. $38.71 78. Beta Accessories, Inc. has the following information from its financial statements ($millions) for the current year and last year. Calculate Beta's federal income tax payment for the current year. Scarlett had no carryforwards prior to last year.

Recall that the Tax Cuts and Jobs Act limits the allowable interest deduction to 30% of EBIT and any amount not

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6. Accounting for Financial Management deducted in a given year may be carried forward to subsequent years. The federal tax rate is 21%. Hint: First, you'll need to calculate last year's maximum interest deduction and calculate how much unused interest deduction is carried forward to this year.

Last year EBIT Interest expense

$215.00 $86.00

This year $258.00 $39.00

a. $40.00 b. $39.40 c. $41.48 d. $43.55 e. $45.73 79. Global Actions, Inc. had pre-tax income of $50 million this year. Last year was not a good year and it had an operating loss of $30 million. Calculate Global's federal income tax payment for the current year. Recall that due to the Tax Cuts and Jobs Act, prior years' cumulative operating losses may be used to offset up to 80% of the current year's taxable income. The federal tax rate is 21%. a. $0.00 b. $3.99 c. $4.20 d. $4.41 e. $4.63 80. Global Products, Inc. had pre-tax income of $50 million this year. Last year was a bad year for Global with an operating loss of $44 million. Calculate Global's federal income tax payment for the current year. Recall that due to the Tax Cuts and Jobs Act, prior years' cumulative operating losses may be used to offset up to 80% of the current year's taxable income. The federal tax rate is 21%. a. $0.00 b. $2.00 c. $2.10 d. $2.21 e. $2.32 81. Local Enterprises, Inc. had pre-tax income of $50 million this year. Last year was a bad year for Local with an operating loss of $44 million. Local will use as much of this loss as allowed to offset this year's pre-tax income and carry forward any remaining amount. Calculate the amount of the prior year's operating loss Local will carry forward to next year. Recall that due to the Tax Cuts and Jobs Act, prior years' cumulative operating losses may be used to offset up to 80% of the current year's taxable income with any unused operating losses carried forward. a. $0.00 b. $3.80 c. $4.00 d. $4.20 e. $4.41

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6. Accounting for Financial Management Answer Key 1. True 2. True 3. False 4. True 5. True 6. a 7. d 8. d 9. e 10. c 11. a 12. b 13. a 14. b 15. True 16. False 17. a 18. d 19. e 20. b 21. d 22. False 23. True 24. c 25. a

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6. Accounting for Financial Management 26. True 27. True 28. c 29. b 30. c 31. a 32. a 33. c 34. e 35. b 36. c 37. e 38. d 39. False 40. e 41. e 42. d 43. c 44. e 45. False 46. True 47. False 48. b 49. c 50. d 51. b

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6. Accounting for Financial Management 52. d 53. b 54. b 55. d 56. b 57. a 58. e 59. c 60. d 61. d 62. e 63. e 64. c 65. False 66. False 67. False 68. True 69. d 70. a 71. c 72. d 73. e 74. c 75. e 76. c

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6. Accounting for Financial Management 77. c 78. c 79. c 80. c 81. c

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7. Analysis of Financial Statements

Indicate whether the statement is true or false.

1. Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength. a. True b. False 2. 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. a. True b. False 3. Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods. a. True b. False 4. 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. a. True b. False 5. One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6. 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."

Indicate whether the statement is true or false.

7. 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

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7. Analysis of Financial Statements how long it takes the firm to convert its inventory into cash. a. True b. False 8. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easyto-use measures of a firm's liquidity position. a. True b. False 9. High current and quick ratios always indicate that a firm is managing its liquidity position well. a. True b. False 10. 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. a. True b. False 11. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

12. 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.

13. 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.

14. 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.

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7. Analysis of Financial Statements 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $)

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7. Analysis of Financial Statements Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc.What is the firm's current ratio? a. 0.97 b. 1.08 c. 1.20 d. 1.33 e. 1.47 20. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets

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7. Analysis of Financial Statements Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's quick ratio? a. 0.49 b. 0.61 c. 0.73 d. 0.87 e. 1.05

Indicate whether the statement is true or false.

21. 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. a. True b. False

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7. Analysis of Financial Statements 22. 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. a. True b. False 23. The inventory turnover and current ratio are related. The combination of a high current ratio and a low inventory turnover ratio, relative to industry norms, suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged. a. True b. False 24. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

25. 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. 26. 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.

27. 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. b. Pay down the accounts payables. c. Reduce the days' sales outstanding (DSO) without affecting sales or operating costs. d. Pay workers more frequently to decrease the accrued wages balance. e. Reduce the inventory turnover ratio without affecting sales or operating costs.

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7. Analysis of Financial Statements 28. 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 29. 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 d. $311.81 e. $328.22 30. 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 31. 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 32. 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

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7. Analysis of Financial Statements d. $191,188 e. $200,747 33. Muscarella Inc. has the following balance sheet and income statement data: Cash Receivables Inventories Total CA Net fixed assets Total assets Sales Net income

$ 14,000Accounts payable 70,000Other current liabilities 210,000 Total CL $294,000Long-term debt 126,000Common equity $420,000 Total liab. and equity $280,000 $ 21,000

$ 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% 34. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

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

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0

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7. Analysis of Financial Statements Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. 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 35. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0

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7. Analysis of Financial Statements Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's total assets turnover? a. 0.90 b. 1.12 c. 1.40 d. 1.68 e. 2.02 36. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0

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7. Analysis of Financial Statements Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's inventory turnover ratio? a. 4.19 b. 4.40 c. 4.62 d. 4.85 e. 5.09

Indicate whether the statement is true or false.

37. 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. a. True b. False 38. The times-interest-earned ratio is one, but not the only, indication of a firm's ability to meet its long-term and shortterm debt obligations. a. True b. False 39. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

40. 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.

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7. Analysis of Financial Statements 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.

41. 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. 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.

42. 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 43. 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 44. 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 45. 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

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7. Analysis of Financial Statements 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% 46. 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 47. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0

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7. Analysis of Financial Statements Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's TIE? a. 1.73 b. 1.93 c. 2.14 d. 2.38 e. 2.62 48. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT)

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0

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7. Analysis of Financial Statements Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's EBITDA coverage? a. 3.03 b. 3.19 c. 3.36 d. 3.53 e. 3.70 49. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0

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7. Analysis of Financial Statements Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's debt-to-assets ratio (also called the debt ratio)? a. 33.87% b. 35.00% c. 36.40% d. 38.00% e. 40.00%

Indicate whether the statement is true or false.

50. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results. a. True b. False 51. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects. a. True b. False 52. Since the ROA measures the firm's effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA. a. True b. False 53. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

54. 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.

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7. Analysis of Financial Statements d. Increase accounts payable while holding sales constant. e. Increase notes payable while holding sales constant.

55. 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.

56. 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.

57. 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.

58. 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. 59. 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.

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7. Analysis of Financial Statements 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. 60. 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% 61. 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% 62. 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% 63. 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% 64. 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

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7. Analysis of Financial Statements e. $64,125 65. 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% 66. 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% 67. 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% 68. 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 25%. 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. 2.48% b. 2.76% c. 3.06% d. 3.40% e. 3.74% 69. 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 25%. 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

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7. Analysis of Financial Statements 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. 4.42% b. 4.64% c. 4.87% d. 5.11% e. 5.37% 70. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

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7. Analysis of Financial Statements

Refer to the data for Pettijohn Inc. What is the firm's ROA? a. 2.70% b. 2.97% c. 3.26% d. 3.59% e. 3.95% 71. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

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7. Analysis of Financial Statements Refer to the data for Pettijohn Inc. What is the firm's ROE? a. 8.54% b. 8.99% c. 9.44% d. 9.91% e. 10.41% 72. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

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7. Analysis of Financial Statements Refer to the data for Pettijohn Inc. What is the firm's BEP? a. 5.37% b. 5.65% c. 5.95% d. 6.24% e. 6.55% 73. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

Refer to the data for Pettijohn Inc. What is the firm's profit margin?

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

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7. Analysis of Financial Statements a. 1.40% b. 1.56% c. 1.73% d. 1.93% e. 2.12% 74. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's dividends per share?

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7. Analysis of Financial Statements a. $2.62 b. $2.91 c. $3.20 d. $3.53 e. $3.88

Indicate whether the statement is true or false.

75. Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

76. 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.

77. 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.

78. 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. 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.

79. 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

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7. Analysis of Financial Statements 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.

80. 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 d. 16.06 e. 16.86 81. 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 82. 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 83. 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 84. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

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7. Analysis of Financial Statements Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's EPS? a. $5.84 b. $6.15 c. $6.47 d. $6.80 e. $7.14 85. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $)

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7. Analysis of Financial Statements Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's P/E ratio? a. 12.0 b. 12.6 c. 13.2 d. 13.9 e. 14.6 86. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets

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7. Analysis of Financial Statements Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's book value per share? a. $61.73 b. $64.98 c. $68.40 d. $72.00 e. $75.60 87. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities

$ 1,554.0

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7. Analysis of Financial Statements Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0 $ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

Refer to the data for Pettijohn Inc. What is the firm's market-to-book ratio? a. 0.56 b. 0.66 c. 0.78 d. 0.92 e. 1.08

Indicate whether the statement is true or false.

88. 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. a. True b. False 89. Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in

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7. Analysis of Financial Statements 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. a. True b. False 90. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

91. 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.

92. 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%. 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.

93. 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.

94. 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?

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7. Analysis of Financial Statements a. Heidee has lower operating income (EBIT) than Leaudy. b. Heidee has a lower total assets turnover ratio than Leaudy. c. Heidee has a lower equity multiplier than Leaudy. d. Heidee has a higher fixed assets turnover ratio than Leaudy. e. Heidee has a higher ROE than Leaudy.

95. 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 higher net income as shown on the income statement than Leaudy. b. Without more information, we cannot tell if Heidee or Leaudy would have a higher or lower net income. c. Heidee would have a lower equity multiplier for use in the DuPont equation than Leaudy. d. Heidee would have to pay more in income taxes than Leaudy. e. Heidee would have lower net income as shown on the income statement than Leaudy.

96. 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. Heidee has more net income than Leaudy. b. Heidee pays less in taxes than Leaudy. c. Heidee has a lower equity multiplier than Leaudy. d. Heidee has a higher ROA than Leaudy. e. Heidee has a higher times interest earned (TIE) ratio than Leaudy.

97. 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. Heidee has a lower times interest earned (TIE) ratio than Leaudy. b. Heidee has a lower equity multiplier than Leaudy. c. Heidee has more net income than Leaudy. d. Heidee pays more in taxes than Leaudy. e. Heidee has a lower ROE than Leaudy.

98. 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% 99. 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%

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7. Analysis of Financial Statements d. 17.10% e. 17.95% 100. 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% 101. 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% 102. 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% 103. Pettijohn Inc. The balance sheet and income statement shown below are for Pettijohn Inc. Note that the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $) Assets Cash and securities Accounts receivable Inventories Total current assets Net plant and equipment Total assets Liabilities and Equity

$ 1,554.0 9,660.0 13,440.0 $24,654.0 17,346.0 $42,000.0

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7. Analysis of Financial Statements Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities Common stock Retained earnings Total common equity Total liabilities and equity Income Statement (Millions of $) Net sales Operating costs except depr'n Depreciation Earnings bef int and taxes (EBIT) Less interest Earnings before taxes (EBT) Taxes Net income Other data: Shares outstanding (millions) Common dividends Int rate on notes payable & L-T bonds Federal plus state income tax rate Year-end stock price

Refer to the data for Pettijohn Inc. What is the firm's equity multiplier? a. 3.33 b. 3.50 c. 3.68 d. 3.86 e. 4.05

$ 7,980.0 5,880.0 4,620.0 $18,480.0 10,920.0 $29,400.0 3,360.0 9,240.0 $12,600.0 $42,000.0 $58,800.0 $55,274.0 $ 1,029.0 $ 2,497.0 1,050.0 $ 1,447.0 $ 314.0 $ 1,133.0 175.00 $ 509.83 6.25% 21.7% $77.69

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7. Analysis of Financial Statements Answer Key 1. True 2. True 3. True 4. False 5. False 6. c 7. True 8. True 9. False 10. False 11. False 12. e 13. d 14. e 15. b 16. c 17. b 18. c 19. d 20. b 21. True 22. False 23. True 24. False 25. d

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7. Analysis of Financial Statements 26. a 27. c 28. d 29. e 30. b 31. d 32. c 33. b 34. e 35. c 36. a 37. True 38. True 39. True 40. d 41. d 42. b 43. e 44. a 45. e 46. b 47. d 48. c 49. e 50. True 51. False

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7. Analysis of Financial Statements 52. False 53. True 54. c 55. b 56. a 57. d 58. a 59. a 60. c 61. a 62. c 63. d 64. e 65. a 66. d 67. c 68. d 69. a 70. a 71. b 72. c 73. d 74. b 75. True 76. a

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7. Analysis of Financial Statements 77. d 78. b 79. c 80. b 81. a 82. d 83. e 84. c 85. a 86. d 87. e 88. True 89. False 90. True 91. c 92. b 93. b 94. e 95. e 96. b 97. a 98. c 99. a 100. b 101. c 102. a

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7. Analysis of Financial Statements 103. a

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8. Basic Stock Valuation

Indicate whether the statement is true or false.

1. A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. a. True b. False 2. The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value. a. True b. False 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

4. 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.

Indicate whether the statement is true or false.

5. 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. a. True b. False 6. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

7. 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.

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8. Basic Stock Valuation 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.

Indicate whether the statement is true or false.

8. The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. a. True b. False 9. According to the basic FCF 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. a. True b. False 10. Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. a. True b. False 11. The free cash flow valuation model cannot be used unless a company doesn't pay dividends. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

12. Which of the following statements is CORRECT? a. Two firms with the same expected free cash flows and growth rates must also have the same value of operations. 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 company has a weighted average cost of capital WACC = 12%, and if its free cash flows are expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. d. The value of operations is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

13. If a company’s free cash flows are 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 company’s stock's dividend yield is 5%. b. The value of operations is expected to decline in the future. c. The company's WACC must be equal to or less than 5%. d. The company’s value of operations one year from now is expected to be 5% above the current price. e. The expected return on the company’s stock is 5% a year.

14. Which of the following statements is NOT CORRECT?

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8. Basic Stock Valuation a. The free cash flow valuation model discounts free cash flows by the required return on equity. b. The free cash flow valuation model can be used to find the value of a division. c. An important step in applying the free cash flow 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 free cash flow valuation model can be used both for companies that pay dividends and those that do not pay dividends.

15. 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 free cash flow valuation model, Vops =FCF1/(WACC − g), cannot be used for firms that have negative growth rates. d. The free cash flow valuation model, Vops = FCF1/(WACC − g), can be used only for firms whose growth rates exceed their WACC. 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.

16. A company’s free cash flow was just FCF0 = $1.50 million. The weighted average cost of capital is WACC = 10.1%, and the constant growth rate is g = 4.0%. What is the current value of operations? a. $23.11 million b. $23.70 million c. $24.31 million d. $24.93 million e. $25.57 million 17. Lance Inc.'s free cash flow was just $1.00 million. If the expected long-run growth rate for this company is 5.4%, if the weighted average cost of capital is 11.4%, Lance has $4 million in short-term investments and $3 million in debt, and 1 million shares outstanding, what is the intrinsic stock price? a. $17.28 b. $17.70 c. $18.13 d. $18.57 e. $19.01 18. 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

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8. Basic Stock Valuation e. $1,158 19. 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 20. Justus Motor Co.has a WACC of 11.50%, and its value of operations is $25.00 million. Justus's free cash flow is expected to grow at a constant rate of 7.00%. What was the last free cash flow, FCF0 in millions? a. $0.95 b. $1.05 c. $1.16 d. $1.27 e. $1.40 21. Judd Corporation has a weighted average cost of capital of 10.25%, and its value of operations is $57.50 million. Free cash flow is expected to grow at a constant rate of 6.00% per year. What is the expected year-end free cash flow, FCF1 in millions? a. $2.20 b. $2.44 c. $2.69 d. $2.96 e. $3.25 22. A company is expected to have free cash flows of $0.75 million next year. The weighted average cost of capital is WACC = 10.5%, and the expected constant growth rate is g = 6.4%. The company has $2 million in short-term investments, $2 million in debt, and 1 million shares. What is the stock's current intrinsic stock price? a. $17.39 b. $17.84 c. $18.29 d. $18.75 e. $19.22

Indicate whether the statement is true or false.

23. According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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8. Basic Stock Valuation 24. Which of the following statements is CORRECT? a. If a company has a WACC = 12% and its free cash flow is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. b. The free cash flow valuation model for constant growth, Vop = FCF1/(WACC − g), can be used to value firms whose free cash flows are expected to decline at a constant rate, i.e., to grow at a negative rate. c. The value of operations of a stock is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. d. The constant growth model cannot be used for a zero growth stock, where free cash flows are 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.

25. 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 26. 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 27. Decker Tires’ free cash flow was just FCF0 = $1.32. Analysts expect the company's free cash flow to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The WACC for this company 9.00%.

Decker has $4 million in short-term investments and $14 million in debt and 1 million shares outstanding. What is the best estimate of the stock's current intrinsic price? a. $31.59 b. $32.65 c. $33.75 d. $34.87 e. $35.99 28. 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

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8. Basic Stock Valuation b. $167 c. $175 d. $184 e. $193 29. 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. $1,456 b. $1,529 c. $1,606 d. $1,686 e. $1,770

1 −$50

2 $100

30. 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. $315 b. $331 c. $348 d. $367 e. $386

1 −$15

2 $10

3 $40

31. Reynolds Construction's value of operations is $750 million based on the free cash flow 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 32. Based on the free cash flow 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

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8. Basic Stock Valuation c. $30.43 d. $33.48 e. $36.82 33. The value of Broadway-Brooks Inc.'s operations is $900 million, based on the free cash flow 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 34. Based on the free cash flow 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 35. Huxley Building Supplies' last free cash flow was $1.75 million. Its free cash flow growth rate is expected to be constant at 25% for 2 years, after which free cash flows are expected to grow at a rate of 6% forever. Its weighted average cost of capital WACC is 12%. Huxley has $5 million in short-term investments and $7 million in debt and has 1 million shares outstanding. What is the best estimate of the current intrinsic stock price? a. $39.58 b. $40.64 c. $41.71 d. $42.80 e. $44.92 36. Atchley Corporation’s last free cash flow was $1.55 million. The free cash flow growth rate is expected to be constant at 1.5% for 2 years, after which free cash flows are expected to grow at a rate of 8.0% forever. The firm's weighted average cost of capital (WACC) is 12.0%. Atchley has $2 million in short-term debt and $14 million in debt and 1 million shares outstanding. What is the best estimate of the intrinsic stock price? a. $25.05 b. $26.16 c. $27.30 d. $28.48 e. $29.70 37. The free cash flows (in millions) shown below are forecast by Simmons Inc. If the weighted average cost of capital is

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8. Basic Stock Valuation 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: a. $586 b. $617 c. $648 d. $680 e. $714

1 −$20

2 $42

3 $45

Indicate whether the statement is true or false.

38. Free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. a. True b. False 39. The expected total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. a. True b. False 40. The constant growth dividend model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

41. 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.

42. 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.

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8. Basic Stock Valuation e. increase.

43. 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.

44. 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.

45. 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.

46. 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.

47. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Required return 10% 12% Market price $25 $40 Expected growth 7% 9% a. These two stocks must have the same dividend yield. b. These two stocks should have the same expected return.

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8. Basic Stock Valuation c. These two stocks must have the same expected capital gains yield. d. These two stocks must have the same expected year-end dividend. e. These two stocks should have the same price.

48. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $40 Expected growth 7% 9% Expected return 10% 12% a. The two stocks could not be in equilibrium with the numbers given in the question. b. A's expected dividend is $0.50. c. B's expected dividend is $0.75. d. A's expected dividend is $0.75 and B's expected dividend is $1.20. e. The two stocks should have the same expected dividend.

49. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $25 Expected growth (constant) 10% 5% Required return 15% 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. 50. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $30 $30 Expected growth (constant) 6% 4% Required return 12% 10% a. Stock Y has a higher dividend yield than Stock X. b. One year from now, Stock X's price is expected to be higher than Stock Y's price. c. Stock X has the higher expected year-end dividend. d. Stock Y has a higher capital gains yield. e. Stock X has a higher dividend yield than Stock Y. 51. 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

$3.00

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8. Basic Stock Valuation $50 Current Price, P0 Expected constant growth rate 6.0% a. The stock's expected dividend yield and growth rate are equal. b. The stock's expected dividend yield is 5%. c. The stock's expected capital gains yield is 5%. d. The stock's expected price 10 years from now is $100.00. e. The stock's required return is 10%.

52. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $25 $25 Expected dividend yield 5% 3% Required return 12% 10% a. Stock X pays a higher dividend per share than Stock Y. b. One year from now, Stock X should have the higher price. c. Stock Y has a lower expected growth rate than Stock X. d. Stock Y has the higher expected capital gains yield. e. Stock Y pays a higher dividend per share than Stock X. 53. 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%.

54. 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.

55. 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.

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8. Basic Stock Valuation 56. 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.

57. 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.

58. 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. c. One of the disadvantages to a corporation of owning preferred stock instead of owning bonds is that 50% of the preferred dividends received represent taxable income to the corporate recipient, whereas none of the interest received from bonds is taxable income to the corporate recipient. d. One of the advantages for a firm financing with preferred stock is that 50% of the dividends the firm pays may be deducted from its taxable income. e. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.

59. 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.

60. The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is

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8. Basic Stock Valuation 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.

61. 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 B Beta 1.10 0.90 Constant growth rate 7.00% 7.00% a. Stock A must have a higher dividend yield than Stock B. b. Stock B's dividend yield equals its expected dividend growth rate. c. Stock B must have the higher required return. d. Stock B could have the higher expected return. e. Stock A must have a higher stock price than Stock B. 62. A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is r s = 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 63. 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 64. 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

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8. Basic Stock Valuation 65. 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% 66. $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 67. 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 68. 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? a. 4.12% b. 4.34% c. 4.57% d. 4.81% e. 5.05% 69. 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% 70. If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock's expected capital gains yield for the

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8. Basic Stock Valuation coming year? a. 6.50% b. 6.83% c. 7.17% d. 7.52% e. 7.90% 71. 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% 72. 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% 73. 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 74. 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 75. 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 riskfree rate is 4.50%. What is the company's current stock price?

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8. Basic Stock Valuation a. $14.52 b. $14.89 c. $15.26 d. $15.64 e. $16.03 76. 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 77. 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 78. 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 ? a. $37.52 b. $39.40 c. $41.37 d. $43.44 e. $45.61 79. 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 80. 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

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8. Basic Stock Valuation b. $27.89 c. $29.05 d. $30.21 e. $31.42 81. 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 (r s) 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 82. 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 (r s) 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 83. 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 (r s) is 11%, what is its current stock price? a. $30.57 b. $31.52 c. $32.49 d. $33.50 e. $34.50 84. 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. $9.94 b. $10.19 c. $10.45 d. $10.72

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

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8. Basic Stock Valuation e. $10.99 85. 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% 86. 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%

Indicate whether the statement is true or false.

87. 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.

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8. Basic Stock Valuation a. True b. False 88. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

89. 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 90. 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% 91. 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%

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8. Basic Stock Valuation Answer Key 1. True 2. True 3. False 4. c 5. True 6. True 7. d 8. True 9. False 10. True 11. False 12. e 13. d 14. a 15. b 16. e 17. d 18. c 19. d 20. b 21. b 22. c 23. True 24. b 25. e

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8. Basic Stock Valuation 26. a 27. d 28. b 29. a 30. e 31. d 32. b 33. c 34. d 35. b 36. a 37. b 38. True 39. False 40. True 41. b 42. d 43. b 44. e 45. d 46. d 47. a 48. d 49. e 50. b 51. a

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8. Basic Stock Valuation 52. a 53. c 54. e 55. a 56. e 57. a 58. a 59. b 60. e 61. a 62. c 63. e 64. d 65. e 66. e 67. e 68. d 69. b 70. a 71. e 72. e 73. a 74. a 75. a 76. b

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8. Basic Stock Valuation 77. b 78. a 79. d 80. c 81. b 82. a 83. d 84. d 85. e 86. d 87. False 88. True 89. e 90. e 91. e

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9. Corporate Valuation & Financial Planning

Indicate whether the statement is true or false.

1. 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. a. True b. False 2. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

3. 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 capital can be raised.

Indicate whether the statement is true or false.

4. 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. a. True b. False 5. The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the need for the firm to forecast those accounts on a continual basis. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6.

Judd Enterprises These are the simplified financial statements for Judd Enterprises.

Income statement Current Projected Sales na 1,000 Costs na 720 Profit before tax na 280 Taxes (25%) na 70

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9. Corporate Valuation & Financial Planning Net income Dividends Balance sheets Current assets Net fixed assets

na na

210 63

Current 100 900

Projected 115 1,080

Current liabilities Long-term debt Common stock Retained earnings

Current Projected 70 81 400 300 230

Refer to the Judd Enterprises financial statements. What is Judd’s projected retained earnings under this plan? a. $339 b. $377 c. $396 d. $415 e. $440 7.

Judd Enterprises These are the simplified financial statements for Judd Enterprises.

Income statement Current Projected Sales na 1,000 Costs na 720 Profit before tax na 280 Taxes (25%) na 70 Net income na 210 Dividends na 63 Balance sheets Current assets Net fixed assets

Current 100 900

Projected 115 1,080

Current liabilities Long-term debt Common stock Retained earnings

Current Projected 70 81 400 300 230

Refer to the Judd Enterprises financial statements. If Judd does not plan on issuing new stock or additional long-term debt, then what is the additional net financing needed for the projected year? a. $30 b. $33 c. $37 d. $339 e. $396 8.

Decker Enterprises Below are the simplified current and projected financial statements for Decker Enterprises.

All of Decker's assets are operating assets. All of Decker's current liabilities are operating liabilities.

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9. Corporate Valuation & Financial Planning Income statement Sales Costs Profit before tax Taxes (25%) Net income Dividends

CurrentProjected na 1,500 na 1,080 na 420 na 105 na 315 na 95

Balance sheets Current assets Net fixed assets

Current Projected 100 115 1,200 1,440

Current liabilities Long-term debt Common stock Retained earnings

Current Projected 70 81 300 360 500 500 430 650

Based on the projections, Decker will have a. a financing surplus of $36 b. a financing deficit of $36 c. a financing surplus of $255 d. a financing deficit of $255 e. zero financing surplus or deficit 9.

Decker Enterprises Below are the simplified current and projected financial statements for Decker Enterprises.

All of Decker's assets are operating assets. All of Decker's current liabilities are operating liabilities.

Income statement Sales Costs Profit before tax Taxes (25%) Net income Dividends

CurrentProjected na 1,500 na 1,080 na 420 na 105 na 315 na 95

Balance sheets Current assets Net fixed assets

Current Projected 100 115 1,200 1,440

Current liabilities Long-term debt Common stock Retained earnings

If Decker had a financing surplus, it could remedy the situation by a. borrowing on its line of credit. b. issuing more common stock. c. reducing its dividend. d. borrowing from its retained earnings e. paying a special dividend

Current Projected 70 81 300 360 500 500 430 650

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9. Corporate Valuation & Financial Planning 10.

Decker Enterprises Below are the simplified current and projected financial statements for Decker Enterprises.

All of Decker's assets are operating assets. All of Decker's current liabilities are operating liabilities.

Income statement Sales Costs Profit before tax Taxes (25%) Net income Dividends

CurrentProjected na 1,500 na 1,080 na 420 na 105 na 315 na 95

Balance sheets Current assets Net fixed assets

Current Projected 100 115 1,200 1,440

Current liabilities Long-term debt Common stock Retained earnings

Current Projected 70 81 300 360 500 500 430 650

If Decker had a financing deficit, it could remedy the situation by a. buying back common stock b. paying a special dividend c. paying down its long-term debt d. borrowing on its line of credit e. borrowing from retained earnings

Indicate whether the statement is true or false.

11. 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. a. True b. False 12. 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. a. True b. False 13. 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. a. True b. False 14. 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. a. True

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9. Corporate Valuation & Financial Planning b. False 15. A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally large decrease in some other asset. a. True b. False 16. A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock. a. True b. False 17. If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it will require some amount of external funding. a. True b. False 18. To determine the amount of additional funds needed (AFN), you may subtract the expected increase in liabilities, which represents a source of funds, from the sum of the expected increases in retained earnings and assets, both of which are uses of funds. a. True b. False 19. 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. a. True b. False 20. If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100%, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it will require external financing. a. True b. False 21. 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. a. True b. False 22. 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. a. True b. False 23. Firms with high capital intensity ratios have found ways to lower this ratio permitting them to achieve a given level of

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9. Corporate Valuation & Financial Planning 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. a. True b. False 24. Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm A is operating at full capacity, while Firm B is operating below capacity. If the two firms expect the same growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant. a. True b. False 25. 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. a. True b. False 26. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

27. 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.

28. 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 offers a longer credit period (with all other terms held equal). d. The company discovers that it has excess capacity in its fixed assets. e. A sharp increase in its forecasted sales.

29. 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

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9. Corporate Valuation & Financial Planning constant. e. Funds that are obtained automatically from routine business transactions.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

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9. Corporate Valuation & Financial Planning 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.

35. 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. 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.

36. 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. $102.8 b. $108.2 c. $113.9 d. $119.9 e. $125.9

$350Last year's accounts payable 30%Last year's notes payable $500Last year's accruals 5%Target payout ratio

$40 $50 $30 60%

37. 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. −$14,440 b. −$15,200 c. −$16,000 d. −$16,800

$200,000Last year's accounts payable 40%Last year's notes payable $135,000Last year's accruals 20.0%Target payout ratio

$50,000 $15,000 $20,000 25.0%

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9. Corporate Valuation & Financial Planning e. −$17,640 38. 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. $31.9 b. $33.6 c. $35.3 d. $37.0 e. $38.9

$300.0Last year's accounts payable 40%Last year's notes payable $500.0Last year's accruals 20.0%Initial payout ratio

$50.0 $15.0 $20.0 10.0%

Indicate whether the statement is true or false.

39. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

40. 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 earnings.

41. 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

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9. Corporate Valuation & Financial Planning 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.

42. 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 43. 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 44. 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% 45. 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% 46. 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

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9. Corporate Valuation & Financial Planning c. $82.69 d. $86.82 e. $91.16

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9. Corporate Valuation & Financial Planning Answer Key 1. False 2. True 3. d 4. True 5. False 6. b 7. c 8. a 9. e 10. d 11. True 12. False 13. True 14. True 15. True 16. True 17. False 18. False 19. True 20. True 21. False 22. False 23. True 24. True 25. False

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9. Corporate Valuation & Financial Planning 26. False 27. a 28. e 29. a 30. d 31. c 32. a 33. c 34. c 35. e 36. d 37. c 38. b 39. True 40. a 41. b 42. a 43. c 44. e 45. b 46. b

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10. Corporate Governance

Indicate whether the statement is true or 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. a. True b. False 2. A poison pill is also known as a corporate restructuring. a. True b. False 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

4. 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.

Indicate whether the statement is true or false.

5. ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6. Which of the following is NOT normally regarded as being a good reason to establish an ESOP? a. To enable the firm to borrow at a below-market interest rate. b. To make it easier to grant stock options to employees. c. To help prevent a hostile takeover. d. To help retain valued employees. e. To increase worker productivity.

7. Which one of the following statements is TRUE? a. An agency relationship is when someone hires someone else to perform a service and gives them decisionmaking authority. b. An agency relationship is when an agent hires a principal to perform a service. c. An agency relationship is when a principal works for an agent.

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10. Corporate Governance d. In an agency relationship, the agent delegates authority to the principal. e. An example of an agency relationship is when the CEO nominates a slate of candidates to be on the board of directors.

8. Which one of the following statements is TRUE? a. An agency relationship is when a principal hires an agent to perform a service and gives them decision-making authority. b. An agency relationship is when a principal works for an agent. c. In an agency relationship, the agent delegates authority to the principal. d. An example of an agency relationship is when the CEO nominates a slate of candidates to be on the board of directors. e. An example of an agency relationship is when a supervisor hires a forklift operator.

9. Which one of the following statements is TRUE? a. In an agency relationship, the principal delegates decision-making authority to the agent. b. In an agency relationship, the agent delegates authority to the principal. c. An example of an agency relationship is when the CEO nominates a slate of candidates to be on the board of directors. d. An example of an agency relationship is when a supervisor hires a forklift operator. e. The supervisor-employee relation between a production line supervisor and a production line operator is an example of an agency relationship.

10. Which one of the following statements is TRUE? a. An example of an agency relationship is when the board of directors hires a CEO to run a company. b. An example of an agency relationship is when the CEO nominates a slate of candidates to be on the board of directors. c. An example of an agency relationship is when a supervisor hires a forklift operator. d. The supervisor-employee relation between a production line supervisor and a production line operator is an example of an agency relationship. e. An agency cost is the wage required to pay someone who is hired to perform a service.

11. Which one of the following statements is TRUE? a. An example of an agency relationship is when a private individual hires a lawyer to prepare her defense in a lawsuit. b. An example of an agency relationship is when a supervisor hires a forklift operator. c. The supervisor-employee relation between a production line supervisor and a production line operator is an example of an agency relationship. d. An agency cost is the wage required to pay someone who is hired to perform a service. e. An example of an agency cost is when the board of directors pays a dividend to shareholders.

12. Which one of the following statements is TRUE? a. An agency cost is the reduction in firm value due to agency conflicts. b. An agency cost is the wage required to pay someone who is hired to perform a service. c. An example of an agency cost is when the board of directors pays a dividend to shareholders. d. An example of an agency cost is when an attorney hires an expert witness for a trial.

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10. Corporate Governance e. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost.

13. Which one of the following statements is TRUE? a. An example of an agency cost is when an outside investor is only willing to pay less for stock because she thinks the original owner will consume too many perquisites. b. An example of an agency cost is when the board of directors pays a dividend to shareholders. c. An example of an agency cost is when an attorney hires an expert witness for a trial. d. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. e. An example of an agency cost is the salary of the agent hired to work for the principal.

14. Which one of the following statements is TRUE? a. Asset switching occurs when a company borrows money for a safe investment but uses it for a risky investment. b. An example of an agency cost is when the board of directors pays a dividend to shareholders. c. An example of an agency cost is when an attorney hires an expert witness for a trial. d. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. e. An example of an agency cost is the salary of the agent hired to work for the principal.

15. Which one of the following statements is TRUE? a. An example of asset switching is when a company borrows for a new manufacturing facility but then uses it to repurchase its own stock. b. An example of an agency cost is when an attorney hires an expert witness for a trial. c. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. d. An example of an agency cost is the salary of the agent hired to work for the principal. e. Creditors have a claim on a firm's earning stream through the dividend payments they receive.

16. Which one of the following statements is TRUE? a. An example of asset switching is borrowing money to buy equipment but instead taking it to Las Vegas to gamble with it. b. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. c. An example of an agency cost is the salary of the agent hired to work for the principal. d. Creditors have a claim on a firm's earning stream through the dividend payments they receive. e. An example of asset switching is an option to exchange one piece of real estate for another.

Indicate one or more answer choices that best complete the statement or answer the question.

17. Which one of the following statements is TRUE? a. Lenders will protect themselves from asset switching by charging a higher interest rate. b. Creditors have a claim on a firm's earning stream through the dividend payments they receive. c. An example of asset switching is an option to exchange one piece of real estate for another.

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10. Corporate Governance d. Lenders can't legally prevent a firm from engaging in asset switching. e. Firms borrowing money have greater flexibility to use that money when there are debt covenants.

Indicate the answer choice that best completes the statement or answers the question.

18. Which one of the following statements is TRUE? a. Lenders will protect themselves from the risk of asset switching by writing debt covenants into loans. b. Lenders can't legally prevent a firm from engaging in asset switching. c. Firms borrowing money have greater flexibility to use that money when there are debt covenants. d. When lenders protect themselves from the risk of asset switching by charging a higher interest rate, the firm's WACC can decrease. e. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching.

19. Which one of the following statements is TRUE? a. When lenders protect themselves from the risk of asset switching, the firm's WACC can increase. b. An example of an agency cost is when the board of directors pays a dividend to shareholders. c. An example of an agency cost is when an attorney hires an expert witness for a trial. d. An example of asset switching is an option to exchange one piece of real estate for another. e. Lenders can't legally prevent a firm from engaging in asset switching.

20. Which one of the following statements is TRUE? a. When lenders protect themselves from the risk of asset switching, the borrowing firms will be limited in the projects they can profitably undertake. b. An agency relationship is when a principal works for an agent. c. In an agency relationship, the agent delegates authority to the principal. d. Firms borrowing money have greater flexibility to use that money when there are debt covenants. e. When lenders protect themselves from the risk of asset switching by raising the interest rate, the firm's WACC can decrease.

21. Which one of the following statements is TRUE? a. An agency problem occurs when an owner/manager sells stock to an outsider but continues to consume perquisites. b. Firms borrowing money have greater flexibility to use that money when there are debt covenants. c. When lenders protect themselves from the risk of asset switching by raising the interest rate, the firm's WACC can decrease. d. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching. e. A supplier substituting a lower-quality raw material without approval is an example of asset switching.

22. Which one of the following statements is TRUE? a. Outside shareholders will pay less for stock if they think the original owners will consume perquisites. b. Creditors have a claim on a firm's earning stream through the dividend payments they receive. c. An example of asset switching is an option to exchange one piece of real estate for another. d. An agency cost is the wage required to pay someone who is hired to perform a service.

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10. Corporate Governance e. An example of an agency cost is when an attorney hires an expert witness for a trial.

23. Which one of the following statements is TRUE? a. When an owner/manager sells stock to an outsider, that outsider now bears some of the costs of the owner/manager's perquisite consumption. b. Lenders can't legally prevent a firm from engaging in asset switching. c. Firms borrowing money have greater flexibility to use that money when there are debt covenants. d. When lenders protect themselves from the risk of asset switching, the firm's WACC can decrease. e. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching.

24. Which one of the following statements is TRUE? a. A corporate golf club membership is an example of a nonpecuniary benefit b. Firms borrowing money have greater flexibility to use that money when there are debt covenants. c. When lenders protect themselves from the risk of asset switching by raising the interest rate, the firm's WACC can decrease. d. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching. e. A supplier substituting a lower-quality raw material without approval is an example of asset switching.

25. Which one of the following statements is TRUE? a. A corporate executive health club is an example of a nonpecuniary benefit. b. When lenders protect themselves from the risk of asset switching by raising the interest rate, the firm's WACC can decrease. c. A lender calling in a corporate loan and then lending the funds out to a safer borrower is an example of asset switching. d. A supplier substituting a lower-quality raw material without approval is an example of asset switching. e. An agency problem occurs when an owner/manager sells stock to an outside investor and the owner/manager fears the outside investor will consume too many perquisites.

26. Which one of the following statements is TRUE? a. Personal use of the corporate jet is an example of a nonpecuniary benefit. b. A supplier substituting a lower-quality raw material without approval is an example of asset switching. c. An agency problem occurs when an owner/manager sells stock to an outside investor and the owner/manager fears the outside investor will consume too many perquisites. d. An agency conflict between inside owners/managers and outside owners occurs when the outside owners sell their shares to someone else. e. A quarter-end bonus is an example of a nonpecuniary benefit.

27. Which one of the following statements is TRUE? a. A manager/shareholder agency conflict arises when the manager's actions aren't in the company's best interest. b. An agency problem occurs when an owner/manager sells stock to an outside investor and the owner/manager fears the outside investor will consume too many perquisites. c. An agency conflict between inside owners/managers and outside owners occurs when the outside owners sell their shares to someone else.

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10. Corporate Governance d. A quarter-end bonus is an example of a nonpecuniary benefit. e. A company's matching contribution to a retirement plan is a nonpecuniary benefit.

28. Which one of the following statements is TRUE? a. A manager avoiding a positive NPV but risky project is an example of a manager-shareholder conflict. b. Management is said to be entrenched when the company is doing badly and is "stuck in a rut." c. A quarter-end bonus is an example of a nonpecuniary benefit. d. A company's matching contribution to a retirement plan is a nonpecuniary benefit. e. Company sponsorship of a local charity is an example of a nonpecuniary benefit.

29. Which one of the following statements is TRUE? a. A manager not closing a factory that is losing money but which is in his hometown is an example of a manager-shareholder conflict. b. Management is said to be entrenched when the senior managers are consuming excessive perquisites c. A company's matching contribution to a retirement plan is a nonpecuniary benefit. d. Company sponsorship of a local charity is an example of a nonpecuniary benefit. e. A manager/shareholder agency conflict arises when shareholders sell their stock even though management says the stock is undervalued.

30. Which one of the following statements is TRUE? a. Management is said to be entrenched when senior managers are unlikely to be fired. b. A company's matching contribution to a retirement plan is a nonpecuniary benefit. c. Company sponsorship of a local charity is an example of a nonpecuniary benefit. d. A manager/shareholder agency conflict arises when shareholders sell their stock even though management says the stock is undervalued. e. A manager/shareholder agency conflict arises when the board of directors pays a larger dividend than the firm's earnings could support.

31. Which one of the following statements is TRUE? a. One tool of corporate governance is the threat of removing current management. b. The commission required by the Federal Housing Agency for a small business loan is an example of an agency cost. c. One tool of corporate governance is the choice of how much dividends to pay. d. Corporate governance is when an officer of a corporation is elected to public office. e. One tool of corporate governance is the location of the company headquarters.

32. Which one of the following statements is TRUE? a. One tool of corporate governance is monitoring management. b. One tool of corporate governance is the choice of how much dividends to pay. c. A company's matching contribution to a retirement plan is a nonpecuniary benefit d. One tool of corporate governance is stock repurchases. e. Corporate governance is better when Directors are also employees of the company so they know the business very well.

33. Which one of the following statements is TRUE?

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10. Corporate Governance a. One tool of corporate governance is how the company's charter affects the likelihood of a takeover. b. One tool of corporate governance is stock repurchases. c. One tool of corporate governance is a company's tax avoidance strategy. d. One tool of corporate governance is choosing a good investment banker. e. Creditors have a claim on a firm's earning stream through the dividend payments they receive.

34. Which one of the following statements is TRUE? a. One tool of corporate governance is the use of accounting control systems. b. An example of asset switching is an option to exchange one piece of real estate for another. c. One tool of corporate governance is the location of the company headquarters. d. An example of an agency relationship is when a supervisor hires a forklift operator. e. One tool of corporate governance is a company's tax avoidance strategy.

35. Which one of the following statements is TRUE? a. A classified board is one in which the board members have staggered terms. b. One tool of corporate governance is a company's tax avoidance strategy. c. One tool of corporate governance is choosing a good investment banker. d. A classified board is one in which the board members serve anonymously. e. A classified board is one in which an announcement requesting applications for board members appears in the newspaper.

36. Which one of the following statements is TRUE? a. If a company has a classified board, fewer board seats are filled each year. b. One tool of corporate governance is choosing a good investment banker. c. A classified board is one in which the board members serve anonymously. d. A classified board is one in which an announcement requesting applications for board members appears in the newspaper. e. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year.

37. Which one of the following statements is TRUE? a. It is harder for dissidents to gain board seats if a company's board is classified. b. A classified board is one in which an announcement requesting applications for board members appears in the newspaper. c. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year. d. Inside directors are more concerned with shareholders' interests since they are more closely concerned with firm operations. e. Management is said to be entrenched when the senior managers are consuming excessive perquisites.

38. Which one of the following statements is TRUE? a. An inside director is a board member who also holds a managerial position in the company. b. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year. c. Inside directors are more concerned with shareholders' interests since they are more closely concerned with

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10. Corporate Governance firm operations. d. Since outside directors have no other connection with the firm, they are indebted to the CEO for putting them on the board. e. Company sponsorship of a local charity is an example of a nonpecuniary benefit.

39. Which one of the following statements is TRUE? a. An outside director is a board member who has no other affiliation with the company. b. A classified board is one in which an announcement requesting applications for board members appears in the newspaper. c. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year. d. Inside directors are more concerned with shareholders' interests since they are more closely concerned with firm operations. e. Since outside directors have no other connection with the firm, they are indebted to the CEO for putting them on the board 40. Which one of the following statements is TRUE? a. Inside directors are likely to side with the CEO since they are employees. b. In a classified board, it is easier for dissidents to gain representation since fewer seats are up for election each year. c. Inside directors are more concerned with shareholders' interests since they are more closely concerned with firm operations. d. Since outside directors have no other connection with the firm, they are indebted to the CEO for putting them on the board. e. The more members of a board of directors, the better its function.

41. Which one of the following statements is TRUE? a. Frequently, large boards of directors are less effective than small boards of directors. b. Since outside directors have no other connection with the firm, they are indebted to the CEO for putting them on the board. c. The more members of a board of directors, the better its function. d. A company has an interlocking board of directors if the CEO also serves as the chairman of the board of directors. e. A company whose board members are elected in staggered terms is said to be an interlocking board of directors.

42. Which one of the following statements is TRUE? a. Companies with interlocking boards of directors have directors that serve on both boards. b. The more members of a board of directors, the better its function. c. A company has an interlocking board of directors if the CEO also serves as the chairman of the board of directors. d. A company whose board members are elected in staggered terms is said to be an interlocking board of directors. e. A shareholder-friendly charter will make it harder for a company to be acquired.

43. Which one of the following statements is TRUE?

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10. Corporate Governance a. A shareholder-friendly charter will make it easier for a company to be acquired. b. A company whose board members are elected in staggered terms is said to be an interlocking board of directors. c. A shareholder-friendly charter will make it easier for shareholders to meet with the CEO if they have concerns. d. A targeted share repurchase can be used to encourage a hostile takeover. e. An example of an agency cost is when the board of directors pays a dividend to shareholders.

44. Which one of the following statements is TRUE? a. A targeted share repurchase is when the company purchases stock from one shareholder at a higher price than it offers to other shareholders. b. An example of asset switching is an option to exchange one piece of real estate for another. c. A shareholder-friendly charter will make it harder for a company to be acquired. d. A targeted share repurchase can be used to encourage a hostile takeover. e. Anti-takeover charter provisions are good for shareholders because they prevent a raider from stealing the company for a below-market price.

45. Which one of the following statements is TRUE? a. A targeted share repurchase can be used to prevent a hostile takeover. b. A targeted share repurchase can be used to increase the stock price if the company is undervalued. c. Anti-takeover charter provisions are good for shareholders because they prevent a raider from stealing the company for a below-market price. d. Shareholders want to prevent takeovers because they don't want the company purchased out from under them. e. One tool of corporate governance is choosing a good investment banker.

46. Which one of the following statements is TRUE? a. Shareholders benefit when the company is acquired because they usually receive a higher price for their shares b. Anti-takeover charter provisions are good for shareholders because they prevent a raider from stealing the company for a below-market price. c. Shareholders want to prevent takeovers because they don't want the company purchased out from under them. d. A shareholder rights provision encourages takeovers because shareholders have the right to approve the takeover if the terms are good. e. A classified board is one in which the board members serve anonymously.

47. Which one of the following statements is TRUE? a. A shareholder rights provision discourages takeovers because the acquiring company will suffer dilution. b. A company has an interlocking board of directors if the CEO also serves as the chairman of the board of directors. c. A company whose board members are elected in staggered terms is said to have an interlocking board of directors. d. Shareholders want to prevent takeovers because they don't want the company purchased out from under them. e. A classified board is one in which the board members serve anonymously.

48. A company issues bonds saying that it will use the proceeds for a safe investment. Instead, it uses the proceeds for a risky investment. Which of the following statements is true about this situation.

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10. Corporate Governance a. This is an example of asset switching or bait and switch. b. What the company does with the funds once it raises them isn't the business of the debtholders. c. This will result in an increase in the value of the debt because the company is riskier. d. All of the above. e. None of the above.

49. A company issues bonds saying that it will use the proceeds for a safe investment. Instead, it uses the proceeds for a risky investment. Which of the following statements is true about this situation. a. This will result in a decrease in the value of the debt because the company is riskier. b. This will result in a decrease in the value of the equity because the company is riskier. c. This will result in a lawsuit from the stockholders because it is bait and switch. d. This will cause bondholders to convert their bonds to stock. e. Dividends will go up to compensate shareholders for their increased risk.

50. Which one of the following corporate board characteristics usually improves corporate governance? a. CEO is not the chairman of the board. b. The board has many outsiders who have lots of other important commitments. c. The board is as large as is possible. d. Board members are paid at a rate higher than their peers and their payment is mostly cash. e. The board has a majority of insiders from company management on it who bring first-hand knowledge of how the company operates.

51. Which one of the following corporate board characteristics usually improves corporate governance? a. The board has a majority of outsiders who have experience and aren't too busy. b. CEO is the chairman of the board. c. The board is as large as is possible. d. Board members are paid at a rate higher than their peers and their payment is mostly cash. e. The board has a majority of insiders from company management on it who bring first-hand knowledge of how the company operates.

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10. Corporate Governance Answer Key 1. False 2. False 3. False 4. e 5. True 6. b 7. a 8. a 9. a 10. a 11. a 12. a 13. a 14. a 15. a 16. a 17. a 18. a 19. a 20. a 21. a 22. a 23. a 24. a 25. a

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10. Corporate Governance 26. a 27. a 28. a 29. a 30. a 31. a 32. a 33. a 34. a 35. a 36. a 37. a 38. a 39. a 40. a 41. a 42. a 43. a 44. a 45. a 46. a 47. a 48. a 49. a 50. a 51. a

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10. Corporate Governance

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11. Determining the Cost of Capital

Indicate whether the statement is true or false.

1. "Capital" is sometimes defined as funds supplied to a firm by investors. a. True b. False 2. The cost of capital used in capital budgeting should reflect the average after-tax cost of providing required returns to investors. a. True b. False 3. The component costs of capital are market-determined variables in the sense that they are based on investors' required returns. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

4. 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.

Indicate whether the statement is true or false.

5. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6. 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.

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11. Determining the Cost of Capital

Indicate whether the statement is true or false.

7. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. a. True b. False 8. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. a. True b. False 9. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

10. 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 25%, what is the component cost of debt for use in the WACC calculation? a. 5.44% b. 5.73% c. 6.03% d. 6.35% e. 6.67% 11. 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 25%. What is the component cost of debt for use in the WACC calculation? a. 5.35% b. 5.58% c. 5.81% d. 6.04% e. 6.28% 12. 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 25%, but Congress is considering a change in the corporate tax rate to 15%. 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%

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11. Determining the Cost of Capital 13. Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

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

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

Liabilities and Equity Accounts payable $ 10,000,000 Accruals 9,000,000 Current liabilities $ 19,000,000 Long-term debt (40,000 bonds, $1,000 par value) 40,000,000 Total liabilities $ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

Refer to the data for the Collins Group. What is the best estimate of the after-tax cost of debt? a. 5.80% b. 6.10% c. 6.43% d. 6.75% e. 7.08%

Indicate whether the statement is true or false.

14. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income. a. True b. False 15. 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. a. True b. False 16. Because 50% 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)(0.50)(0.50).

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11. Determining the Cost of Capital a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

17. 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% 18. 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% d. 9.10% e. 9.56% 19. 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 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 aftertax 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.

Indicate whether the statement is true or false.

20. The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. a. True b. False 21. 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.

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11. Determining the Cost of Capital a. True b. False 22. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost. a. True b. False 23. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. a. True b. False 24. The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock. a. True b. False 25. 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 r s 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. a. True b. False 26. When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs. a. True b. False 27. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the dividend growth method is widely used in practice. a. True b. False 28. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.

Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. a. True b. False

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11. Determining the Cost of Capital 29. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

30. 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).

31. 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% 32. 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% 33. Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

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

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

Liabilities and Equity Accounts payable Accruals

$ 10,000,000 9,000,000

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11. Determining the Cost of Capital Current liabilities $ 19,000,000 Long-term debt (40,000 bonds, $1,000 par value) 40,000,000 Total liabilities $ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

Refer to the data for the Collins Group. 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% 34. 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 dividend growth model 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-riskpremium 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.

Indicate whether the statement is true or false.

35. When estimating the cost of equity by use of the dividend growth method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

36. As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and gL = 8.00% (constant). What is the cost of common from reinvested earnings based on the dividend growth approach? a. 9.42%

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11. Determining the Cost of Capital b. 9.91% c. 10.44% d. 10.96% e. 11.51% 37. 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 gL = 6.50% (constant). Based on the dividend growth 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% 38. 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 gL = 7.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings? a. 9.29% b. 9.68% c. 10.08% d. 10.50% e. 10.92% 39. 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 gL = 8.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings? a. 10.69% b. 11.25% c. 11.84% d. 12.43% e. 13.05% 40. 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 gL = 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 dividend growth model, 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%

Indicate whether the statement is true or false.

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11. Determining the Cost of Capital 41. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt. a. True b. False 42. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity. a. True b. False 43. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. a. True b. False 44. The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 − T). a. True b. False 45. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

46. 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.

47. 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.

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11. Determining the Cost of Capital 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 company must try to adjust its current actual market value weights toward its target weights. 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 50% of the dividends received by corporate investors are excluded from their taxable income.

48. 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. 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.

49. 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. 50. 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 required return on debt used in calculating a firm's WACC should be based on the debt's current required return even if it is higher than the debt's coupon rate. e. The WACC is calculated using before-tax costs for all components.

51. 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 company's outstanding debt as shown on its balance sheet.

52. Which of the following statements is CORRECT?

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11. Determining the Cost of Capital 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.

53. 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. Whether shareholders are already equity holders or are brand-new equity holders, they all have the

same required rate of return on stock. 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.

54. Which of the following statements is CORRECT? a. The dividend growth model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the dividend growth 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 dividend growth model 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.

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11. Determining the Cost of Capital 55. 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% 56. 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 25%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from reinvested earnings? a. 7.53% b. 7.85% c. 8.18% d. 8.50% e. 8.84% 57. 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 25%. The firm will not be issuing any new common stock. What is Avery's WACC? a. 8.49% b. 8.83% c. 9.19% d. 9.55% e. 9.94% 58. 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 longterm 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, r s, is 14.00%; and the firm's tax rate is 25%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs? a. 1.42% b. 1.57% c. 1.75% d. 1.94% e. 2.16% 59. 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 25%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new

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11. Determining the Cost of Capital shares. What is its WACC? a. 7.48% b. 7.88% c. 8.29% d. 8.73% e. 9.19% 60. Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

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

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

Liabilities and Equity Accounts payable $ 10,000,000 Accruals 9,000,000 Current liabilities $ 19,000,000 Long-term debt (40,000 bonds, $1,000 par value) 40,000,000 Total liabilities $ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

Refer to the data for the Collins Group. 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% 61. Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

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

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

Liabilities and Equity Accounts payable

$ 10,000,000

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11. Determining the Cost of Capital Accruals 9,000,000 Current liabilities $ 19,000,000 Long-term debt (40,000 bonds, $1,000 par value) 40,000,000 Total liabilities $ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

Refer to the data for the Collins Group. What is the best estimate of the firm's WACC? a. 11.08% b. 11.42% c. 11.77% d. 12.13% e. 12.49%

Indicate whether the statement is true or false.

62. 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. a. True b. False 63. 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)." a. True b. False 64. If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 − F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

65. 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%

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11. Determining the Cost of Capital b. 13.37% c. 14.04% d. 14.74% e. 15.48% 66. 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; gL = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock? a. 9.06% b. 9.44% c. 9.84% d. 10.23% e. 10.64% 67. 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; gL = 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% 68. 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% 69. 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. 70. 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

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11. Determining the Cost of Capital 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 WACC for a firm that pays dividends and regularly issues new equity will be greater than the WACC for an otherwise identical company that pays lower dividends and that rarely issues new equity. 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.

71. 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 25%; the next expected dividend is $0.65 a share; the dividend is expected to grow at a constant rate of 6.00% a year; the price of the stock is $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. 7.34% b. 7.73% c. 8.14% d. 8.56% e. 8.99%

Indicate whether the statement is true or false.

72. 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 dividend growth model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company. a. True b. False 73. When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

74. 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%

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11. Determining the Cost of Capital e. 14.74%

Indicate whether the statement is true or false.

75. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.

They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

76. 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.

77. 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.

78. 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

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11. Determining the Cost of Capital 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.

79. 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.

80. 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.

81. 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? a. Project C, which is of above-average risk and has a return of 11%. b. Project A, which is of average risk and has a return of 9%. c. None of the projects should be accepted.

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11. Determining the Cost of Capital d. All of the projects should be accepted. e. Project B, which is of below-average risk and has a return of 8.5%.

82. 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.

83. 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. 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.

84. 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.

Indicate whether the statement is true or false.

85. 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 25%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC). a. True b. False

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11. Determining the Cost of Capital

Indicate the answer choice that best completes the statement or answers the question.

86. 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.

87. 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.

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11. Determining the Cost of Capital Answer Key 1. True 2. True 3. True 4. a 5. False 6. d 7. False 8. True 9. True 10. d 11. c 12. c 13. c 14. False 15. True 16. False 17. b 18. d 19. d 20. True 21. False 22. False 23. False 24. False 25. True

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11. Determining the Cost of Capital 26. True 27. False 28. False 29. True 30. d 31. a 32. e 33. d 34. b 35. True 36. c 37. d 38. d 39. c 40. c 41. False 42. True 43. False 44. True 45. False 46. e 47. c 48. c 49. c 50. d 51. c

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11. Determining the Cost of Capital 52. a 53. c 54. c 55. b 56. c 57. a 58. e 59. e 60. a 61. c 62. False 63. False 64. True 65. b 66. c 67. b 68. c 69. a 70. c 71. d 72. True 73. True 74. a 75. True 76. b

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11. Determining the Cost of Capital 77. b 78. e 79. d 80. b 81. e 82. c 83. e 84. c 85. False 86. a 87. e

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12. Capital Budgeting: Decision Criteria

Indicate whether the statement is true or 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). a. True b. False 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. a. True b. False 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. a. True b. False 4. A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted. a. True b. False 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. a. True b. False 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. a. True b. False 7. When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

8. 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 cost of capital 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 cost of capital. 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 cost of capital.

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12. Capital Budgeting: Decision Criteria 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 cost of capital.

9. 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 cost of capital 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 cost of capital. 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 costs of capital. e. A project's NPV is generally found by compounding the cash inflows at the cost of capital to find the terminal value (TV), then discounting the TV at the IRR to find its PV. 10. Ellmann Systems is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. r: 9.00% Year 0 Cash flows −$1,000 a. $265.65 b. $278.93 c. $292.88 d. $307.52 e. $322.90

1 $500

2 $500

3 $500

11. Scott Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. r: 11.00% Year 0 Cash flows −$1,000 a. $77.49 b. $81.56 c. $85.86 d. $90.15 e. $94.66

1 $350

2 $350

3 $350

4 $350

12. Robbins Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected. r: 10.25% Year 0 Cash flows −$1,000 a. $105.89 b. $111.47 c. $117.33 d. $123.51 e. $130.01

1 $300

2 $300

3 $300

4 $300

5 $300

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12. Capital Budgeting: Decision Criteria 13. Reed Enterprises is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r: 10.00% Year 0 Cash flows −$1,050 a. $92.37 b. $96.99 c. $101.84 d. $106.93 e. $112.28

1 $450

2 $460

3 $470

14. Patterson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r: 10.00% Year 0 Cash flows −$950 a. $54.62 b. $57.49 c. $60.52 d. $63.54 e. $66.72

1 $500

2 $400

3 $300

15. Yoga Center Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r: 14.00% Year 0 Cash flows −$1,200 a. $41.25 b. $45.84 c. $50.93 d. $56.59 e. $62.88

1 $400

2 $425

3 $450

4 $475

16. Dickson Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected. r: 12.00% Year 0 Cash flows −$1,100 a. $250.15 b. $277.94 c. $305.73 d. $336.31 e. $369.94

1 $400

2 $390

3 $380

4 $370

5 $360

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12. Capital Budgeting: Decision Criteria 17. 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 cost of capital (r). The Fed's action did not affect the forecasted cash flows. By how much did the change in the r affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected.

Old r: 10.00% Year 0 Cash flows −$1,000 a. −$18.89 b. −$19.88 c. −$20.93 d. −$22.03 e. −$23.13

New r: 1 $410

11.25% 2 $410

3 $410

18. 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 cost of capital (r). The Fed's action did not affect the forecasted cash flows. By how much did the change in the r affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected.

Old r: 8.00% Year 0 Cash flows −$1,000 a. −$59.03 b. −$56.08 c. −$53.27 d. −$50.61 e. −$48.08

New r: 1 $410

11.25% 2 $410

3 $410

Indicate whether the statement is true or false.

19. The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows. a. True b. False 20. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR. a. True b. False 21. 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. a. True b. False 22. Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life. a. True

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12. Capital Budgeting: Decision Criteria b. False 23. 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. a. True b. False 24. The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False 25. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False 26. The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method. a. True b. False 27. Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life. Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs. Now suppose interest rates and money costs decline. Other things held constant, this change will cause L to become preferred to S. a. True b. False 28. An increase in the firm's cost of capital will decrease projects' NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital. a. True b. False 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. a. True b. False 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. a. True b. False

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12. Capital Budgeting: Decision Criteria 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

32. 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.

33. 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 cost of capital 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 cost of capital. e. A project's regular IRR is found by compounding the cash inflows at the cost of capital to find the terminal value (TV), then discounting this TV at the cost of capital.

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 compounding the cash inflows at the cost of capital to find the present value (PV), then discounting the TV to find the IRR. b. If a project's IRR is smaller than the cost of capital, 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 cost of capital to find the terminal value (TV), then discounting the TV at the cost of capital.

35. 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.

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12. Capital Budgeting: Decision Criteria e. If a project has "normal" cash flows, then its IRR must be positive.

36. 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. 37. 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.

38. 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 cost of capital 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.

39. 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 cost of capital, 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.

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. 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 cost of capital.

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12. Capital Budgeting: Decision Criteria 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 cost of capital, 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. 41. 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 cost of capital.

42. 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 cost of capital, 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 cost of capital, while the IRR method assumes reinvestment at the IRR. 43. Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project's cash flows come in the early years, while most of the other project's cash flows occur in the later years. The two NPV profiles are given below:

Which of the following statements is CORRECT? a. More of Project 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.

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12. Capital Budgeting: Decision Criteria 44. 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 cost of capital of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the cost of capital? a. Project L. b. Both projects are equally sensitive to changes in the cost of capital 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. 45. Projects C and D both have normal cash flows and are mutually exclusive. Project C has a higher NPV if the cost of capital is less than 12%, whereas Project D has a higher NPV if the cost of capital 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. 46. The cost of capital 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 cost of capital. However, you believe that money costs and thus your cost of capital will also increase. You also think that the projects will not be funded until the cost of capital 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 cost of capital it will have the higher NPV. c. You should recommend Project K, because at the new cost of capital 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 cost of capital. e. You should reject both projects because they will both have negative NPVs under the new conditions.

47. The cost of capital 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 cost of capital. Interest rates are currently high. However, you believe that money costs and thus your cost of capital will soon decline. You also think that the projects will not be funded until the cost of capital 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 cost of capital it will have the higher NPV. c. You should recommend Project K, because at the new cost of capital it will have the higher NPV. d. You should recommend Project R because it will have both a higher IRR and a higher NPV under the new conditions. e. You should reject both projects because they will both have negative NPVs under the new conditions.

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12. Capital Budgeting: Decision Criteria 48. 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 cost of capital, 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 cost of capital, the project must also have a positive NPV. 49. 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 cost of capital, 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.

50. 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 cost of capital to find the PV. b. The NPV and IRR methods both assume that cash flows can be reinvested at the cost of capital. 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 cost of capital will change both the NPV and the IRR. 51. 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 cost of capital, 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 cost of capital), 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.

52. 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 cost of capital is 7%. Which of the following statements is CORRECT? a. If the cost of capital is 6%, Project S will have the higher NPV. b. If the cost of capital is 13%, Project S will have the lower NPV.

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12. Capital Budgeting: Decision Criteria c. If the cost of capital is 10%, both projects will have a negative NPV. d. Project S's NPV is more sensitive to changes in cost of capital than Project L's. e. If the cost of capital is 10%, both projects will have positive NPVs. 53. 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 cost of capital is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT? a. If the cost of capital is 9%, Project A's NPV will be higher than Project B's. b. If the cost of capital is 6%, Project B's NPV will be higher than Project A's. c. If the cost of capital is greater than 14%, Project A's IRR will exceed Project B's. d. If the cost of capital is 9%, Project B's NPV will be higher than Project A's. e. If the cost of capital is 13%, Project A's NPV will be higher than Project B's.

54. You are considering two mutually exclusive, equally risky, projects. Both have IRRs that exceed the cost of capital.

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.

55. 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 cost of capital 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%. b. If the cost of capital is 8%, Project X will have the higher NPV. c. If the cost of capital is 18%, Project Y will have the higher NPV. d. Project X is larger in the sense that it has the higher initial cost. e. The crossover rate must be less than 10%.

56. 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 cost of capital. 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 cost of capital 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 cost of capital. b. You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two

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12. Capital Budgeting: Decision Criteria IRRs, in this case it would be better to focus on the MIRR, which exceeds the cost of capital. 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 cost of capital, 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 cost of capital, 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 cost of capital.

57. Consider projects S and L. Both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same cost of capital, 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 cost of capital falls, each project's IRR will increase. c. If the cost of capital increases, each project's IRR will decrease. d. If Projects S and L have the same NPV at the current cost of capital, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the cost of capital used to evaluate the projects declined. e. Project S must have a higher NPV than Project L. 58. 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 cost of capital, then under all reasonable conditions, the project's IRR must be negative. b. If a project's IRR is equal to its cost of capital, then under all reasonable conditions the project's NPV must be zero. c. There is no necessary relationship between a project's IRR, its cost of capital, and its NPV. 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 cost of capital, then, under all reasonable conditions, the project's NPV must be negative.

59. 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 the cost of capital. b. If the company uses the NPV method, it will tend to favor smaller, shorter-term projects over larger, longerterm projects, regardless of how high or low the cost of capital 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 cost of capital 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 cost of capital 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 the cost of capital.

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12. Capital Budgeting: Decision Criteria 60. Martin Manufacturing is considering two normal, equally risky, mutually exclusive, but not repeatable projects.

Martin's cost of capital 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. 61. 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 cost of capital 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 cost of capital of 12%. e. The crossover rate for the two projects must be less than 12%.

62. 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 cost of capital or negative, in both cases it will be rejected.

Year Cash flows a. 12.55% b. 13.21% c. 13.87% d. 14.56% e. 15.29%

0 −$1,000

1 $425

2 $425

3 $425

63. 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 cost of capital or negative, in both cases it will be rejected.

Year Cash flows a. 14.05% b. 15.61% c. 17.34% d. 19.27% e. 21.20%

0 −$1,050

1 $400

2 $400

3 $400

4 $400

64. 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 cost of capital or negative, in both cases it will be rejected.

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12. Capital Budgeting: Decision Criteria Year Cash flows a. 9.43% b. 9.91% c. 10.40% d. 10.92% e. 11.47%

0 −$1,250

1 $325

2 $325

3 $325

4 $325

5 $325

65. 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 cost of capital (and even negative), in which case it will be rejected.

Year Cash flows a. 9.70% b. 10.78% c. 11.98% d. 13.31% e. 14.64%

0 −$1,100

1 $450

2 $470

3 $490

66. 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 cost of capital (and even negative), in which case it will be rejected.

Year Cash flows a. 13.13% b. 14.44% c. 15.89% d. 17.48% e. 19.22%

0 −$850

1 $300

2 $290

3 $280

4 $270

67. 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 cost of capital (and even negative), in which case it will be rejected.

Year Cash flows a. 2.08% b. 2.31% c. 2.57% d. 2.82% e. 3.10%

0 −$9,500

1 $2,000

2 $2,025

3 $2,050

4 $2,075

5 $2,100

68. 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.

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12. Capital Budgeting: Decision Criteria r: 7.50% Year 0 −$1,100 CFS −$2,700 CFL a. $138.10 b. $149.21 c. $160.31 d. $171.42 e. $182.52

1 $550 $650

2 $600 $725

3 $100 $800

4 $100 $1,400

69. 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? r: 6.00% Year 0 −$1,025 CFS −$2,150 CFL a. $188.68 b. $198.61 c. $209.07 d. $219.52 e. $230.49

1 $380 $765

2 $380 $765

3 $380 $765

4 $380 $765

70. 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. r: 10.25% Year 0 −$2,050 CFS −$4,300 CFL a. $134.79 b. $141.89 c. $149.36 d. $164.29 e. $205.36

1 $750 $1,500

2 $760 $1,518

3 $770 $1,536

4 $780 $1,554

71. 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. r: 10.00%

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12. Capital Budgeting: Decision Criteria Year CFS CFL a. $5.47 b. $6.02 c. $6.62 d. $7.29 e. $7.82

0 −$1,025 −$1,025

1 $650 $100

2 $450 $300

3 $250 $500

4 $50 $700

72. 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. r: 7.75% Year 0 −$1,050 CFS −$1,050 CFL a. $11.45 b. $12.72 c. $14.63 d. $16.82 e. $19.35

1 $675 $360

2 $650 $360

3

4

$360

$360

73. 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. r: 8.75% Year 0 −$1,100 CFS −$2,200 CFL a. $32.12 b. $35.33 c. $38.87 d. $40.15 e. $42.16

1 $375 $725

2 $375 $725

3 $375 $725

4 $375 $725

74. 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.

Year CFS

r =10.25% 0 −$950

1 $500

2 $800

3 $0

4 $0

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12. Capital Budgeting: Decision Criteria −$2,100

CFL

$400

$800

$800

$1,000

a. $24.14 b. $26.82 c. $29.80 d. $33.11 e. $36.42 75. 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. r =7.00% Year CFS CFL

0 −$1,100 −$2,750

1 $550 $725

2 $600 $725

3 $100 $800

4 $100 $1,400

a. $185.90 b. $197.01 c. $208.11 d. $219.22 e. $230.32

Indicate whether the statement is true or false.

76. For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost. a. True b. False 77. 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. a. True b. False 78. When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated. a. True b. False 79. The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant. a. True b. False

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12. Capital Budgeting: Decision Criteria 80. 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. a. True b. False 81. 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. a. True b. False 82. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

83. 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 cost of capital, 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 cost of capital 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. 84. 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 cost of capital, then the MIRR will be less than the IRR. c. If a project's IRR is greater than its cost of capital, 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 cost of capital. e. A project's MIRR is always greater than its regular IRR. 85. Computer Consultants Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. r =10.00% Year 0 Cash flows −$1,000 a. 9.32% b. 10.35% c. 11.50%

1 $450

2 $450

3 $450

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12. Capital Budgeting: Decision Criteria d. 12.78% e. 14.20% 86. Wiley's Wire Products is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. r =11.00% Year 0 Cash flows −$800 a. 8.86% b. 9.84% c. 10.94% d. 12.15% e. 13.50%

1 $350

2 $350

3 $350

87. Watts Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. r = 10.00% Year 0 Cash flows −$850 a. 14.08% b. 15.65% c. 17.21% d. 18.94% e. 20.83%

1 $300

2 $320

3 $340

4 $360

88. Westwood Painting Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's MIRR? Note that a project's MIRR can be less than the cost of capital (and even negative), in which case it will be rejected. r = 12.25% Year 0 Cash flows −$850 a. 13.42% b. 14.91% c. 16.56% d. 18.22% e. 20.04%

1 $300

2 $320

3 $340

4 $360

Indicate whether the statement is true or false.

89. One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk. a. True

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12. Capital Budgeting: Decision Criteria b. False 90. The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

91. 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.

92. 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.

93. 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.

94. 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.

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12. Capital Budgeting: Decision Criteria 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.

95. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4year 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).

96. 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 cost of capital. 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.

97. 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 cost of capital. 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.

98. McGlothin Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 1.86 years b. 2.07 years c. 2.30 years d. 2.53 years e. 2.78 years

0 −$1,150

1 $500

2 $500

3 $500

99. Garner Inc. is considering a project that has the following cash flow data. What is the project's payback?

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12. Capital Budgeting: Decision Criteria Year Cash flows a. 1.42 years b. 1.58 years c. 1.75 years d. 1.93 years e. 2.12 years

0 −$350

1 $200

2 $200

3 $200

100. Worthington Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 2.03 years b. 2.25 years c. 2.50 years d. 2.75 years e. 3.03 years

0 −$500

1 $150

2 $200

3 $300

101. Poder Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year Cash flows a. 1.91 years b. 2.12 years c. 2.36 years d. 2.59 years e. 2.85 years

0 −$750

1 $300

2 $325

3 $350

102. Suzanne's Cleaners is considering a project that has the following cash flow data. What is the project's payback?

Year 0 Cash flows −$1,100 a. 2.31 years b. 2.56 years c. 2.85 years d. 3.16 years e. 3.52 years

1 $300

2 $310

3 $320

4 $330

5 $340

103. Craig's Car Wash Inc. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's discounted payback? r = 10.00% Year 0 Cash flows −$900 a. 1.88 years b. 2.09 years c. 2.29 years

1 $500

2 $500

3 $500

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12. Capital Budgeting: Decision Criteria d. 2.52 years e. 2.78 years 104. Shannon Co. is considering a project that has the following cash flow and cost of capital (r) data. What is the project's discounted payback? r = 10.00% Year 0 Cash flows −$950 a. 1.61 years b. 1.79 years c. 1.99 years d. 2.22 years e. 2.44 years

1 $525

2 $485

3 $445

4 $405

Indicate whether the statement is true or false.

105. In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects. a. True b. False 106. If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

107. 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 cost of capital declines. b. A project's MIRR is unaffected by changes in the cost of capital. c. A project's regular payback increases as the cost of capital declines. d. A project's discounted payback increases as the cost of capital declines. e. A project's IRR increases as the cost of capital declines.

108. 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.

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12. Capital Budgeting: Decision Criteria e. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

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12. Capital Budgeting: Decision Criteria Answer Key 1. False 2. False 3. False 4. False 5. True 6. False 7. False 8. b 9. a 10. a 11. c 12. e 13. a 14. c 15. e 16. b 17. d 18. a 19. True 20. False 21. True 22. True 23. False 24. True 25. False

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12. Capital Budgeting: Decision Criteria 26. True 27. True 28. False 29. False 30. False 31. False 32. d 33. c 34. c 35. d 36. e 37. d 38. c 39. d 40. d 41. c 42. e 43. e 44. a 45. e 46. c 47. b 48. e 49. b 50. d 51. a

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12. Capital Budgeting: Decision Criteria 52. e 53. d 54. a 55. a 56. b 57. d 58. b 59. c 60. b 61. b 62. b 63. d 64. a 65. d 66. a 67. c 68. a 69. c 70. c 71. e 72. b 73. d 74. d 75. a 76. True

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12. Capital Budgeting: Decision Criteria 77. False 78. False 79. False 80. False 81. False 82. True 83. d 84. b 85. e 86. e 87. b 88. c 89. True 90. False 91. c 92. a 93. a 94. c 95. d 96. b 97. e 98. c 99. c 100. c 101. c 102. e

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12. Capital Budgeting: Decision Criteria 103. b 104. d 105. True 106. False 107. a 108. c

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk

Indicate whether the statement is true or 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 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. a. True b. False 9. In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk on the firm's long-run cash flows. a. True b. False 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. a. True b. False 11. 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. a. True b. False 12. It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop. This is why subjective judgment is often used for such projects along with discounted cash flow analysis. a. True b. False 13. 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. a. True b. False 14. Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated. a. True b. False 15. Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

16. 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.

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 17. 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. 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.

18. 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.

19. 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.

20. Which of the following statements is CORRECT? a. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its 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.

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 21. 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.

22. 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.

23. 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.

24. 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.

25. Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 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 5%.

26. 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.

27. 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.

28. 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 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

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 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. 29. 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.

30. 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 produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.

31. 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.

Indicate whether the statement is true or false.

32. 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. a. True

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk b. False 33. 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. a. True b. False 34. 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. a. True b. False 35. 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. a. True b. False 36. 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. a. True b. False 37. 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. a. True b. False 38. 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. a. True b. False 39. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

40. 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.

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 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. 41. 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.

42. 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.

43. 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 cost of capital 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 cost of capital. If interest were deducted when estimating cash flows, this would, in effect, "double count" it.

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 44. 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 longterm 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.

45. 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. $6,250 b. $6,406 c. $6,566 d. $6,731 e. $6,899

$13,000 $4,000 $6,000 25.0%

46. 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. $9,115 b. $9,397 c. $9,688 d. $9,978 e. $10,277

$22,250 $8,000 $12,000 25.0%

47. 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) Straight-line depreciation rate

$65,000 33.333%

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk Sales revenues, each year Operating costs (excl. deprec.)

Tax rate a. $29,351 b. $30,103 c. $30,875 d. $31,667 e. $32,458

$60,000 $25,000 25.0%

48. 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. $17,614 b. $18,541 c. $19,517 d. $20,544 e. $21,625

$42,500 $10,000 $17,000 $4,000 25.0%

49. 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. $28,619 b. $30,125 c. $31,631 d. $33,213 e. $34,873

$62,500 $8,000 $25,000 $8,000 25.0%

50. 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. $31,666 b. $31,849

$65,000 $60,000 $25,000 25.0%

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk c. $33,442 d. $35,114 e. $36,869 51. 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. $13,016 b. $13,701 c. $14,422 d. $15,143 e. $15,900

$70,000 $42,500 $25,000 25.0%

52. 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. The riskadjusted cost of capital is 10%. What is the project’s NPV? Risk-adjusted cost of capital Net investment cost (depreciable basis) Straight-line deprec. rate Sales revenues, each year Operating costs (excl. deprec.), each year Tax rate a. $19,555 b. $20,584 c. $21,668 d. $22,808 e. $24,009

10.0% $65,000 33.3333% $65,500 $25,000 25.0%

53. 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 25%. What is the equipment's after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale. a. $5,611 b. $5,906 c. $6,202 d. $6,512 e. $6,837

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 54. 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 25%, 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. $9,367 b. $9,860 c. $10,379 d. $10,925 e. $11,500

Depreciation Rate 0.20 0.32 0.19 0.12 0.11 0.06

55. 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 pretax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

Cost of capital 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. $6,196 b. $6,522 c. $6,848 d. $7,190 e. $7,550

10.0% $5,000 $80,000 33.333% $67,500 $25,000 25.0%

56. 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.)

Project cost of capital (r) Opportunity cost Net equipment cost (depreciable basis) Straight-line deprec. rate for equipment Sales revenues, each year Operating costs (excl. deprec.), each year

10.0% $100,000 $65,000 33.333% $123,000 $25,000

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk Tax rate a. $26,796 b. $28,207 c. $29,691 d. $31,254 e. $32,817

25%

57. 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.)

Project cost of capital (r) Net investment in fixed assets (basis) Required new working capital Straight-line deprec. rate Sales revenues, each year Operating costs (excl. deprec.), each year Tax rate a. $30,069 b. $31,573 c. $33,152 d. $34,809 e. $36,550

10.0% $75,000 $15,000 33.333% $75,000 $25,000 25.0%

58. 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? Project cost of capital (r) 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. $25,964 b. $27,330 c. $28,768 d. $30,207 e. $31,717

10.0% $70,000 $10,000 33.333% $75,000 $30,000 $5,000 25.0%

59. 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

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 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? Project cost of capital (r) 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. $27,625 b. $29,079 c. $30,610 d. $32,140 e. $33,747

10.0% $200,000 50,000 $25.00 $150,000 $20.20 33.333% 5.00% 25.0%

60. 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?

Project cost of capital (r) 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. $15,330 b. $16,136 c. $16,986 d. $17,835 e. $18,727

10.0% $200,000 50,000 $25.00 $150,000 $20.20 33.333% 4.00% 25.0%

Indicate whether the statement is true or false.

61. If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 62. 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.

63. Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a risk-adjusted project cost of capital 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%.

64. 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: Expected NPV Standard deviation (σNPV) Project beta (vs. market)

Project X $500,000 $200,000 1.4

Project Y $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. 65. 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.

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 66. A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following? a. Increase the estimated 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.

67. 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 risk-adjusted project cost of capital of 8%, average-risk projects at 10%, and high-risk projects at 12%.

The company is considering the following projects: Project Risk Expected Return A High 15% B Average 12% C High 11% D Low 9% E Low 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.

Indicate whether the statement is true or false.

68. Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk. a. True b. False 69. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

70. 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

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 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.)

Project cost of capital (r) 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. $33,391 b. $35,149 c. $36,999 d. $38,946 e. $40,996

10.0% $60,000 2,800 $25.00 $10,000 $5.375 $20,000 25.0%

Indicate whether the statement is true or false.

71. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return. a. True b. False 72. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

73. 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 74. 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

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 75. 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. 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.

76. 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.

77. 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 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.

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 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. $55.08 b. $57.98 c. $61.03 d. $64.08 e. $67.29

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk Answer Key 1. False 2. True 3. False 4. False 5. True 6. False 7. True 8. False 9. True 10. False 11. False 12. True 13. False 14. True 15. False 16. d 17. b 18. c 19. a 20. d 21. c 22. b 23. a 24. a 25. e

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 26. b 27. a 28. c 29. c 30. c 31. a 32. False 33. False 34. True 35. False 36. True 37. True 38. False 39. False 40. e 41. c 42. d 43. e 44. c 45. a 46. c 47. d 48. e 49. b 50. a 51. c

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 52. e 53. b 54. e 55. b 56. d 57. a 58. c 59. c 60. c 61. True 62. e 63. a 64. b 65. e 66. d 67. c 68. True 69. True 70. e 71. True 72. False 73. a 74. a 75. d 76. e

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13. Capital Budgeting: Estimating Cash Flows & Analyzing Risk 77. d 78. c

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14. Real Options

Indicate whether the statement is true or false.

1. Real options exist when managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project's cash flows. a. True b. False 2. Real options are options to buy real assets, like stocks, rather than interest-bearing assets, like bonds. a. True b. False 3. The option to abandon a project is a real option, but a call option on a stock is not a real option. a. True b. False 4. Real options are most valuable when the underlying source of risk is very low. a. True b. False 5. Real options affect the size, but not the risk, of a project's expected cash flows. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6. Which of the following is NOT a real option? a. The option to buy shares of stock if its price goes up. b. The option to expand into a new geographic region. c. The option to abandon a project. d. The option to switch the type of fuel used in an industrial furnace. e. The option to expand production if the product is successful.

7. Whether to invest in a project today or to postpone the decision until next year is a decision facing the CEO of the Aaron Co. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Aaron decides to wait. Which of the following statements best describes the issues that Aaron faces when considering this investment timing option? a. The more uncertainty about the future cash flows, the more logical it is for Aaron to go ahead with this project today. b. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it chooses to wait a year. c. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV. d. Waiting would probably reduce the project's risk. e. The investment timing option does not affect the cash flows and will therefore have no impact on the project's risk.

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14. Real Options 8. Which of the following will NOT increase the value of a real option? a. An increase in the volatility of the underlying source of risk. b. An increase in the risk-free rate. c. An increase in the cost of obtaining the real option. d. A decrease in the probability that a competitor will enter the market of the project in question. e. Lengthening the time in which a real option must be exercised.

9. Which of the following is most CORRECT? a. Real options change the risk, but not the size, of projects' expected cash flows. b. Real options are likely to reduce the cost of capital that should be used to discount a project's expected cash flows. c. Very few projects actually have real options. d. Real options are less valuable when there is a lot of uncertainty about the true values future sales and costs. e. Real options change the size, but not the risk, of projects' expected cash flows.

10. Which one of the following is an example of a "flexibility" option? a. A company has an option to close down an operation if it turns out to be unprofitable. b. A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or outputs at a later date if conditions change. c. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date. d. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly commercial. e. A company has an option to invest in a project today or to wait a year.

11. Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good job of estimating projects' sales and costs. However, it never considers real options that might be associated with projects. Which of the following statements is most likely to describe its situation? a. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options. b. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is unclear what impact not considering real options has on the overall capital budget. c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget. d. Real options should not have any effect on the size of the optimal capital budget. e. Its estimated capital budget is probably too small, because projects' NPVs are often larger when real options are taken into account.

12. Drilling Experts, Inc. Drilling Experts, Inc. (DEI) finds and develops oil properties and then sells the successful ones to major oil refining companies. DEI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars. t = 0.

A $400 feasibility study would be conducted at t = 0. The results of this study would determine if the company should commence drilling operations or make no further

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14. Real Options investment and abandon the project.

t = 1.

If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill exploratory wells. The best estimate is that there is an 80% probability that the exploratory wells would indicate good potential and thus that further work would be done, and a 20% probability that the outlook would look bad and the project would be abandoned.

t = 2.

If the exploratory wells test positive, DEI would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2. The best estimate now is that there is a 60% probability that the results would be very good and a 40% probability that results would be poor and the field would be abandoned.

t = 3.

If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving a $25,000 cash inflow at t = 3, and a 50% probability of finding less oil and then only receiving a $10,000 inflow.

Refer to the data for Drilling Experts, Incorporated. Since the project is considered to be quite risky, a 20% cost of capital is used. What is the project's expected NPV, in thousands of dollars? a. $336.15 b. $373.50 c. $415.00 d. $461.11 e. $507.22 13. Drilling Experts, Inc. Drilling Experts, Inc. (DEI) finds and develops oil properties and then sells the successful ones to major oil refining companies. DEI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars. t = 0.

A $400 feasibility study would be conducted at t = 0. The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project.

t = 1.

If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill exploratory wells. The best estimate is that there is an 80% probability that the exploratory wells would indicate good potential and thus that further work would be done, and a 20% probability that the outlook would look bad and the project would be abandoned.

t = 2.

If the exploratory wells test positive, DEI would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2. The best estimate now is that there is a 60% probability that the results would be very good and a 40% probability that results would be poor and the field would be abandoned.

t = 3.

If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving a $25,000 cash inflow at t = 3, and a 50% probability of finding less oil and then only receiving a $10,000 inflow.

Refer to the data for Drilling Experts. Calculate the project's coefficient of variation. (Hint: Use the expected NPV.) a. 5.87

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14. Real Options b. 6.52 c. 7.25 d. 7.97 e. 8.77 14. Nationwide Pharmaceutical Corporation A project with an up-front cost at t = 0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC).

(All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7).

NPC will know for sure one year from today whether the competitor's product has been approved.

NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor's product is rejected and $25 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7).

Refer to the data for Nationwide Pharmaceutical Corporation (NPC). Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before proceeding, how much will this increase or decrease the project's expected NPV in today's dollars (i.e., at t = 0), relative to the NPV if it proceeds today? a. $77.23 b. $85.81 c. $95.34 d. $105.94 e. $116.53 15. Nationwide Pharmaceutical Corporation A project with an up-front cost at t = 0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC).

(All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7).

NPC will know for sure one year from today whether the competitor's product has been approved.

NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor's product is rejected and $25 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7).

Refer to the data for Nationwide Pharmaceutical Corporation (NPC). Calculate the effect of waiting on the project's risk, using the same data. By how much will delaying reduce the project's coefficient of variation? (Hint: Use the expected NPV.) a. 2.23 b. 2.46 c. 2.70

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14. Real Options d. 2.97 e. 3.27 16. Garner-Wagner Incorporated The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%.

Refer to the data for Garner-Wagner Incorporated. Based on the above data, what is the project's net present value? a. −$1,312,456 b. −$1,104,607 c. −$875,203 d. $105,999 e. $321,788 17. Garner-Wagner Incorporated The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%.

Refer to the data for Garner-Wagner Incorporated. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of −$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity? a. −$1,104,607 b. −$875,203 c. $199,328 d. $561,947 e. $898,205 18. Steppingstone Incorporated The Z−90 project being considered by Steppingstone Incorporated (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, Z−45, becomes an industry standard.

There is a 50% chance that the Z−45 will become the industry standard, in which case the Z−90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the Z−45 will not become the industry standard, in which case the Z−90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.

Refer to data for Steppingstone Incorporated. Based on the above information, what is the Z−90's expected net present value? a. −$6,678 b. −$3,251 c. $15,303 d. $20,004 e. $45,965

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14. Real Options 19. Steppingstone Incorporated The Z−90 project being considered by Steppingstone Incorporated (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, Z−45, becomes an industry standard.

There is a 50% chance that the Z−45 will become the industry standard, in which case the Z−90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the Z−45 will not become the industry standard, in which case the Z−90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.

Refer to data for Steppingstone Incorporated (SI). Now assume that one year from now SI will know if the Z−45 has become the industry standard. Also assume that after receiving the cash flows at t = 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option? a. $0 b. $2,075 c. $4,067 d. $8,945 e. $10,745

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14. Real Options Answer Key 1. True 2. False 3. True 4. False 5. False 6. a 7. d 8. c 9. b 10. b 11. e 12. d 13. c 14. d 15. a 16. b 17. c 18. a 19. e

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15. Distributions to Shareholders: Dividends & Repurchases

Indicate the answer choice that best completes the statement or answers the question.

1. 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.

2. 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. If a company offers a dividend reinvestment plan, almost all of its shareholders enroll in the plan.

3. 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. Companies may pay too high a price in a large open market repurchase if it takes too long to complete. d. An investor’s capital gains from selling stock in a repurchase are always taxed at a higher rate than if the distribution were dividends. e. The tax code encourages companies to pay dividends rather than reinvest earnings.

4. 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 because a repurchase announcement usually is seen as a positive signal from management. 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.

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15. Distributions to Shareholders: Dividends & Repurchases 5. The following data apply to Garber Industries, Inc. (GII): Value of operations $1,000 Short-term investments $100 Debt $300 Number of shares 100 The company plans on distributing $100 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 6. The following data apply to Elizabeth's Electrical Equipment: Value of operations $20,000 Short-term investments $1,000 Debt $6,000 Number of shares 300 The company plans on distributing $1,000 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

Indicate whether the statement is true or false.

7. The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price. a. True b. False 8. 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. a. True b. False 9. MM's dividend irrelevance theory says that while dividend policy does not affect a firm's value, it can affect the cost of capital. a. True b. False 10. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a low payout ratio. a. True

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15. Distributions to Shareholders: Dividends & Repurchases b. False 11. 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. a. True b. False 12. Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk. a. True b. False 13. One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held constant. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

14. 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.

15. 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.

Indicate whether the statement is true or false.

16. If the signaling, hypothesis (which is also called the information content hypothesis) is correct, then changes in dividend policy can have an important effect on the firm's value and capital costs. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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15. Distributions to Shareholders: Dividends & Repurchases 17. 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.

18. 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.

Indicate whether the statement is true or false.

19. 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. a. True b. False 20. If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual distribution policy. a. True b. False 21. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

22. 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

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15. Distributions to Shareholders: Dividends & Repurchases market averages. e. Its earnings become more stable.

23. 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.

24. 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 25. 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% 26. 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 27. 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

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15. Distributions to Shareholders: Dividends & Repurchases e. $3,050,000 28. 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 29. 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 30. 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 31. 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 32. 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?

Net Income Payout a. $ 898,750 55.63% b. $ 943,688 58.41%

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15. Distributions to Shareholders: Dividends & Repurchases c. $ 990,872 d. $1,040,415 e. $1,092,436

61.34% 64.40% 67.62%

33. 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 34. 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 a. 46.9% b. 49.3% c. 51.9% d. 54.7% e. 57.4%

$2,000,000Capital budget 10%% Debt $5,000,000% Equity $5,000,000Tax rate

$850,000 40% 60% 25%

35. 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 36. 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% e. 37.50%

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15. Distributions to Shareholders: Dividends & Repurchases 37. 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?

Dividends Stock Issued a. $514,425 $162,901 b. $541,500 $171,475 c. $570,000 $180,500 d. $600,000 $190,000 e. $ 0 $200,000 38. 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.

Increase in Capital Budget Increase Lower Debt to 75% Payout to 20% Do both a. $114.0 $73.3 $333.9 b. $120.0 $77.2 $351.5 c. $126.4 $81.2 $370.0 d. $133.0 $85.5 $389.5 e. $140.0 $90.0 $410.0 39. 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. e. no dividends except out of past retained earnings.

40. 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.

41. 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.

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15. Distributions to Shareholders: Dividends & Repurchases 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.

42. Which of the following statements is correct? 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.

43. 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. 44. 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 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.

Indicate whether the statement is true or false.

45. Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders' wealth. a. True

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15. Distributions to Shareholders: Dividends & Repurchases b. False 46. A reverse split reduces the number of shares outstanding. a. True b. False 47. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

48. 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.

49. 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 then the after-split price will be higher than if the 3-for-1 split had been used.

50. 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

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15. Distributions to Shareholders: Dividends & Repurchases they paid for it will be subject to capital gains taxes.

51. 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 52. 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 53. 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 54. 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 55. 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

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15. Distributions to Shareholders: Dividends & Repurchases d. $33.08 e. $34.73 56. 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 57. 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.

58. 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.

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15. Distributions to Shareholders: Dividends & Repurchases Answer Key 1. b 2. c 3. c 4. b 5. c 6. b 7. True 8. False 9. False 10. True 11. False 12. True 13. True 14. c 15. c 16. True 17. d 18. a 19. True 20. False 21. False 22. b 23. e 24. e 25. d

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15. Distributions to Shareholders: Dividends & Repurchases 26. a 27. c 28. e 29. b 30. b 31. e 32. a 33. d 34. d 35. d 36. e 37. e 38. e 39. a 40. b 41. d 42. a 43. a 44. e 45. True 46. True 47. True 48. a 49. d 50. e 51. c

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15. Distributions to Shareholders: Dividends & Repurchases 52. a 53. c 54. c 55. c 56. b 57. d 58. d

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16. Capital Structure Decisions

Indicate whether the statement is true or 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. a. True b. False 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. a. True b. False 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. a. True b. False 4. As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components. a. True b. False 5. A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows. a. True b. False 6. Whenever a firm borrows money, it is using financial leverage. a. True b. False 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. a. True b. False 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. a. True b. False 9. 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. a. True b. False 10. 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. a. True

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16. Capital Structure Decisions b. False 11. 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. a. True b. False 12. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

13. 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.

14. 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.

15. 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.

16. 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.

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16. Capital Structure Decisions 17. 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 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.

18. 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.

19. 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 return on invested capital (ROIC), 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.

20. Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its return on invested operating capital (ROIC) is 14.5%. 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 ROIC would decline. c. The ROIC would increase. d. The ROE would increase. e. The ROA would increase.

21. 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.

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16. Capital Structure Decisions 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.

22. 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 taxadjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

23. 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 24. 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 25. 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

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16. Capital Structure Decisions 26. Hernandez Corporation expects to have the following data during the coming year. What is Hernandez's expected ROE? Assets D/A EBIT a. 15.64% b. 16.43% c. 17.25% d. 18.11% e. 19.01%

$200,000Interest rate 65%Tax rate $25,000

8% 25%

27. 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 28. 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 29. 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 $200Debt ratio EBIT $40Interest rate Tax rate 25% a. 2.51% b. 2.65% c. 2.79% d. 2.93% e. 3.07%

Firm LD's Data 50%Debt ratio 12%Interest rate

30% 10%

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16. Capital Structure Decisions

Indicate whether the statement is true or false.

30. The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing. a. True b. False 31. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

32. 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.

33. 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.

34. 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.

Indicate whether the statement is true or false.

35. The Miller model begins with the MM model with corporate taxes and then adds personal taxes. a. True

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16. Capital Structure Decisions b. False 36. The Miller model begins with the MM model without corporate taxes and then adds personal taxes. a. True b. False 37. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes. a. True b. False 38. The MM model is the same as the Miller model, but with zero corporate taxes. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

39. The major contribution of the Miller model is that it demonstrates that a. personal taxes decrease the value of using corporate debt. b. financial distress and agency costs reduce the value of using corporate debt. c. equity costs increase with financial leverage. d. debt costs increase with financial leverage. e. personal taxes increase the value of using corporate debt.

40. Which of the following statements concerning capital structure theory is NOT CORRECT? a. Under MM with zero taxes, financial leverage has no effect on a firm's value. b. Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt. c. Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing. d. Under MM with corporate taxes, the effect of business risk is automatically incorporated because r sL is a function of rsU. e. The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

41. Eccles Inccorporated Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.

Refer to the data for Eccles Incorporated. What is the value of the firm according to MM with corporate taxes? a. $480,938 b. $534,375 c. $593,750 d. $653,125 e. $718,438

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16. Capital Structure Decisions 42. Eccles Inccorporated Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.

Refer to the data for Eccles Incorporated.What is the firm's cost of equity according to MM with corporate taxes? a. 21.0% b. 23.3% c. 25.9% d. 28.8% e. 32.0% 43. Eccles Inccorporated Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.

Refer to the data for Eccles Incorporated. Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income? a. 12.8% b. 14.2% c. 15.8% d. 17.6% e. 19.6% 44. 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.

45. 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.

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16. Capital Structure Decisions 46. 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.

47. 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.

48. 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).

49. 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. 50. 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).

51. 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 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.

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16. Capital Structure Decisions 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.

52. 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 return on invested capital. (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 return on invested capital.

53. Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC), and their ROIC exceeds their after-tax cost of debt, (1-T) 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. 54. Firms U and L both have a return on invested capital (ROIC) of 12% 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 an after-tax cost of 4.8%. 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.

55. 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 return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T)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. c. Given that ROIC > (1-T) rd, HD's stock price must exceed that of LD. d. Given that ROIC > (1-T) rd, LD's stock price must exceed that of HD. e. HD should have a higher return on assets (ROA) than LD. 56. Which of the following statements is CORRECT? a. The capital structure that maximizes the stock price is generally the capital structure that also maximizes

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16. Capital Structure Decisions 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.

57. 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 return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) 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. 58. 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 25%. What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta? a. 0.60 b. 0.63 c. 0.66 d. 0.70 e. 0.73 59. The following information has been presented to you about the Gibson Corporation.

Total assets $3,000 millionTax rate 25% Operating income (EBIT) $800 millionDebt ratio 0% Interest expense $0 millionWACC 10% Net income $480 millionM/B ratio 1.00× Share price $32.00EPS = DPS $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 8%. If the company makes this change, what would be the total market value (in millions) of the firm? a. $4,400 b. $4,800 c. $5,200 d. $5,400 e. $6,000 60. Morales Publishing's tax rate is 25%, 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?

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16. Capital Structure Decisions a. 1.91% b. 2.12% c. 2.33% d. 2.57% e. 2.82% 61. 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 25%. 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. −5.40% b. −6.00% c. −6.60% d. −7.26% e. −7.99% 62. 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 25%. 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. 11.50% b. 12.50% c. 13.58% d. 14.77% e. 16.05% 63. 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 25%.

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. $70.31 b. $74.01 c. $77.71 d. $81.60 e. $85.68 64. 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

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16. Capital Structure Decisions company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 25%. 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. 13.65% c. 14.84% d. 15.58% e. 16.00% 65. 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 Percent financed Debt-to-equity Bond Before-tax Rating cost of debt with debt (wd) with equity (ws) ratio = wd/ws = (D/S) 0.10 0.90 0.10/0.90 = 0.11 AAA 7.0% 0.20 0.80 0.20/0.80 = 0.25 AA 7.2 0.30 0.70 0.30/0.70 = 0.43 A 8.0 0.40 0.60 0.40/0.60 = 0.67 BBB 8.8 0.50 0.50 0.50/0.50 = 1.00 BB 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 25%.

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. ws = 0.9; wd = 0.1; WACC = 11.73% b. ws = 0.8; wd = 0.2; WACC = 10.78% c. ws = 0.7; wd = 0.3; WACC = 9.11% d. ws = 0.6; wd = 0.4; WACC = 9.50% e. ws = 0.5; wd = 0.5; WACC = 11.37% 66. Pennewell Publishing Inc. (PP) Pennewell Publishing Inc. (PP) is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000. PP's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00.

Refer to the data for Pennewell Publishing Inc. (PP). 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. $552,941 b. $588,235 c. $617,647 d. $648,529 e. $680,956

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16. Capital Structure Decisions 67. VanMannen Foundations, Inc. (VF) VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown below.

EBIT = Growth = Orig cost of equity, rs = No. of shares = Price per share = Tax rate =

$80,000 0% 10.0% 10,000 $60.00 25%

Refer to the data for VanMannen Foundations, Inc. (VF). Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised 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 somewhat, as indicated below. If this plan were carried out, what would be VF's new WACC and its new value of operations?

New interest rate = rd =

6.00%

New cost of equity = rs =

10.75%

New Debt/Value = wd =

20%

New Equity/Value = ws =

80%

WACC Value a. 9.50% $631,579 b. 9.80% $644,211 c. 10.10% $657,095 d. 10.40% $670,237 e. 10.70% $683,641 68. Best Bagels, Inc. (BB) Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $130,000, and it is a zero growth company. BB’s current cost of equity is 13%, and its tax rate is 25%. The firm has 30,000 shares of common stock outstanding selling at a price per share of $25.

Refer to the data for Best Bagels, Inc. (BB). 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 8.2%. 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 13.9%. If this plan were carried out, what would BB's new value of operations be? a. $789,474 b. $821,053 c. $853,895 d. $888,051 e. $923,573

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16. Capital Structure Decisions 69. Anson Jackson Court Company (AJC) The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.

AJC's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.

Refer to the data for the Anson Jackson Court Company (AJC). What is AJC's current total market value and weighted average cost of capital?

Total Market Value; WACC a. $650,000; 8.9% b. $650,000; 9.4% c. $750,000; 8.4% d. $750,000; 8.9% e. $750,000; 9.4% 70. Anson Jackson Court Company (AJC) The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.

AJC's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.

Refer to the data for Anson Jackson Court (AJC). AJC is considering moving to a capital structure that is comprised of 25% debt and 75% 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 6.56%, while the required rate of return on equity would rise to 10.07%. If this plan were carried out, what would be AJC's new WACC and total value?

WACC; Total Market Value a. 8.28%; $690,034 b. 8.78%; $760,034 c. 9.28%; $660,034 d. 9.28%; $820,034 71. 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.

72. 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

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16. Capital Structure Decisions 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).

73. Merriwether Building has operating income of $20 million, a tax rate of 25%, and no debt. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $27 per share, and it has 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. $28 b. $30 c. $33 d. $35 e. $40 74. Pennewell Publishing Inc. (PP) Pennewell Publishing Inc. (PP) is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000. PP's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00.

Refer to the data for Pennewell Publishing Inc. (PP). 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 9.125% and a new value of operations of $657,534. Assume PP raises $230,137 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. $55.04 b. $61.15 c. $65.75 d. $71.01 e. $74.56 75. Pennewell Publishing Inc. (PP) Pennewell Publishing Inc. (PP) is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000. PP's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00.

Refer to the data for Pennewell Publishing Inc. (PP). 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 9.125% and a new value of operations of $657,534. Assume PP raises $230,137 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?

Remaining Shares; P Post a. 7,500; $86.18 b. 7,000; $74.26

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16. Capital Structure Decisions c. 6,500; $65.75 d. 6,649; $63.48 e. 6,959; $58.03 76. VanMannen Foundations, Inc. (VF) VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown below.

EBIT = Growth = Orig cost of equity, rs = No. of shares = Price per share = Tax rate =

$80,000 0% 10.0% 10,000 $60.00 25%

Refer to the data for VanMannen Foundations, Inc. (VF). 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?

Debt/Value = Equity/Value = a. $66.67 b. $70.18 c. $73.68 d. $77.37 e. $81.24

40%Value of new debt = 60%New WACC =

$280,702 8.55%

77. VanMannen Foundations, Inc. (VF) VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown below.

EBIT = Growth = Orig cost of equity, rs = No. of shares = Price per share = Tax rate =

$80,000 0% 10.0% 10,000 $60.00 25%

Refer to the data for VanMannen Foundations, Inc. (VF). What would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock? a. $65.04 b. $66.71 c. $68.42 d. $70.18

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16. Capital Structure Decisions e. $73.68 78. Best Bagels, Inc. (BB) Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $130,000, and it is a zero growth company. BB’s current cost of equity is 13%, and its tax rate is 25%. The firm has 30,000 shares of common stock outstanding selling at a price per share of $25.

Refer to the data for Best Bagels, Inc. (BB). Now assume that BB is considering changing from its original capital structure to a new capital structure with 40% debt and 60% equity. This results in a weighted average cost of capital equal to 11.7% and a new value of operations of $833,333. Assume BB raises $333,333 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?

Remaining shares; Stock price after repurchase a. 18,000; $27.78 b. 19,400; $29.44 c. 20,800; $31.51 d. 21,800; $34.34 e. 23,500; $35.71 79. Best Bagels, Inc. (BB) Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $130,000, and it is a zero growth company. BB’s current cost of equity is 13%, and its tax rate is 25%. The firm has 30,000 shares of common stock outstanding selling at a price per share of $25.

Refer to the data for Best Bagels, Inc. (BB). Now assume that BB is considering changing from its original capital structure to a new capital structure with 40% debt and 60% equity. This results in a weighted average cost of capital equal to 11.7% and a new value of operations of $833,333. Assume BB raises $333,333 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. $18.58 b. $20.65 c. $25.00 d. $27.78 e. $30.19 80. Anson Jackson Court Company (AJC) The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.

AJC's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.

Refer to the data for the Anson Jackson Court Company (AJC). Now assume that AJC is considering changing from its original capital structure to a new capital structure with 40% debt and 60% equity. If it makes this change, its resulting market value would be $791,667. What would be its new stock price per share? a. $60.17 b. $61.17 c. $62.27 d. $63.27

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16. Capital Structure Decisions e. $64.17 81. Anson Jackson Court Company (AJC) The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.

AJC's current cost of equity is 10%, and its tax rate is 25%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.

Refer to the data for the Anson Jackson Court Company (AJC). 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

Indicate whether the statement is true or false.

82. Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient. a. True b. False 83. When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt. a. True b. False 84. When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

85. Wilson Dover Inc. The total value (debt plus equity) of Wilson Dover Inc. is $500 million and the face value of its 1-year coupon debt is $200 million. The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050.

Refer to the data for Wilson Dover Inc. What is the value (in millions) of Wilson Dover's equity if it is viewed as an option? a. $228.77 b. $254.19 c. $282.43 d. $313.81

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16. Capital Structure Decisions e. $345.19 86. Wilson Dover Inc. The total value (debt plus equity) of Wilson Dover Inc. is $500 million and the face value of its 1-year coupon debt is $200 million. The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050.

Refer to the data for Wilson Dover Inc. What is the value (in millions) of Wilson Dover's debt if its equity is viewed as an option? a. $167.57 b. $186.19 c. $204.81 d. $225.29 e. $247.82 87. Wilson Dover Inc. The total value (debt plus equity) of Wilson Dover Inc. is $500 million and the face value of its 1-year coupon debt is $200 million. The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050.

Refer to the data for Wilson Dover Inc. What is the yield on Wilson Dover's debt? a. 6.04% b. 6.36% c. 6.70% d. 7.05% e. 7.42%

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16. Capital Structure Decisions Answer Key 1. True 2. False 3. True 4. False 5. True 6. True 7. False 8. False 9. True 10. False 11. False 12. True 13. e 14. c 15. d 16. c 17. d 18. d 19. b 20. d 21. e 22. e 23. d 24. a 25. c

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16. Capital Structure Decisions 26. a 27. b 28. c 29. c 30. True 31. True 32. e 33. a 34. a 35. True 36. False 37. True 38. False 39. a 40. c 41. c 42. e 43. e 44. c 45. c 46. c 47. b 48. a 49. d 50. d 51. a

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16. Capital Structure Decisions 52. b 53. a 54. a 55. b 56. b 57. b 58. e 59. e 60. b 61. b 62. e 63. b 64. c 65. d 66. b 67. a 68. a 69. d 70. b 71. e 72. e 73. b 74. c 75. c 76. b

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16. Capital Structure Decisions 77. d 78. a 79. d 80. c 81. e 82. True 83. True 84. False 85. d 86. b 87. e

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17. Dynamic Capital Structures & Corporate Valuation

Indicate whether the statement is true or false.

1. The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt. a. True b. False 2. In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased. a. True b. False 3. According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing. a. True b. False 4. MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt. a. True b. False 5. MM showed that in a world without taxes, a firm's value is not affected by its capital structure. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6. Kitto Electronics Data Kitto Electronics expects an EBIT of $200,000 for Year-1. EBIT is expected to grow at 6% thereafter. The tax rate is 25%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.

Refer to data for Kitto Electronics. According to the compressed adjusted present value model, what is Kitto's unlevered value? a. $1,782,000 b. $1,980,000 c. $2,200,000 d. $2,420,000 e. $2,662,000

Indicate whether the statement is true or false.

7. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the unlevered cost of equity. a. True b. False

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17. Dynamic Capital Structures & Corporate Valuation 8. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

9. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt. b. The horizon value is calculated by discounting the expected earnings at the WACC. c. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC. d. The horizon value must always be more than 20 years in the future. e. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

Indicate whether the statement is true or false.

10. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the after-tax cost of debt. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

11. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity. b. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity. c. The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity. d. The CAPV approach stands for the accounting pre-valuation approach. e. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

Indicate whether the statement is true or false.

12. If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the compressed adjusted present value model calculates the horizon value by discounting the post-horizon free cash flows and post-horizon expected future tax shields at the weighted average cost of capital. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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17. Dynamic Capital Structures & Corporate Valuation 13. Sallie's Sandwiches Sallie's Sandwiches is financed using 20% debt at a cost of 8%. Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4. Sallie's beta is 2.0, and its tax rate is 25%. The risk-free rate is 6%, and the market risk premium is 5%.

Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings? a. 12.0% b. 13.9% c. 14.4% d. 16.0% e. 16.9% 14. Sallie's Sandwiches Sallie's Sandwiches is financed using 20% debt at a cost of 8%. Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4. Sallie's beta is 2.0, and its tax rate is 25%. The risk-free rate is 6%, and the market risk premium is 5%.

Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the total value (in millions)? a. $72.37 b. $73.99 c. $74.49 d. $75.81 e. $76.45 15.15.

Glassmaker Corporation Data Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock. Glassmaker's beta is 1.5. Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years. (Its tax rate will remain unchanged.)

Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4. Glass maker will increase its debt to $140 million in the recapitalization. This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4. Glassmaker has no nonoperating assets. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

Refer to data for Glassmaker Corporation. What is Glassmaker's current levered cost of equity based on its current capital structure? a. 11.00% b. 11.50% c. 12.00% d. 12.50%

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17. Dynamic Capital Structures & Corporate Valuation e. 13.00% 16.16.

Glassmaker Corporation Data Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock. Glassmaker's beta is 1.5. Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years. (Its tax rate will remain unchanged.)

Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4. Glass maker will increase its debt to $140 million in the recapitalization. This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4. Glassmaker has no nonoperating assets. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

Refer to data for Glassmaker Corporation. According to the compressed adjusted present value model, what discount rate should you use to discount Glassmaker's free cash flows and interest tax savings? a. 10.00% b. 11.00% c. 11.25% d. 12.03% e. 13.11% 17.17.

Glassmaker Corporation Data Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock. Glassmaker's beta is 1.5. Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years. (Its tax rate will remain unchanged.)

Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4. Glass maker will increase its debt to $140 million in the recapitalization. This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4. Glassmaker has no nonoperating assets. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.

Refer to data for Glassmaker Corporation. Using the compressed adjusted present value model, how much will Glassmaker's equity be worth after completing the recapitalization? (Round your answer to the closest thousand dollars.) a. $316 b. $340 c. $348 d. $366 e. $380 18. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

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17. Dynamic Capital Structures & Corporate Valuation a. The value of a growing tax shield is greater than the value of a constant tax shield. b. For a given D/S, the levered cost of equity using the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions. c. For a given D/S, the WACC in the compressed APV model is less than the WACC under MM's original (with tax) assumptions. d. The total value of the firm increases with the amount of debt. e. The tax shields should be discounted at the unlevered cost of equity.

19. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT? a. The value of a growing tax shield is greater than the value of a constant tax shield. b. For a given D/S, the levered cost of equity is greater in the compressed APV model than the levered cost of equity under MM's original (with tax) assumptions. c. For a given D/S, the WACC is greater in the compressed APV model than the WACC under MM's original (with tax) assumptions. d. The total value of the firm increases with the amount of debt. e. The tax shields should be discounted at the cost of debt.

20. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT? a. The value of a growing tax shield is greater than the value of a constant tax shield. b. For a given D/S, the levered cost of equity in the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions. c. For a given D/S, the WACC in the compressed APV model is greater than the WACC under MM's original (with tax) assumptions. d. The total value of the firm is independent of the amount of debt it uses. e. The tax shields should be discounted at the unlevered cost of equity.

21. The market value of Rudyard Incorporated's debt is $200,000 and its yield is 9%. The firm's equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 25%. A similar firm with no debt has a cost of equity of 12%. Using the compressed adjusted present value model, what is Rudyard's cost of equity? a. 11.4% b. 12.0% c. 12.6% d. 13.3% e. 14.0% 22. The market value of DeLoach Photography’s debt is $200,000 and its yield is 8%. The firm's equity has a market value of $800,000, its free cash flows are growing at a 4% rate, and its tax rate is 25%. A similar firm with no debt has a cost of equity of 12%. Using the compressed adjusted present value (CAPV) model, what would its total value be if it had no debt? a. $878,750 b. $925,000 c. $950,000 d. $997,500 e. $1,050,000

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17. Dynamic Capital Structures & Corporate Valuation 23. Angelou Corporation has debt worth $150,000, with a yield of 8%, and equity worth $350,000. It is growing at a 5% rate, and its tax rate is 25%. A similar firm with no debt has a cost of equity of 13%. Using the compressed adjusted present value model, what is the value of the firm's tax shield, i.e., how much value does the use of debt add? a. $33,750 b. $37,500 c. $41,250 d. $45,375 e. $49,913 24. Kitto Electronics Data Kitto Electronics expects an EBIT of $200,000 for Year-1. EBIT is expected to grow at 6% thereafter. The tax rate is 25%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.

Refer to data for Kitto Electronics. Using the compressed adjusted present value model, what is the value of Kitto's tax shield? a. $97,741 b. $102,885 c. $108,300 d. $114,000 e. $120,000 25. Kitto Electronics Data Kitto Electronics expects an EBIT of $200,000 for Year-1. EBIT is expected to grow at 6% thereafter. The tax rate is 25%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.

Refer to data for Kitto Electronics. Using the compressed adjusted present value model, what is Kitto's value of equity? a. $2,020,000 b. $2,070,500 c. $2,122,263 d. $2,175,319 e. $2,229,702

Indicate whether the statement is true or false.

26. The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

27. Raymond Supply, a national hardware chain, is considering purchasing a smaller chain, Strauss & Glazer Parts (SGP).

Raymond's analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:

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17. Dynamic Capital Structures & Corporate Valuation Year 1 2 3 4 Free cash flow $20.00 $25.00 $30.00 $35.00 Unlevered horizon value $366.00 Tax shield $2.10 $2.20 $2.30 $2.40 Horizon value of tax shield $25.00 Assume that all cash flows occur at the end of the year. SGP is currently financed with 25% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current debt and issue enough new debt to continue at the 25% target level. The interest rate would remain the same. SGP's pre-merger beta is 2.0, and its post-merger tax rate would be 25%. The risk-free rate is 8% and the market risk premium is 4%. Using the compressed adjusted present value approach, what is the value of SGP to Raymond? (Show your answer in millions of dollars.) a. $210 b. $233 c. $256 d. $282 e. $310 28. Volunteer Enterprises has the following information for the current year. Calculate its free cash flow to equity.

FCF $1,000 Interest expense $40 Principal payments $200 New debt $300 Tax rate 25%

a. $1,070 b. $1,177 c. $1,295 d. $1,424 e. $1,567 29. Gators Incorporated has the following information for the current year and projected for next year. Calculate its projected free cash flow to equity. (Assume new debt is added at the beginning of the year.)

Current year Projected FCF NA $1,000 Total debt $400 $600 Interest rate on debt 6% 6% Tax rate 25% 25%

a. $1,066 b. $1,173 c. $1,290 d. $1,419 e. $1,561 30. Gamma Pharmaceuticals has the following financial information for the current year and projected for next year.

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17. Dynamic Capital Structures & Corporate Valuation Calculate Gamma's projected free cash flow to equity.

Current year Projected NOPAT NA $1,000 Total operating capital $2,000 $2,200 Total debt $900 $800 Interest rate on debt 6% 6% Tax rate 25% 25%

a. $549 b. $604 c. $664 d. $730 e. $803 31. Alpha Manufacturing has the following financial information for the current year and projected for next year.

Calculate its projected free cash flow to equity.

Current year Projected EBIT $1,500 $1,800 Operating assets $3,000 $3,400 Operating liabilities $200 $220 Total debt $1,500 $1,800 Interest rate on debt 6% 6% Tax rate 25% 25% a. $893 b. $983 c. $1,081 d. $1,189 e. $1,308 32. Eta Edibles had free cash flow to equity, required return, and long-term growth rate as indicated below. Eta has no non-operating assets. Calculate Eta's intrinsic value of equity using the FCFE model.

Most recent FCFE $1000 Required return on equity 9% Long-term growth rate 4%

a. $18,909 b. $20,800 c. $22,880 d. $25,168 e. $27,685

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17. Dynamic Capital Structures & Corporate Valuation 33. Epsilon Consultants has the following projected free cash flows to equity and other information. It has no nonoperating assets. Calculate Epsilon's intrinsic value of equity using the FCFE model.

Year 1 Year 2 Year 3 FCFE $1,000 $1,200 $1,260 Long-term FCFE growth 5% Required return on equity 9% a. $28,440 b. $31,284 c. $34,413 d. $37,854 e. $41,640 34. Zeta Technologies has the following projections. It has no non-operating assets. Calculate Zeta's intrinsic value of equity using the FCFE model.

Current year Year 1 Year 1 Year 3 FCF NA $1,000 $1,200 $1,248 Total debt $3,000 $3,900 $4,290 $4,462 Interest rate on debt 6% 6% 6% 6% Tax rate 25% 25% 25% 25% Long-term growth rate 4% Required return on equity 9%

a. $21,165 b. $23,282 c. $25,610 d. $28,171 e. $30,988 35. Theta Therapeutics has the following information and projections. Use the FCFE model to calculate the intrinsic value of Theta's equity.

Current year Year 1 Year 2 Year 3 EBIT (operating profit) NA $1,000 $1,100 $1,200 Operating assets $1,200 $1,300 $1,500 $1,600 Operating liabilities $300 $300 $400 $500 Total Debt $1,000 $900 $1,100 $1,200 Tax rate NA 25% 25% 25% Interest rate on debt NA 6% 6% 6% long-term growth rate 4% Required return on equity 9%

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17. Dynamic Capital Structures & Corporate Valuation a. $14,156 b. $15,572 c. $17,129 d. $18,842 e. $20,726 36. Holland Auto Parts is considering a merger with Workman Car Parts. Workman's market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. Using the Compressed APV Model, what will Workman's required rate of return on equity be after it is acquired? a. 7.4% b. 8.9% c. 9.3% d. 9.6% e. 9.7%

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17. Dynamic Capital Structures & Corporate Valuation Answer Key 1. True 2. True 3. False 4. True 5. True 6. c 7. True 8. False 9. c 10. False 11. b 12. False 13. c 14. e 15. c 16. c 17. b 18. c 19. e 20. d 21. e 22. c 23. b 24. e 25. a

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17. Dynamic Capital Structures & Corporate Valuation 26. False 27. b 28. a 29. b 30. c 31. d 32. b 33. a 34. b 35. c 36. e

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18. Initial Public Offerings, Investment Banking, & Financial Restructuring

Indicate whether the statement is true or false.

1. Going public establishes a market value for the firm's stock, and it also ensures that a liquid market will continue to exist for the firm's shares. This is especially true for small firms that are not widely followed by security analysts. a. True b. False 2. The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of financial information, the danger of losing control, and the possibility of an inactive market and an attendant low stock price are potential disadvantages of going public. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

3. Which of the following is generally NOT true and an advantage of going public? a. Increases the liquidity of the firm's stock. b. Makes it easier to obtain new equity capital. c. Establishes a market value for the firm. d. Makes it easier for owner-managers to engage in profitable self-dealings. e. Facilitates stockholder diversification.

4. Which of the following statements about listing on a stock exchange is most CORRECT? a. Any firm can be listed on the NYSE as long as it pays the listing fee. b. Listing provides a company with some "free" advertising, and it may enhance the firm's prestige and help it do more business. c. Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC. d. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE. e. Listing is a decision of more significance to a firm than going public.

Indicate whether the statement is true or false.

5. The term "leaving money on the table" refers to the situation where an investment banking house makes a very low bid for the right to underwrite a firm's new stock offering. The banker is, in effect, "buying the job" with the low bid and thus not getting all the money his firm would normally earn on the job. a. True b. False 6. Whereas commercial banks take deposits from some customers and make loans to other customers, the principal activities of investment banks are (1) to help firms issue new stock and bonds and (2) to give firms advice with regard to mergers and other financial matters. However, financial corporations often own and operate subsidiaries that operate as commercial banks and others that are investment banks. This was not true some years ago, when the two types of banks were required by law to be completely independent of one another. a. True b. False

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18. Initial Public Offerings, Investment Banking, & Financial Restructuring

Indicate the answer choice that best completes the statement or answers the question.

7. In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go public by selling $5,000,000 of new common stock. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 price occurs, what would the present value of the entire underwriting compensation be? Assume that the investment banker's required return on such arrangements is 15%, and ignore taxes. a. $1,235,925 b. $1,300,973 c. $1,369,446 d. $1,441,522 e. $1,517,391

Indicate whether the statement is true or false.

8. The term "equity carve-out" refers to the situation where a firm's managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it "carves out" some of their value. a. True b. False 9. If its managers make a tender offer and buy all shares that were not held by the management team, this is called a private placement. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

10. Which of the following statements is most CORRECT? a. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement. b. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs. c. The SEC requires that all private placements be handled by a registered investment banker. d. Private placements can generally bring in funds faster than is the case with public offerings. e. In a private placement, securities are sold to private (individual) investors rather than to institutions.

11. Which of the following statements concerning common stock and the investment banking process is NOT CORRECT? a. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary market. b. Listing a large firm's stock is often considered to be beneficial to stockholders because the increases in liquidity and reputation probably outweigh the additional costs to the firm. c. Stockholders have the right to elect the firm's directors, who in turn select the officers who manage the business. If stockholders are dissatisfied with management's performance, an outside group may ask the stockholders to vote for it in an effort to take control of the business. This action is called a tender offer. d. The announcement of a large issue of new stock could cause the stock price to fall. This loss is called "market pressure," and it is treated as a flotation cost because it is a cost to stockholders that is associated with the new

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18. Initial Public Offerings, Investment Banking, & Financial Restructuring issue. e. The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.

12. Which of the following statements is NOT CORRECT? a. "Going public" establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares. b. Publicly owned companies have sold shares to investors who are not associated with management, and they must register with and report to a regulatory agency such as the SEC. 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. It is possible for a firm to go public and yet not raise any additional new capital. e. When a corporation's shares are owned by a few individuals who own most of the stock or are part of the firm's management, we say that the firm is "closely, or privately, held."

13. To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues? a. $79,425 b. $83,606 c. $88,006 d. $92,406 e. $97,027

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18. Initial Public Offerings, Investment Banking, & Financial Restructuring Answer Key 1. False 2. True 3. d 4. b 5. False 6. True 7. e 8. False 9. False 10. d 11. c 12. a 13. c

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19. Lease Financing

Indicate whether the statement is true or false.

1. Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases." a. True b. False 2. A sale and leaseback arrangement is a type of financial, or capital, lease. a. True b. False 3. Operating leases help to shift the risk of obsolescence from the user to the lessor. a. True b. False 4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

5.

Operating leases often have terms that include a. full amortization over the life of the lease. b. very high penalties if the lease is canceled. c. restrictions on how much the leased property can be used. d. much longer lease periods than for most financial leases. e. maintenance of the equipment by the lessor.

6. Which of the following statements is most CORRECT? a. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation. b. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan. c. Capital, or financial, leases generally provide for maintenance by the lessor. d. A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment. e. Finance leases usually have a cancelation feature.

Indicate whether the statement is true or false.

7. A company must capitalize any lease lasting more than a year by reporting it on the balance sheets as a

liability and as an asset. a. True b. False

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19. Lease Financing

Indicate the answer choice that best completes the statement or answers the question.

8. Almost all leases lasting more than a year must be included in the balance sheet by reporting the a. residual value as a liability. b. present value of future lease payments as an asset and also showing this same amount as an offsetting liability. c. undiscounted sum of future lease payments as an asset and as an offsetting liability. d. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability. e. residual value as a fixed asset.

Indicate whether the statement is true or false.

9. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines. a. True b. False 10. After a project has been accepted, the decision to lease or buy is determined by the present value of the lease's cash flows when discounted at the project's risk-adjusted cost of capital. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

11. A lessee should calculate the present value of a lease by discounting its cash flows at the same rate used to determine the present value of its a. proposed projects. b. debt. c. pension fund. d. sales. e. dividends.

12. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased a. is financed with long-term debt. b. is financed with debt whose maturity matches the term of the lease. c. is financed with a mix of debt and equity based on the firm's target capital structure, i.e., at the WACC. d. is financed with retained earnings. e. is financed with short-term debt.

13. Stanley Inc. must purchase $6,000,000 worth of service equipment and is weighing the merits of leasing the equipment or purchasing. The company has a zero tax rate due to tax loss carry-forwards, and is considering a 5-year, bank loan to finance the equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 endof-year payments. Stanley can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment. a. $177,169

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19. Lease Financing b. $196,854 c. $207,215 d. $217,576 e. $228,455 14. To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 25%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.) a. $119 b. $132 c. $139 d. $146 e. $153 15. Delamont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the truck's 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC's tax rate is 25%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07.) a. $1,020 b. $1,075 c. $1,134 d. $1,197 e. $1,257 16. Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. Due to special circumstances, the firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.) a. $5,734 b. $6,023 c. $6,324 d. $6,640 e. $6,972

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19. Lease Financing

Indicate whether the statement is true or false.

17. A leveraged lease is more risky from the lessee's standpoint than an unleveraged lease. a. True b. False 18. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease. a. True b. False 19. In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the use of an asset.

The SPE borrows up to 97% of its capital, uses its funds to buy the asset, and then leases it to the sponsoring corporation on a short-term basis. This keeps both the asset and the debt off the sponsoring company's books. a. True b. False 20. If a leased asset has a negative residual value, for example, as a result of a statutory requirement to dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value. a. True b. False 21. Assume that a piece of leased equipment has a relatively high rather than low expected residual value. From the lessee's viewpoint, it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

22. In the lease versus buy decision, leasing is often preferable a. because, generally, no down payment is required, and there are no indirect interest costs. b. because lease obligations do not affect the firm's risk as seen by investors. c. because the lessee owns the property at the end of the least term. d. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset. e. because it has no effect on the firm's ability to borrow to make other investments.

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19. Lease Financing Answer Key 1. True 2. True 3. True 4. True 5. e 6. d 7. True 8. b 9. True 10. False 11. b 12. b 13. c 14. b 15. d 16. a 17. False 18. False 19. True 20. False 21. False 22. d

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20. Hybrid Financing: Preferred Stock, Warrants, & Convertibles

Indicate whether the statement is true or false.

1. The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock. a. True b. False 2. Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible. a. True b. False 3. Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been omitted for some specified period, for example, 4 quarters. a. True b. False 4. Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy. a. True b. False 5. Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders. a. True b. False 6. Preferred stock can provide a financing alternative for some firms when market conditions are such that they cannot issue either pure debt or common stock at any reasonable cost. a. True b. False 7. Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price, which is desirable for liquidity portfolios, and they also benefit from the 50% tax exemption on preferred dividends received. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

8. Which of the following statements is most CORRECT? a. By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm's common stock. b. From the issuer's point of view, preferred stock is less risky than bonds. c. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally

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20. Hybrid Financing: Preferred Stock, Warrants, & Convertibles 25 years or less. d. Unlike bonds, preferred stock cannot have a convertible feature. e. Preferred stock generally has a higher component cost of capital to the firm than does common stock.

9. Mariano Manufacturing can issue a 25-year, 8.8% annual payment bond at par. Its investment bankers also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 25% tax bracket.

The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par? a. 8.27% b. 8.69% c. 9.12% d. 9.58% e. 10.05%

Indicate whether the statement is true or false.

10. A warrant is an option, and as such it cannot be used as a "sweetener." a. True b. False 11. A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock. a. True b. False 12. The problem of dilution of stockholders' earnings never results from the sale of call options, but it can arise if warrants are used. a. True b. False 13. A detachable warrant is a warrant that can be detached and traded separately from the bond with which it was issued.

Most traded warrants are originally attached to bonds or preferred stocks. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

14. Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells for $42 per share, and each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47. The firm's straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par? a. 7.83% b. 8.24% c. 8.65% d. 9.08% e. 9.54%

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20. Hybrid Financing: Preferred Stock, Warrants, & Convertibles 15. McGovern Enterprises is interested in issuing bonds with warrants attached. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $10.00. A similar straightdebt issue would require a 10% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000? a. 6.75% b. 7.11% c. 7.48% d. 7.88% e. 8.27% 16. Potter & Lopez Inc. just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 15%. What is the implied value of each warrant? a. $3.76 b. $3.94 c. $4.14 d. $4.35 e. $4.56

Indicate whether the statement is true or false.

17. The owner of a convertible bond owns, in effect, both a bond and a call option. a. True b. False 18. A convertible debenture can never sell for more than its conversion value or less than its bond value. a. True b. False 19. Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder. a. True b. False 20. Firms generally do not call their convertibles unless the conversion value is greater than the call price. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

21. Which of the following statements about convertibles is most CORRECT? a. One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted. b. Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt

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20. Hybrid Financing: Preferred Stock, Warrants, & Convertibles because convertibles are less risky than straight debt. c. At the time it is issued, a convertible's conversion (or exercise) price is generally set equal to or below the underlying stock's price. d. For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock. e. The coupon interest rate on a firm's convertibles is generally set higher than the market yield on its otherwise similar straight debt.

22. The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond? a. $707.33 b. $744.56 c. $783.75 d. $825.00 e. $866.25 23. Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc? a. $40.00 b. $42.00 c. $44.10 d. $46.31 e. $48.62 24. Mikkleson Mining stock is selling for $40 per share and has an expected dividend in the coming year of $2.00, and has an expected constant growth rate of 5.00%. The company is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8.00% annual coupon, and each bond could be converted into 20 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.00%. What is the estimated floor price of the convertible at the end of Year 3? a. $794.01 b. $835.81 c. $879.80 d. $926.10 e. $972.41 25. Neuman Corporation Convertible Bonds The following data apply to Neuman Corporation's convertible bonds: Maturity: Par value: Annual coupon:

10Stock price: $1,000.00Conversion price: 5.00%Straight-debt yield:

$30.00 $35.00 8.00%

Refer to the data for the Neuman Corporation's convertible bonds. What is the bond's conversion ratio? a. 27.14 b. 28.57

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20. Hybrid Financing: Preferred Stock, Warrants, & Convertibles c. 30.00 d. 31.50 e. 33.08 26. Neuman Corporation Convertible Bonds The following data apply to Neuman Corporation's convertible bonds: Maturity: Par value: Annual coupon:

10Stock price: $1,000.00Conversion price: 5.00%Straight-debt yield:

$30.00 $35.00 8.00%

Refer to the data for the Neuman Corporation's convertible bonds. What is the bond's conversion value? a. $698.15 b. $734.89 c. $773.57 d. $814.29 e. $857.14 27. Neuman Corporation Convertible Bonds The following data apply to Neuman Corporation's convertible bonds: Maturity: Par value: Annual coupon:

10Stock price: $1,000.00Conversion price: 5.00%Straight-debt yield:

$30.00 $35.00 8.00%

Refer to the data for the Neuman Corporation's convertible bonds. What is the bond's straight-debt value? a. $684.78 b. $720.82 c. $758.76 d. $798.70 e. $838.63 28. Neuman Corporation Convertible Bonds The following data apply to Neuman Corporation's convertible bonds: Maturity: Par value: Annual coupon:

10Stock price: $1,000.00Conversion price: 5.00%Straight-debt yield:

$30.00 $35.00 8.00%

Refer to the data for the Neuman Corporation's convertible bonds. What is the minimum price (or "floor" price) at which the Neuman's bonds should sell? a. $698.15 b. $734.89 c. $773.57 d. $814.29 e. $857.14 29. Which of the following statements concerning warrants is correct? a. Warrants are long-term put options that have value because holders can sell the firm's common stock at the

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20. Hybrid Financing: Preferred Stock, Warrants, & Convertibles exercise price regardless of how low the market price drops. b. Warrants are long-term call options that have value because holders can buy the firm's common stock at the exercise price regardless of how high the stock's price has risen. c. A firm's investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders. d. A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital. e. Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock's price increases. However, if the option is exercised, the issuing company's debt declines if warrants were used but remains the same if it used convertibles.

30. Which of the following statements is most CORRECT? a. One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds. b. The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt. c. The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant. d. Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual. e. Warrants have an option feature but convertibles do not.

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20. Hybrid Financing: Preferred Stock, Warrants, & Convertibles Answer Key 1. False 2. True 3. True 4. False 5. True 6. True 7. True 8. b 9. a 10. False 11. False 12. True 13. True 14. b 15. d 16. a 17. True 18. False 19. True 20. True 21. d 22. d 23. a 24. d 25. b

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20. Hybrid Financing: Preferred Stock, Warrants, & Convertibles 26. e 27. d 28. e 29. b 30. b

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21. Supply Chains & Working Capital Management

Indicate the answer choice that best completes the statement or answers the question.

1. 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.

Indicate whether the statement is true or false.

2. Net working capital, defined as current assets minus the sum of payables and accruals, is equal to the current ratio minus the quick ratio. a. True b. False 3. Net working capital is defined as current assets divided by current liabilities. a. True b. False 4. Net operating working capital is defined as operating current assets minus operating current liabilities.. a. True b. False 5. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6. 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 25%. 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. 5.32% b. 5.91% c. 6.56% d. 7.22% e. 7.94% 7. Hardwig Inc. Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%. If the company

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21. Supply Chains & Working Capital Management follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

Refer to the data for Hardwig Inc. 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 8. Hardwig Inc. Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

Refer to the data for Hardwig, Inc. What's the difference in the projected ROEs under the restricted and relaxed policies? a. 1.50% b. 1.88% c. 2.25% d. 2.70% e. 3.24% 9. Hardwig Inc. Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

Refer to the data for Hardwig, Inc.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. 2.79% b. 3.07% c. 3.38% d. 3.72% e. 4.09%

Indicate whether the statement is true or false.

10. Determining a firm's optimal investment in working capital and deciding how that investment should be financed are critical to working capital management. a. True b. False 11. An increase in any current asset must be accompanied by an equal increase in some current liability. a. True b. False

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21. Supply Chains & Working Capital Management 12. 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. a. True b. False 13. A conservative current operating asset financing approach will result in permanent current assets and some seasonal current assets being financed using long-term securities. a. True b. False 14. 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. a. True b. False 15. Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to match maturities on an ex ante (expected) basis. a. True b. False 16. The maturity matching, or "self-liquidating," approach to financing involves obtaining the funds for permanent current assets with a combination of long-term capital and short-term capital that varies depending on the level of interest rates.

When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs. a. True b. False 17. 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. a. True b. False 18. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

19. 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.

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21. Supply Chains & Working Capital Management 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 shortterm debt is often less expensive than long-term capital.

20. 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.

21. 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 shortterm debt is considered to be an aggressive strategy because of the inherent risks associated with using shortterm 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. 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.

22. 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.

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21. Supply Chains & Working Capital Management 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. e. The firm must make a known future payment, such as paying for a new plant that is under construction.

23. 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

Indicate whether the statement is true or false.

24. 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). a. True b. False 25. Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts payable, this will lengthen its cash conversion cycle (CCC). a. True b. False 26. The longer its customers normally hold inventory, the longer the credit period supplier firms normally offer. Still, suppliers have some flexibility in the credit terms they offer. If a supplier lengthens the credit period offered, this will shorten the customer's cash conversion cycle but lengthen the supplier firm's own CCC. a. True b. False 27. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

28. 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.

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21. Supply Chains & Working Capital Management e. Increase average inventory without increasing sales.

29. 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 cash discounts that are offered. c. Continue to take all cash 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.

30. 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 cash discounts on inventory purchases; the terms are 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.

31. Brothers Breads has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = Average collection period = Payables deferral period = a. 31 days b. 34 days c. 38 days d. 42 days e. 46 days

50 days 17 days 25 days

32. Fireside Inc. has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = Average collection period = Payables deferral period = a. 33 days b. 37 days c. 41 days d. 45 days e. 49 days

38 days 19 days 20 days

33. Whaley & Whaley has the following data. What is the firm's cash conversion cycle?

Inventory conversion period = Average collection period = Payables deferral period = a. 31 days b. 34 days

41 days 31 days 38 days

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21. Supply Chains & Working Capital Management c. 37 days d. 41 days e. 45 days 34. 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 35. 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. $8,078 b. $8,975 c. $9,973 d. $10,970 e. $12,067

$110,000 $16,000 53.09 20.00

36. 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 37. 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. $7,316 b. $8,129 c. $9,032

$85,000 $20,000 85.88 38.00

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21. Supply Chains & Working Capital Management d. $10,036 e. $11,151 38. 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 = a. $764 b. $849 c. $943 d. $1,048 e. $1,164

$75,000 $5,000 24.33 30.00

39. 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. 120.6 days b. 126.9 days c. 133.6 days d. 140.6 days e. 148.0 days

$75,000 $600,000 $360,000 $160,000 $25,000

40. 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. 25 days b. 28 days c. 31 days d. 35 days e. 38 days

$45,000 $31,500 $4,000 $2,000 $2,400

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21. Supply Chains & Working Capital Management 41. 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. 28 days b. 32 days c. 35 days d. 39 days e. 43 days

$45,000 $30,000 $4,500 $1,800 $2,500

42. 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. 34.0 b. 37.4 c. 41.2 d. 45.3 e. 49.8

Original $110,000 $80,000 $20,000 $16,000 $10,000 365

Revised $110,000 $80,000 $16,000 $14,000 $12,000 365

43. 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 44. 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

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21. Supply Chains & Working Capital Management 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 45. 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 $100,000 $ 80,000 $ 20,000 $ 16,000 $ 5,000

Benchmark Related CCC CCC

91.25 58.40 22.81 126.84

38.00 20.00 30.00 28.00

a. 1,901 b. 2,092 c. 2,301 d. 2,531 e. 2,784 46. 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

Indicate whether the statement is true or false.

47. 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. a. True b. False 48. The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are

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21. Supply Chains & Working Capital Management available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

49. 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.

Indicate whether the statement is true or false.

50. The average accounts receivable balance is a function of both the volume of credit sales and the days sales outstanding. a. True b. False 51. 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. a. True b. False 52. The aging schedule is a commonly used method for monitoring receivables. a. True b. False 53. The four primary elements in a firm's credit policy are (1) credit standards, (2) cash discounts offered, (3) credit period, and (4) collection policy. a. True b. False 54. Changes in a firm's collection policy can affect sales, working capital, and profits. a. True b. False 55. Not taking cash discounts is costly, and as a result, firms that do not take them are usually those that are performing poorly and have inadequate cash balances. a. True b. False 56. 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. a. True

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21. Supply Chains & Working Capital Management b. False 57. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio. a. True b. False 58. Dimon Products' sales are expected to be $5 million this year, with 90% on credit and 10% for cash. Sales are expected to grow at a stable, steady rate of 10% annually in the future. Dimon's accounts receivable balance will remain constant at the current level, because the 10% cash sales can be used to support the 10% growth rate, other things held constant. a. True b. False 59. 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. a. True b. False 60. A firm's collection policy, i.e., the procedures it follows to collect accounts receivable, plays an important role in keeping its average collection period short, although too strict a collection policy can reduce profits due to lost sales. a. True b. False 61. Because money has time value, a cash sale is always more profitable than a credit sale. a. True b. False 62. If a firm sells on terms of 2/10 net 30 days, and its DSO is 28 days, then the fact that the 28-day DSO is less than the 30-day credit period tells us that the credit department is functioning efficiently and there are no past-due accounts. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

63. 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.

64. 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.

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21. Supply Chains & Working Capital Management 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.

65. 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.

66. 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.

67. 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 68. 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

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21. Supply Chains & Working Capital Management d. 6.42 e. 7.07

Indicate whether the statement is true or false.

69. If a firm busy on terms of 2/10 net 30, it should pay as early as possible during the discount period. a. True b. False 70. Trade credit can be separated into two components: free trade credit, which is credit received after the discount period ends, and costly trade credit, which is the cost of discounts not taken. a. True b. False 71. As a rule, managers should try to always use the free component of trade credit but should use the costly component only if the cost of this credit is lower than the cost of credit from other sources. a. True b. False 72. If a firm's suppliers stop offering cash discounts, then its use of trade credit is more likely to increase than to decrease, other things held constant. a. True b. False 73. When deciding whether or not to take a cash discount, the cost of borrowing from a bank or other source should be compared to the cost of trade credit to determine if the cash discount should be taken. a. True b. False 74. The calculated cost of trade credit can be reduced by paying late. a. True b. False 75. The calculated cost of trade credit for a firm that buys on terms of 2/10 net 30 is lower (other things held constant) if the firm plans to pay in 40 days than in 30 days. a. True b. False 76. One of the effects of ceasing to take trade credit discounts is that the firm's accounts payable will rise, other things held constant. a. True b. False 77. "Stretching" accounts payable is a widely accepted, entirely ethical, and costless financing technique. a. True b. False

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21. Supply Chains & Working Capital Management 78. Accruals are "free" capital in the sense that no explicit interest must normally be paid on accrued liabilities. a. True b. False 79. Accruals are "spontaneous," but unfortunately, due to law and economic forces, firms have little control over the level of these accounts. a. True b. False 80. 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. a. True b. False 81. If a firm switched from taking trade credit discounts to paying on the net due date, this might cost the firm some money, but such a policy would probably have only a negligible effect on the income statement and no effect whatever on the balance sheet. a. True b. False 82. If a profitable firm finds that it simply must "stretch" its accounts payable, then this suggests that it is undercapitalized, i.e., that it needs more working capital to support its operations. a. True b. False 83. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it does not represent a real financial cost to your firm as long as the customer periodically pays off its entire balance. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

84. 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 uses a current asset financing policy that matches maturities, is conservative, or is aggressive 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.

85. 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%

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21. Supply Chains & Working Capital Management c. 30.35% d. 33.39% e. 36.73% 86. 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% 87. 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% 88. 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% 89. 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% 90. 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

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21. Supply Chains & Working Capital Management e. $22,479 91. 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 92. 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 93. 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 365day year, and note that purchases are net of discounts.) a. $90,411 b. $94,932 c. $99,678 d. $104,662 e. $109,895 94. 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% 95. 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%

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21. Supply Chains & Working Capital Management b. 63.5% c. 66.7% d. 70.0% e. 73.5% 96. 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 97. 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 25%. If the firm implements the plan, what is the expected change in net income? a. $41,202 b. $43,370 c. $45,657 d. $48,060 e. $50,463 98. During the coming year, Gold & Gold wants to increase its free cash flow by $180 million, which should result in a higher stock price. The CFO has made these projections for the upcoming year: ∙ EBIT is projected to equal $852 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 25%. ∙ 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. $175 b. $219 c. $263 d. $316 e. $379

Indicate whether the statement is true or false.

99. 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. a. True

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21. Supply Chains & Working Capital Management b. False 100. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality payments are concentrated at the beginning of each month. a. True b. False 101. 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. a. True b. False 102. The cash budget and the capital budget are handled separately, and although they are both important, they are developed completely independently of one another. a. True b. False 103. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. Thus, if the depreciation charge for the coming year doubled or halved, this would have no effect on the cash budget. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

104. 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.

105. 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 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.

106. 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.

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21. Supply Chains & Working Capital Management d. New shares issued in a stock dividend. e. Its monthly depreciation expense.

107. 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.

108. 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. $36,300 109. 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

Indicate whether the statement is true or false.

110. 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. a. True b. False 111. 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. a. True

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21. Supply Chains & Working Capital Management b. False 112. For a firm that makes heavy use of net float, being able to forecast collections and disbursement check clearings is essential. a. True b. False 113. Setting up a lockbox arrangement is one way for a firm to speed up the collection of payments from its customers. a. True b. False 114. Synchronization of cash flows is an important cash management technique, as proper synchronization can reduce the required cash balance and increase a firm's profitability. a. True b. False 115. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

116. 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.

117. 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.

118. 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

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21. Supply Chains & Working Capital Management b. $32,400 c. $36,000 d. $40,000 e. $44,000 119. 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.

120. 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.

Indicate whether the statement is true or false.

121. 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. a. True b. False 122. The maturity of most bank loans is short term. Bank loans to businesses are frequently made as 90-day notes which are often rolled over, or renewed, rather than repaid when they mature. However, if the borrower's financial situation deteriorates, then the bank may refuse to roll over the loan. a. True b. False 123. 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. a. True b. False 124. A promissory note is the document signed when a bank loan is executed, and it specifies financial aspects of the loan. a. True

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21. Supply Chains & Working Capital Management b. False 125. A line of credit can be either a formal or an informal agreement between a borrower and a bank regarding the maximum amount of credit the bank will extend to the borrower during some future period, assuming the borrower maintains its financial strength. a. True b. False 126. If a firm has set up a revolving credit agreement with a bank, the risk to the firm of being unable to obtain funds when needed is lower than if it had an informal line of credit. a. True b. False 127. A revolving credit agreement is a formal line of credit. The firm must generally pay a fee on the unused balance of the committed funds to compensate the bank for the commitment to extend those funds. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

128. 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.

129. 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. $347,288 130. 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.

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21. Supply Chains & Working Capital Management 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.

131. 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.

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21. Supply Chains & Working Capital Management Answer Key 1. b 2. False 3. False 4. True 5. False 6. c 7. d 8. b 9. a 10. True 11. False 12. True 13. True 14. True 15. True 16. False 17. True 18. False 19. e 20. b 21. a 22. b 23. e 24. False 25. False

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21. Supply Chains & Working Capital Management 26. True 27. True 28. a 29. c 30. e 31. d 32. b 33. b 34. d 35. c 36. d 37. e 38. e 39. e 40. d 41. d 42. a 43. b 44. e 45. a 46. c 47. False 48. True 49. a 50. True 51. False

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21. Supply Chains & Working Capital Management 52. True 53. True 54. True 55. True 56. True 57. False 58. False 59. True 60. True 61. False 62. False 63. d 64. a 65. b 66. a 67. a 68. c 69. False 70. False 71. True 72. True 73. True 74. True 75. True 76. True

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21. Supply Chains & Working Capital Management 77. False 78. True 79. True 80. False 81. False 82. True 83. False 84. b 85. a 86. e 87. b 88. d 89. c 90. a 91. a 92. a 93. a 94. e 95. b 96. e 97. d 98. b 99. True 100. False 101. True 102. False

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21. Supply Chains & Working Capital Management 103. False 104. a 105. e 106. a 107. d 108. d 109. c 110. True 111. True 112. True 113. True 114. True 115. False 116. c 117. d 118. d 119. c 120. c 121. False 122. True 123. True 124. True 125. True 126. True 127. True

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21. Supply Chains & Working Capital Management 128. e 129. b 130. a 131. e

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22. Providing & Obtaining Credit

Indicate whether the statement is true or false.

1. The credit period is the amount of time it takes to do a credit search on a potential customer. a. True b. False 2. Credit standards refer to the financial strength and importance of a potential customer to the firm required in order to qualify for credit. a. True b. False 3. The collection process, although sometimes difficult, is a fairly inexpensive component of doing business. a. True b. False 4. The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket expenses. a. True b. False 5. Cash discounts are mostly used to get new customers in the door since existing customers almost always use the delayed payment terms. a. True b. False 6. When deciding whether to offer a discount for cash payment, a firm must balance the profits from additional sales with the lost revenues from the discount. a. True b. False 7. The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are paying more slowly. a. True b. False 8. DSO analysis of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales. a. True b. False 9. If sales are seasonal, the days sales outstanding will fluctuate from month to month, even if the amount of time customers take to pay remains unchanged. a. True b. False 10. The percentage aging schedule of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales. a. True

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22. Providing & Obtaining Credit b. False 11. The uncollected balances schedule is constructed at the end of a quarter by dividing the dollar amount of remaining receivables from each month in that quarter by that month's sales. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

12. Which of the following is not correct? a. A more aggressive collection policy will reduce bad debt expenses, but may also decrease sales. b. Collection policy usually has little impact on sales since collecting past-due accounts occurs only after the customer has already purchased. c. Typically a firm will turn over an account to a collection agency only after it has tried several times on its own to collect the account. d. A lax collection policy will frequently lead to an increase in accounts receivable. e. Collection policy is how a firm goes about collecting past-due accounts.

13. Which of the following is not correct for a firm with seasonal sales and customers who all pay promptly at the end of 30 days? a. The quarterly uncollected balances schedule will be the same in each quarter. b. The level of accounts receivable will be constant from month to month. c. The ratio of accounts receivable to sales will vary from month to month. d. The level of accounts receivable at the end of each quarter will be the same. e. DSO will vary from month to month.

14. A firm's credit policy consists of which of the following items? a. Credit period, cash discounts, credit standards, collection policy. b. Credit period, cash discounts, receivables monitoring, collection policy. c. Cash discounts, credit standards, receivables monitoring, collection policy. d. Credit period, receivables monitoring, credit standards, collection policy. e. Credit period, cash discounts, credit standards, receivables monitoring.

15. Which of the following statements is most correct? a. It is possible for a firm to overstate profits by offering very lenient credit terms which encourage additional sales to financially "weak" firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts. b. A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity. c. Firms use seasonal dating primarily to decrease their DSO. d. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the original sale took place on February 1st, the customer can take the discount up until March 15th, but must pay the net invoice amount by April 1st. e. If credit sales as a percentage of a firm's total sales increases, and the volume of credit sales also increases, then the firm's accounts receivable will automatically increase.

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22. Providing & Obtaining Credit 16. Exhibit Reese Brothers Reese Brothers Publishers Inc (RBP) expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Since RBP wants to improve its profitability, the treasurer has proposed that the credit period be shortened to 15 days. This change would reduce expected sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days.

Expected bad debt losses on the remaining sales would fall to 3 percent. The variable cost percentage is 60 percent, and the cost of capital is 15 percent.

Refer to Exhibit Reese Brothers. What would be the incremental bad losses if the change were made? a. $315,000 b. $260,500 c. −$260,500 (bad debt losses would decline) d. −$315,000 (Bad debt losses would decline) e. $0 (no change would occur) 17. Exhibit Reese Brothers Reese Brothers Publishers Inc (RBP) expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Since RBP wants to improve its profitability, the treasurer has proposed that the credit period be shortened to 15 days. This change would reduce expected sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days.

Expected bad debt losses on the remaining sales would fall to 3 percent. The variable cost percentage is 60 percent, and the cost of capital is 15 percent.

Refer to Exhibit Reese Brothers. What would be the incremental cost of carrying receivables if this change were made? a. $108,750 b. −$116,250 (carrying costs would decline) c. $157,900 d. −$225,000 (carrying costs would decline) e. $260,500 18. Exhibit Reese Brothers Reese Brothers Publishers Inc (RBP) expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Since RBP wants to improve its profitability, the treasurer has proposed that the credit period be shortened to 15 days. This change would reduce expected sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days.

Expected bad debt losses on the remaining sales would fall to 3 percent. The variable cost percentage is 60 percent, and the cost of capital is 15 percent.

Refer to Exhibit Reese Brothers. What are the incremental pre-tax profits from this proposal? a. $181,250 b. $271,750 c. $256,250 d. $206,500 e. $231,250 19. Exhibit Van Doren Van Doren Housing expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Also, Van Doren’s cost of capital is 15 percent, and its variable costs total 60 percent of sales. Since Van Doren wants to improve its profitability,

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22. Providing & Obtaining Credit a proposal has been made to offer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30. The consultants predict that sales would increase by $500,000, and that 50 percent of all customers would take the discount. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 4 percent.

Refer to Exhibit Van Doren. What would be the cost to Van Doren of the discounts taken? a. $116,750 b. −$108,750 c. $155,000 d. $225,000 e. $260,500 20. Exhibit Van Doren Van Doren Housing expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Also, Van Doren’s cost of capital is 15 percent, and its variable costs total 60 percent of sales. Since Van Doren wants to improve its profitability, a proposal has been made to offer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30. The consultants predict that sales would increase by $500,000, and that 50 percent of all customers would take the discount. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 4 percent.

Refer to Exhibit Van Doren. What would be the incremental bad debt losses if the change were made? a. $130,000 b. $250,000 c. −$250,000 (bad debt losses would decline) d. −$130,000 (bad debt losses would decline) e. $620,000 21. Exhibit Van Doren Van Doren Housing expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Also, Van Doren’s cost of capital is 15 percent, and its variable costs total 60 percent of sales. Since Van Doren wants to improve its profitability, a proposal has been made to offer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30. The consultants predict that sales would increase by $500,000, and that 50 percent of all customers would take the discount. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 4 percent.

Refer to Exhibit Van Doren. What would be the incremental cost of carrying receivables if the change were made? a. −$108,750 (carrying costs would decline) b. $116,250 c. $157,900 d. −$225,000 (carrying costs would decline) e. $260,000 22. Exhibit Van Doren Van Doren Housing expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Also, Van Doren’s cost of capital is 15 percent, and its variable costs total 60 percent of sales. Since Van Doren wants to improve its profitability, a proposal has been made to offer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30. The consultants predict that sales would increase by $500,000, and that 50 percent of all customers would take the discount. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 4 percent.

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22. Providing & Obtaining Credit Refer to Exhibit Van Doren. What are the incremental pre-tax profits from this proposal? a. $283,750 b. $250,500 c. $303,250 d. $493,750 e. $288,250 23. Campbell Computing Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days. The financial manager estimates that offering longer credit terms would (1) increase the days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2 percent on the old sales, would amount to 5 percent on the incremental sales only (bad debts on the old sales would stay at 2 percent). Variable costs are 80 percent of sales, and Campbell has a 15 percent receivables financing cost. What would the annual incremental pre-tax profit be if Bass extended its credit period? a. −$20,000 b. −$10,000 c. $0 d. $10,000 e. $20,000 24. Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank? a. Competitive cost of services provided. b. Size of the bank's deposits. c. Experience of personnel. d. Loyalty and willingness to assume lending risks. e. Convenience of location.

25. Exhibit Brother's Loan Your brother has just taken out a loan for $75,000. The stated (simple) interest rate on this loan is 10 percent, and the bank requires him to maintain a compensating balance equal to 15 percent of the initial face amount of the loan. He currently has $20,000 in his checking account, and he plans to maintain this balance. The loan is an add-on installment loan which he will repay in 12 equal monthly installments, beginning at the end of the first month.

Refer to Exhibit Brother's Loan. How large are your brother's monthly payments? a. $6,250 b. $7,000 c. $7,500 d. $5,250 e. $6,875 26. Exhibit Brother's Loan Your brother has just taken out a loan for $75,000. The stated (simple) interest rate on this loan is 10 percent, and the bank requires him to maintain a compensating balance equal to 15 percent of the initial face amount of the loan. He currently has $20,000 in his checking account, and he plans to maintain this balance. The loan is an add-on installment loan which he will repay in 12 equal monthly installments, beginning at the end of the first month.

Refer to Exhibit Brother's Loan. What is the nominal annual add-on interest rate on this loan? a. 10.00%

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22. Providing & Obtaining Credit b. 16.47% c. 18.83% d. 20.00% e. 24.00% 27. Suppose that you're planning a vacation and borrow $2,000 from a bank for one year at a stated annual interest rate of 14 percent, with interest prepaid (a discounted loan). Also, assume that the bank requires you to maintain a compensating balance equal to 20 percent of the initial loan value. What effective annual interest rate are you being charged? a. 14.00% b. 8.57% c. 16.28% d. 21.21% e. 28.00% 28. Faircross Farms harvests its crops four times annually and receives payment for its crop 90 days after it is picked and shipped. However, planting, irrigating, and harvesting must be done on a nearly continual schedule. The firm uses 90-day bank notes to finance its operations. The firm arranges an 11 percent discount interest loan with a 20 percent compensating balance four times annually. What is the effective annual interest rate of these discount loans? a. 11.00% b. 15.94% c. 11.46% d. 13.75% e. 12.72% 29. Gladys Turner borrowed $12,000 from the bank using a 10.19 percent "add-on", one-year installment loan, payable in four equal quarterly payments. What is the effective annual rate of interest? a. 9.50% b. 10.19% c. 15.99% d. 16.98% e. 20.38% 30. The Arthos Group needs to borrow $200,000 from its bank. The bank has offered the company a 12-month installment loan (monthly payments) with 9 percent add-on interest. What is the effective annual rate (EAR) of this loan? a. 16.22% b. 17.97% c. 17.48% d. 18.67% e. 18.00% 31. The Somerset Bank offered Blakemore Inc. the following loan alternatives in response to its request for a $75,000, 1year loan.

Alternative 1: Alternative 2:

7 percent discount interest, with a 10 percent compensating balance.

8 percent simple interest, with interest paid monthly.

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22. Providing & Obtaining Credit What is the effective annual rate on the cheaper loan? a. 8.00% b. 7.23% c. 7.67% d. 8.43% e. 8.30% 32. Harris Flooring Inc. is planning to borrow $12,000 from the bank for new sanding machines. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 12 percent discounted loan? a. 10.7% b. 12.0% c. 12.5% d. 13.6% e. 14.1% 33. Maxwell Gardens requires a $100,000 annual loan in order to pay laborers to tend and harvest its organic vegetable crop. Maxwell borrows on a discount interest basis at a nominal annual rate of 11 percent. If Maxwell must actually receive $100,000 net proceeds to finance its crop, then what must be the face value of the note? a. $111,000 b. $100,000 c. $112,360 d. $89,000 e. $108,840 34. Sunnydale Organics, Inc. harvests crops in roughly 90-day cycles based on a 360-day year. The firm receives payment from its harvests sometime after shipment. Due in part to the firm's rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds from each note, what must be the face value of each note? a. $61,856 b. $67,531 c. $60,000 d. $68,182 e. $67,423 35. Danby Design Inc. has approached the bank with its plan to borrow $12,000. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments.

What is the approximate (nominal) rate of interest on the 10.19 percent add-on loan? a. 5.10% b. 10.19% c. 12.00% d. 20.38% e. 30.57% 36. Darren's Hair Products, Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Darren takes

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22. Providing & Obtaining Credit the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount. Darren needs an additional $50,000 to support an expansion of fixed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 12 percent discount interest. Additionally, the bank requires an average compensating balance of 20 percent of the loan amount. Darren already has a commercial checking account at this bank that could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Darren would otherwise keep in the account. Which of the following statements is most correct? a. The cost of using additional trade credit is approximately 36 percent. b. Considering only the explicit costs, Darren should finance the expansion with the bank loan. c. The cost of expanding trade credit using the approximation formula is less than the cost of the bank loan.

However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan. d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Darren would hold a cash balance of one-half the compensating balance amount even if the loan were not taken. e. If Darren had transaction balances that exceeded the compensating balance requirement, the effective cost of the bank loan would be 12.00 percent.

37. Tillyard Inc. requires a $25,000 1-year loan. The bank offers to make the loan, and it offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent nominal interest, daily compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments. The first two loans would require a single payment at the end of the year, the third would require 12 equal monthly payments beginning at the end of the first month. What is the difference between the highest and lowest effective annual rates? a. 1.12% b. 2.48% c. 3.60% d. 4.25% e. 5.00% 38. No Tree Too Tall, Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 10.19 percent add-on loan? a. 9.50% b. 10.19% c. 15.22% d. 16.99% e. 22.05%

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22. Providing & Obtaining Credit Answer Key 1. False 2. False 3. False 4. True 5. False 6. True 7. True 8. False 9. True 10. False 11. True 12. a 13. b 14. a 15. a 16. d 17. b 18. e 19. c 20. d 21. a 22. a 23. e 24. d 25. e

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22. Providing & Obtaining Credit 26. d 27. d 28. b 29. d 30. c 31. e 32. d 33. c 34. a 35. d 36. d 37. c 38. d

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23. Other Topics in Working Capital Management

Indicate whether the statement is true or false.

1. The cash balances of most firms consist of transactions, compensating, precautionary, and speculative balances. We can produce a total desired cash balance by calculating the amount needed for each purpose and then summing them together. a. True b. False 2. The easier a firm's access to borrowed funds the higher its precautionary balances will be, in order to protect against sudden increases in interest rates. a. True b. False 3. For some firms, holding highly liquid marketable securities is a substitute for holding cash because a marketable securities portfolio can accomplish the same objective as cash. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

4.

Which of the following is true of the Baumol model? Note that the optimal cash transfer amount is C*. a. If the total amount of cash needed during the year increases by 20%, then C* will increase by 20%. b. If the average cash balance increases by 20%, then the total holding costs will increase by 20%. c. If the average cash balance increases by 20% the total transactions costs will increase by 20%. d. The optimal transfer amount is the same for all companies. e. If the fixed costs of selling securities or obtaining a loan (cost per transaction) increase by 20%, then C* will increase by 20%.

5. Halliday Inc. receives a $2 million payment once a year. Of this amount, $700,000 is needed for cash payments made during the next year. Each time Halliday deposits money in its account, a charge of $2.00 is assessed to cover clerical costs. If Halliday can hold marketable securities that yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit charge, what is the total cost for one year of holding the minimum cost cash balance according to the Baumol model? a. $7,483 b. $187 c. $3,741 d. $374 e. $748 6. Humphrey's Housing has been practicing cash management for some time by using the Baumol model for determining cash balances. Some time ago, the model called for an average balance (C*/2) of $500; at that time, the rate on marketable securities was 4 percent. A rapid increase in interest rates has driven the interest rate up to 9 percent. What is the appropriate average cash balance now? a. $200 b. $333 c. $414 d. $500

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23. Other Topics in Working Capital Management e. $666 7. Gemini Inc.'s optimal cash transfer amount, using the Baumol model, is $60,000. The firm's fixed cost per cash transfer of marketable securities to cash is $180, and the total cash needed for transactions annually is $960,000. On what opportunity cost of holding cash was this analysis based? a. 19.2% b. 10.4% c. 6.3% d. 12.1% e. 9.6% 8. Gemini Inc.'s optimal cash transfer amount, using the Baumol model, is $60,000. The firm's fixed cost per cash transfer of marketable securities to cash is $180. In addition, the total estimated cash costs (transfers and carrying cost) for the firm, based on 16 transactions per year, are $5,760. On what opportunity cost of holding cash was this analysis based? a. 19.2% b. 10.4% c. 6.3% d. 12.1% e. 9.6% 9. Suppose Stanley's Office Supply purchases 50,000 boxes of pens every year. Ordering costs are $100 per order and carrying costs are $0.40 per box. Moreover, management has determined that the EOQ is 5,000 boxes. The vendor now offers a quantity discount of $0.20 per box if the company buys pens in order sizes of 10,000 boxes. Determine the before-tax benefit or loss of accepting the quantity discount. (Assume the carrying cost remains at $0.40 per box whether or not the discount is taken.) a. $1,000 loss b. $1,000 benefit c. $500 loss d. $500 benefit e. $0 (The change would not affect profits.)

10. Exhibit Duckett Group The Duckett Group is trying to determine its optimal average cash balance. The firm has determined that it will need $5,000,000 net new cash during the coming year. The fixed transaction cost of converting securities to cash is $50, and the firm earns 10 percent on its marketable securities investments.

Refer to Exhibit Duckett Group. According to the Baumol model, what is the optimal transaction size for transfers from marketable securities to cash? a. $7,071 b. $38,357 c. $70,711 d. $102,956 e. $87,000 11. Exhibit Duckett Group The Duckett Group is trying to determine its optimal average cash balance. The firm has determined that it will need $5,000,000 net new cash during the coming year. The fixed transaction cost of converting securities to cash is $50, and

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23. Other Topics in Working Capital Management the firm earns 10 percent on its marketable securities investments.

Refer to Exhibit Duckett Group. According to the Baumol model, what should be Duckett's average cash balance? a. $35,356 b. $3,536 c. $22,157 d. $70,711 e. $42,918 12. Exhibit Duckett Group The Duckett Group is trying to determine its optimal average cash balance. The firm has determined that it will need $5,000,000 net new cash during the coming year. The fixed transaction cost of converting securities to cash is $50, and the firm earns 10 percent on its marketable securities investments.

Refer to Exhibit Duckett Group. What will be the total cost to Duckett of maintaining the optimal average cash balance, as determined by the Baumol model? a. $35,356 b. $7,071 c. $18,493 d. $70,711 e. $53,190

Indicate whether the statement is true or false.

13. A just-in-time system is designed to stretch accounts payable as long as possible. a. True b. False 14. If a company increases its safety stock, then its EOQ will go up. a. True b. False 15. If a company increases its safety stock, then its average inventory will go up. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

16. Which of the following would cause average inventory holdings to decrease, other things held constant? a. The purchase price of inventory items decreases by 50 percent. b. The carrying price of an item decreases (as a percent of purchase price). c. The sales forecast is revised downward by 10 percent. d. Interest rates fall. e. Fixed order costs double.

17. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ.

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23. Other Topics in Working Capital Management a. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%. b. If the average inventory increases by 20%, then the total carrying costs will increase by 20%. c. If the average inventory increases by 20% the total order costs will increase by 20%. d. The EOC is the same for all companies. e. If the fixed per order cost increases by 20%, then EOQ will increase by 20%.

18. Each year, Holly's Best Salad Dressing, Inc. (HBSD) purchases 50,000 gallons of extra virgin olive oil. Ordering costs are $100 per order, and the carrying cost, as a percentage of inventory value, is 80 percent. The purchase price to HBSD is $0.50 per gallon. Management currently orders the EOQ each time an order is placed. No safety stock is carried. The supplier is now offering a quantity discount of $0.03 per gallon if HBSD orders 10,000 gallons at a time. Should HBSD take the discount? a. From a cost standpoint, HBSD is indifferent. b. No, the cost exceeds the benefit by $500. c. No, the cost exceeds the benefit by $1,000. d. Yes, the benefit exceeds the cost by $500. e. Yes, the benefit exceeds the cost by $1,120.

19. New England Charm, Inc. specializes in selling scented candles. The company has established a policy of reordering inventory every 30 days. A recently employed MBA has considered New England's inventory problem from the EOQ model viewpoint. If the following constitute the relevant data, how does the current policy compare with the optimal policy?

Ordering cost = $10 per order Carrying cost = 20% of purchase price Purchase price = $10 per unit Total sales for year = 1,000 units Safety stock =0 a. Total costs will be the same, since the current policy is optimal. b. Total costs under the current policy will be less than total costs under the EOQ by $10. c. Total costs under the current policy exceed those under the EOQ by $3. d. Total costs under the current policy exceed those under the EOQ by $10. e. Cannot be determined due to insufficient information.

20. Exhibit Cartwright Computing Cartwright Computing expects to order 126,000 memory chips for inventory during the coming year, and it will use this inventory at a constant rate. Fixed ordering costs are $200 per order; the purchase price per chip is $25; and the firm's inventory carrying costs is equal to 20 percent of the purchase price. (Assume a 360-day year.)

Refer to Exhibit Cartwright Computing. What is the economic ordering quantity for chips? a. 12,088 b. 3,175 c. 6,243 d. 13,675 e. 8,124 21. Exhibit Cartwright Computing Cartwright Computing expects to order 126,000 memory chips for inventory during the coming year, and it will use this

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23. Other Topics in Working Capital Management inventory at a constant rate. Fixed ordering costs are $200 per order; the purchase price per chip is $25; and the firm's inventory carrying costs is equal to 20 percent of the purchase price. (Assume a 360-day year.)

Refer to Exhibit Cartwright Computing. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is its average inventory level? a. 12,088 b. 3,175 c. 15,750 d. 13,675 e. 8,124 22. Exhibit Cartwright Computing Cartwright Computing expects to order 126,000 memory chips for inventory during the coming year, and it will use this inventory at a constant rate. Fixed ordering costs are $200 per order; the purchase price per chip is $25; and the firm's inventory carrying costs is equal to 20 percent of the purchase price. (Assume a 360-day year.)

Refer to Exhibit Cartwright Computing. Assume that Cartwright holds a safety stock equal to a 30-day supply of chips.

What is the maximum amount of inventory that will have on hand at any time, that is, what will be the inventory level right after a delivery is made? a. 9,216 b. 3,175 c. 6,243 d. 13,675 e. 8,124 23. Exhibit Cartwright Computing Cartwright Computing expects to order 126,000 memory chips for inventory during the coming year, and it will use this inventory at a constant rate. Fixed ordering costs are $200 per order; the purchase price per chip is $25; and the firm's inventory carrying costs is equal to 20 percent of the purchase price. (Assume a 360-day year.)

Refer to Exhibit Cartwright Computing. How many orders should Cartwright place during the year? a. 12 b. 25 c. 30 d. 40 e. 60 24. Exhibit Cartwright Computing Cartwright Computing expects to order 126,000 memory chips for inventory during the coming year, and it will use this inventory at a constant rate. Fixed ordering costs are $200 per order; the purchase price per chip is $25; and the firm's inventory carrying costs is equal to 20 percent of the purchase price. (Assume a 360-day year.)

Refer to Exhibit Cartwright Computing. If the lead time for placing an order is 5 days, and Cartwright holds a safety stock equal to a 30-day supply of chips, then at what inventory level should an order be placed? a. 15,570 b. 3,175 c. 12,250 d. 13,675

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23. Other Topics in Working Capital Management e. 8,124 25. Exhibit Cartwright Computing Cartwright Computing expects to order 126,000 memory chips for inventory during the coming year, and it will use this inventory at a constant rate. Fixed ordering costs are $200 per order; the purchase price per chip is $25; and the firm's inventory carrying costs is equal to 20 percent of the purchase price. (Assume a 360-day year.)

Refer to Exhibit Cartwright Computing. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is Cartwright's minimum cost of ordering and carrying inventory? a. $28,500 b. $15,950 c. $68,440 d. $34,220 e. $47,693 26. Exhibit Palmer Pens Assume that Palmer Executive Pens uses 1,440,000 gallons of ink each year. Further, assume that Palmer can order the ink at a cost of $2 per gallon plus fixed ordering costs of $100 per order. The firm's carrying cost is 20 percent of the inventory value, at cost.

Refer to Exhibit Palmer Pens. What is the firm's EOQ? a. 26,833 b. 30,040 c. 43,987 d. 13,563 e. 21,456 27. Exhibit Palmer Pens Assume that Palmer Executive Pens uses 1,440,000 gallons of ink each year. Further, assume that Palmer can order the ink at a cost of $2 per gallon plus fixed ordering costs of $100 per order. The firm's carrying cost is 20 percent of the inventory value, at cost.

Refer to Exhibit Palmer Pens. What is Palmer's minimum costs of ordering and holding inventory? a. $6,254 b. $10,733 c. $11,560 d. $13,563 e. $19,825 28. Exhibit Palmer Pens Assume that Palmer Executive Pens uses 1,440,000 gallons of ink each year. Further, assume that Palmer can order the ink at a cost of $2 per gallon plus fixed ordering costs of $100 per order. The firm's carrying cost is 20 percent of the inventory value, at cost.

Refer to Exhibit Palmer Pens. Now, suppose the manufacturer offers a discount of 0.5 percent for orders of a least 40,000 gallons. Should Palmer increase its ordering quantity to take the discount? a. Yes; it will save $827 if it takes the discount. b. No; it will lose $827 if it takes the discount.

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23. Other Topics in Working Capital Management c. Yes; it will save $14,400 if it takes the discount. d. Yes; it will save $13,573 if it takes the discount. e. No; it will lose $13,573 if it takes the discount.

29. During times of inflation, which of these inventory accounting methods is best for cash flow? a. LIFO, because the most expensive goods are recorded as being sold first, resulting in a higher cost of goods sold and a lower reported net income. b. Specific identification, because it correctly identifies the actual item sold and so the actual cost is recorded on the income statement. c. Weighted average, because it smoothes the reported cost of goods sold over time. d. It doesn't matter which you use since cash flow is unaffected by the choice of inventory identification method. e. FIFO, because the cheapest goods are recorded as being sold first, resulting in lower cost of goods sold and higher reported net income.

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23. Other Topics in Working Capital Management Answer Key 1. False 2. False 3. True 4. b 5. d 6. b 7. e 8. e 9. d 10. c 11. a 12. b 13. False 14. False 15. True 16. c 17. b 18. e 19. c 20. b 21. a 22. d 23. d 24. c 25. c

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23. Other Topics in Working Capital Management 26. a 27. b 28. d 29. a

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24. Enterprise Risk Management

Indicate whether the statement is true or false.

1. One objective of risk management can be to reduce the volatility of a firm's cash flows. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

2. Which of the following are NOT ways risk management can be used to increase the value of a firm? a. Risk management can help a firm maintain its optimal capital budget. b. Risk management can reduce the expected costs of financial distress. c. Risk management can help firms minimize taxes. d. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments. e. Risk management can increase debt capacity.

3. Which of the following statements about interest rate and reinvestment rate risk is CORRECT? a. Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested. b. Interest rate price risk can be eliminated by holding zero coupon bonds. c. Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds. d. Interest rate risk can never be reduced. e. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.

Indicate whether the statement is true or false.

4. Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses. a. True b. False 5. In theory, reducing the volatility of its cash flows will always increase a company's value. a. True b. False 6. The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long" and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

7. A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT? a. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies,

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24. Enterprise Risk Management say dollars and pounds. b. Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties. c. A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market. d. A company can swap fixed interest payments for floating interest payments. e. A swap involves the exchange of cash payment obligations.

8. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates? a. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates. b. Purchase principal only (PO) strips that decline in value whenever interest rates rise. c. Enter into a short hedge where the bank agrees to sell interest rate futures. d. Sell some of the bank's floating-rate loans and use the proceeds to make fixed-rate loans. e. Buying inverse floaters.

9. Company A can issue floating-rate debt at LIBOR + 1% and can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5% and can issue fixed-rate debt at 9.4%. Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. What are the resulting net payments of A and B? a. A pays a fixed rate of 9%, B pays LIBOR + 1.5%. b. A pays a fixed rate of 8.95%, B pays LIBOR + 1.45%. c. A pays LIBOR plus 1%, B pays a fixed rate of 9.4%. d. A pays a fixed rate of 7.95%, B pays LIBOR. e. None of the above answers is correct.

10. Suppose the September CBOT Treasury bond futures contract has a quoted price of 89'09. What is the implied annual interest rate inherent in this futures contract? a. 6.32% b. 6.65% c. 7.00% d. 7.35% e. 7.72% 11. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80'07. What is the implied annual interest rate inherent in the futures contract? a. 6.86% b. 7.22% c. 7.60% d. 8.00% e. 8.40% 12. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80'07. If annual interest rates go up by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, and round to the

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24. Enterprise Risk Management nearest whole dollar.) a. −$78.00 b. −$82.00 c. −$86.00 d. −$90.00 e. −$95.00

Indicate whether the statement is true or false.

13. Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

14. Which of the following statements is most CORRECT? a. Futures contracts generally trade on an organized exchange and are marked to market daily. b. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts. c. There are futures contracts for currencies but no forward contracts for currencies. d. Futures contracts don't have any margin requirements but forward contracts do. e. One advantage of forward contracts is that they are default free.

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24. Enterprise Risk Management Answer Key 1. True 2. d 3. a 4. False 5. False 6. False 7. c 8. c 9. b 10. c 11. d 12. a 13. True 14. a

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25. Bankruptcy, Reorganization, & Liquidation

Indicate whether the statement is true or false.

1. A central question that must be addressed in bankruptcy proceedings is whether the firm's inability to meet scheduled interest payments results from a temporary cash flow problem or from a potentially permanent problem caused by falling asset values. a. True b. False 2. In the event of bankruptcy under the federal bankruptcy laws, debtholders have a prior claim to a firm's income and assets before both common and preferred stockholders. Moreover, in a bankruptcy all debtholders are treated equally as a single class of claimants. a. True b. False 3. The basic doctrine of fairness under bankruptcy provisions states that claims must be recognized in the order of their legal and contractual priority. a. True b. False 4. The primary test of feasibility in a reorganization is whether the firm's fixed charges after reorganization can be covered by its projected cash flows. a. True b. False 5. Even if a firm's cash flow projections indicate that it will soon be unable to meet its interest payments, a bankruptcy case cannot begin until the firm actually defaults on a scheduled payment. a. True b. False 6. One of the actions that can be taken in bankruptcy under the standard of feasibility is to replace existing management with a new team if the quality of management is judged to have been substandard. a. True b. False 7. Bankruptcy plays no role in settling labor disputes and product liability suits. Such issues are outside the bounds of bankruptcy law and are covered by other statutes. a. True b. False 8. Bankruptcy laws have been used to help reach settlements in major product liability lawsuits. By using financial projections to show that contingent claims against the company jeopardize its existence, agreements are reached, partially satisfying claimants, and allowing the firm to continue operating. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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25. Bankruptcy, Reorganization, & Liquidation 9. What would be the priority of the claims as to the distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act? 1 is the highest claim, 5 is the lowest.

(1) (2) (3) (4)

Trustees' costs to administer and operate the firm.

Common stockholders.

General, or unsecured, creditors.

Secured creditors, who have a claim to the proceeds from the sale of specific property pledged to secure a loan.

(5) Taxes due to federal and state governments.a.

5, 4, 1, 3, 2 b. 4, 1, 5, 3, 2 c. 5, 1, 4, 2, 3 d. 1, 5, 4, 3, 2 e. 1, 4, 3, 5, 2 10. Chapter 7 of the Bankruptcy Act is designed to do which of the following? a. Establish the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments. b. Ensure that the firm is viable after emerging from bankruptcy. c. Allow the firm to negotiate with each creditor individually. d. Provide safeguards against the withdrawal of assets by the owners of the bankrupt firm and allow insolvent debtors to discharge all of their obligations and to start over unhampered by a burden of prior debt. e. Protect shareholders against creditors.

11. Which of the following statements is most CORRECT? a. Federal bankruptcy law deals only with corporate bankruptcies. Municipal and personal bankruptcy are governed solely by state laws. b. All bankruptcy petitions are filed by creditors seeking to protect their claims against firms in financial distress.

Thus, all bankruptcy petitions are involuntary as viewed from the perspective of the firm's management. c. Chapters 11 and 7 are the most important bankruptcy chapters for financial management purposes. If a reorganization plan cannot be worked out under Chapter 11, then the company will be liquidated as prescribed in Chapter 7 of the Act. d. "Restructuring" a firm's debt can involve forgiving a certain portion of the debt, but it cannot call for changing the debt's maturity or its contractual interest rate. e. Our bankruptcy laws were enacted in the 1800s, revised in the 1930s, and have remained unaltered since that time.

12. Which of the following statements is most CORRECT? a. The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan. b. The basic doctrine of fairness states that all debtholders must be treated equally. c. Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the "public interest" is not a relevant concern. d. While a firm is in bankruptcy, the existing management is always allowed to retain control, though the court will monitor its actions closely. e. To a large extent, the decision to dissolve a firm through liquidation versus keeping it alive through reorganization depends on a determination of the value of the firm if it is rehabilitated versus the value of its

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25. Bankruptcy, Reorganization, & Liquidation assets if they are sold off individually.

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25. Bankruptcy, Reorganization, & Liquidation Answer Key 1. True 2. False 3. True 4. True 5. False 6. True 7. False 8. True 9. b 10. d 11. c 12. e

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26. Mergers & Corporate Control

Indicate whether the statement is true or false.

1. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies' pre-merger values. a. True b. False 2. Synergistic benefits can arise from a number of different sources, including operating economies of scale, financial economies, and increased managerial efficiency. a. True b. False 3. A spin-off is a type of divestiture in which the assets of a division are sold to another firm. a. True b. False 4. The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers. a. True b. False 5. The primary reason managers give for most mergers is to acquire more assets so as to increase sales and market share. a. True b. False 6. Since managers' central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm's stockholders. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

7. Which of the following are legal and acceptable reasons for the high level of merger activity in the U.S. during the 1980s? a. A profitable firm acquires a firm with large accumulated tax losses that may be carried forward. b. Attempts to stabilize earnings by diversifying. c. Purchase of assets below their replacement costs. d. Reduction in competition resulting from mergers. e. Synergistic benefits arising from mergers.

8. Which of the following statements is most CORRECT? a. The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed. b. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger. c. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what's probably a lower cost, diversification benefits is generally not a valid motive for a

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26. Mergers & Corporate Control publicly held firm. d. Operating economies are never a motive for mergers. e. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.

Indicate whether the statement is true or false.

9. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine. a. True b. False 10. One of the main reasons why foreign firms are interested in buying U.S. companies is to gain entrance to the U.S. market. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive. a. True b. False 11. If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger. a. True b. False 12. A congeneric merger is one where the merging firms operate in related businesses but do not necessarily produce the same products or have a producer-supplier relationship. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

13. A parent holding company sells shares in its subsidiary such that the parent now owns only 65% of the subsidiary and, thus, the tax returns of the parent and its subsidiary can't be consolidated. The parent receives annual dividends from the subsidiary of $2,500,000. If the parent's marginal tax rate is 25% and if the exclusion on intercompany dividends is 50%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received? a. 12.5%; $2,187,500 b. 12.5%; $2,135,000 c. 23.8%; $1,905,000 d. 12.5%; $1,750,000 e. 25.0%; $1,650,000

Indicate whether the statement is true or false.

14. Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price. a. True b. False 15. Most defensive mergers occur as a result of managers' actions to maximize shareholders' wealth.

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26. Mergers & Corporate Control a. True b. False 16. Post-merger control and the negotiated price paid by the acquirer are two of the most important issues in agreeing on the terms of a merger. a. True b. False 17. A company seeking to fight off a hostile takeover might employ the services of an investment banking firm to develop a defensive strategy. a. True b. False 18. Since a manager's central goal is to maximize the firm's stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

19. Firms use defensive tactics to fight off undesired mergers. These tactics do not include a. getting a white squire to purchase stock in the firm. b. getting white knights to bid for the firm. c. repurchasing their own stock. d. changing the bylaws to eliminate supermajority voting requirements. e. raising antitrust issues.

20. Which of the following statements is most CORRECT? a. A defensive merger is one where the firm's managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover. b. Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition. c. Cash payments are used in takeovers but never in mergers. d. Managers often are fired in takeovers, but never in mergers. e. If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger.

Indicate whether the statement is true or false.

21. Since the primary rationale for any operating merger is synergy, in planning such mergers, the development of accurate pro forma cash flows is the single most important action. a. True b. False 22. Only if a target firm's value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified.

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26. Mergers & Corporate Control a. True b. False 23. Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated. a. True b. False 24. In a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the two companies, measured as if they were operated independently. a. True b. False 25. Coca-Cola's acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger. a. True b. False 26. If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the horizon value is calculated by discounting the free cash flows plus the expected future tax shields at the weighted average cost of capital. a. True b. False 27. The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

28. Which of the following statements is most CORRECT? a. Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm's capital structure, it will not affect its overall required rate of return. b. The basic rationale for any financial merger is synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis. c. In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms. d. The primary rationale for most operating mergers is synergy. e. The acquiring firm's required rate of return in most horizontal mergers will not be affected, because the 2 firms will have similar betas.

29. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt. b. The horizon value is calculated by discounting the expected earnings at the WACC.

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26. Mergers & Corporate Control c. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC. d. The horizon value must always be more than 20 years in the future. e. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

30. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity. b. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity. c. The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity. d. The CAPV approach stands for the accounting pre-valuation approach. e. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

31. Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers has determined that Fast Fruit's current cost of equity is 17.5%; Fast Fruit currently has no debt outstanding. In Year 1, Juicers expects Fast Fruit to generate $9 million in NOPAT and invest $50 million in total net operating capital. Fast Fruit will borrow to finance this expansion, with the first interest payment ($5 million) due at Year 2. (There will be no interest due at Year 1.) In Year 2, Fast Fruit will generate $25 million in NOPAT and invest $10 million in total net operating capital. Fast Fruit's marginal tax rate is 25%.

After the second year, the free cash flows and the tax shields each will grow at a constant rate of 4%. Assume that all cash flows occur at the end of the year. If Juicers must pay $90 million to acquire Fast Fruit, what is the NPV of the proposed acquisition? (Report your answer in millions of dollars.) a. $16.75 million b. $17.63 million c. $18.56 million d. $19.53 million e. $20.56 million

Indicate whether the statement is true or false.

32. A two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction. Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal. a. True b. False 33. The distribution of synergistic gains between the stockholders of two merged firms is almost always based strictly on their respective market values before the announcement of the merger. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

34. The owners of Arthouse Inc., a national artist supplies chain, are contemplating purchasing Craftworks Inc, a smaller

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26. Mergers & Corporate Control chain. Arthouse's analysts project that the merger will result in incremental free flows and interest tax savings with a combined present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Craftworks is 16%. Craftworks has 4 million shares outstanding and no debt. Craftworks' current price is $16.25. What is the maximum price per share that Arthouse should offer? a. $16.25 b. $16.97 c. $17.42 d. $18.13 e. $19.00

Indicate whether the statement is true or false.

35. Currently (2018), mergers can be accounted for using either the purchase method or the pooling method. a. True b. False 36. Any goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes. a. True b. False 37. Although goodwill created in a merger may not be amortized for shareholder reporting purposes, it may be amortized for Federal tax purposes. a. True b. False 38. Borrowing funds on terms that would require immediate repayment of all funds if the firm is acquired, selling off valuable assets, and granting huge "golden parachutes" that open if the firm is acquired are three procedures used to defend against hostile takeovers. These strategies are known as "poison pills." a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

39. Which of the following statements is most CORRECT? a. Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm. b. Defensive mergers are designed to make a company less vulnerable to a takeover. c. Hostile mergers always create value for the acquiring firm. d. In a tender offer, the target firm's management always remain after the merger is completed. e. A conglomerate merger is one where a firm combines with another firm in the same industry.

Indicate whether the statement is true or false.

40. A joint venture is one in which two, or sometimes more, independent companies agree to combine resources in order to achieve a specific objective, usually limited in scope. a. True

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26. Mergers & Corporate Control b. False 41. The two principal advantages of holding companies are (1) the holding company can control a great deal of assets with limited equity and (2) the dividends received by the parent from the subsidiary are not taxed if the parent holds at least 50% of the subsidiary's stock. a. True b. False 42. The three main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks. a. True b. False

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26. Mergers & Corporate Control Answer Key 1. True 2. True 3. False 4. True 5. False 6. False 7. d 8. c 9. False 10. True 11. True 12. True 13. a 14. False 15. False 16. True 17. True 18. False 19. d 20. a 21. True 22. True 23. False 24. True 25. True

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26. Mergers & Corporate Control 26. False 27. True 28. d 29. c 30. b 31. c 32. False 33. False 34. d 35. False 36. False 37. True 38. True 39. b 40. True 41. False 42. False

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27. Multinational Financial Management

Indicate whether the statement is true or false.

1. Multinational financial management requires that financial analysts consider the effects of changing currency values. a. True b. False 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. a. True b. False 3. Exchange rate quotations consist solely of direct quotations. a. True b. False 4. Calculating a currency cross rate involves determining the exchange rate for two currencies by using a third currency as a base. a. True b. False 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

6. 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 d. 1.41 e. 2.81 7. 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 8. 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

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27. Multinational Financial Management c. 1.41 d. 1.64 e. 2.27 9. 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 10. 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% 11. 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

Indicate whether the statement is true or false.

12. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

13. 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

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27. Multinational Financial Management

Indicate whether the statement is true or false.

14. The United States and most other major industrialized nations currently operate under a system of floating exchange rates. a. True b. False 15. 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. a. True b. False 16. Individuals and corporations can buy or sell forward currencies to hedge their exchange rate exposure. Essentially, the process involves simultaneously selling the currency expected to appreciate in value and buying the currency expected to depreciate. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

17. 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.

18. 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

Indicate whether the statement is true or false.

19. A Eurodollar is a U.S. dollar deposited in a bank outside the United States. a. True b. False 20. The Eurodollar market is essentially a long-term market; most loans and deposits in this market have maturities longer than one year.

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27. Multinational Financial Management a. True b. False 21. 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. a. True b. False 22. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

23. 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.

24. 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.

25. 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% 26. 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%

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27. Multinational Financial Management b. 11.50% c. 17.44% d. 20.00% e. 21.79%

Indicate whether the statement is true or false.

27. Because political risk is seldom negotiable, it cannot be explicitly addressed in multinational corporate financial analysis. a. True b. False 28. The cash flows relevant for a foreign investment should, from the parent company's perspective, include the financial cash flows that the subsidiary can legally send back to the parent company plus the cash flows that must remain in the foreign country. a. True b. False 29. The cost of capital may be different for a foreign project than for an equivalent domestic project because foreign projects may be more or less risky. a. True b. False 30. When considering the risk of a foreign investment, a higher risk might arise from exchange rate risk and political risk while lower risk might result from international diversification. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

31. 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

Indicate whether the statement is true or false.

32. 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.

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27. Multinational Financial Management a. True b. False 33. 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. a. True b. False 34. Exchange rates influence a multinational firm's inventory policy because changing currency values can affect the value of inventory. a. True b. False 35. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

36. 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 37. 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 38. 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?

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27. Multinational Financial Management a. $0 b. $1,834.86 c. $4,517.26 d. $5,712.31 e. $7,547.17

Indicate whether the statement is true or false.

39. If an investor can obtain more of a foreign currency for a dollar in the forward market than in the spot market, then the forward currency is said to be selling at a discount to the spot rate. a. True b. False 40. If a dollar will buy fewer units of a foreign currency in the forward market than in the spot market, then the forward currency is said to be selling at a premium to the spot rate. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

41. 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

Indicate whether the statement is true or false.

42. A foreign currency will, on average, depreciate against the U.S. dollar at a percentage rate approximately equal to the amount by which its inflation rate exceeds that of the United States. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

43. 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% b. −4.13% c. 6.00%

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27. Multinational Financial Management d. 8.25% e. 12.00% 44. 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.

45. 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 46. 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 47. 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? a. 123.75 Swiss francs b. 454.55 Swiss francs c. 750.00 Swiss francs d. 1,237.50 Swiss francs e. 1,650.00 Swiss francs 48. 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

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27. Multinational Financial Management c. $74.55 d. $85.88 e. $147.88 49. 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

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27. Multinational Financial Management Answer Key 1. True 2. False 3. False 4. True 5. True 6. d 7. b 8. b 9. b 10. d 11. c 12. False 13. a 14. True 15. True 16. False 17. e 18. d 19. True 20. False 21. False 22. True 23. d 24. c 25. d

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27. Multinational Financial Management 26. e 27. False 28. False 29. True 30. True 31. b 32. True 33. False 34. True 35. True 36. e 37. b 38. d 39. True 40. True 41. e 42. True 43. a 44. e 45. b 46. d 47. d 48. c 49. e

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28. Time Value of Money

Indicate whether the statement is true or false.

1. Starting to invest early for retirement increases the benefits of compound interest. a. True b. False 2. Starting to invest early for retirement reduces the benefits of compound interest. a. True b. False 3. A time line is meaningful even if all cash flows do not occur annually. a. True b. False 4. A time line is not meaningful unless all cash flows occur annually. a. True b. False 5. Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly. a. True b. False 6. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. a. True b. False 7. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods. a. True b. False 8. Time lines cannot be constructed for annuities unless all the payments occur at the end of the periods. a. True b. False 9. Some of the cash flows shown on a time line can be in the form of annuity payments while others can be uneven amounts. a. True b. False 10. Some of the cash flows shown on a time line can be in the form of annuity payments but none can be uneven amounts. a. True b. False 11. 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. a. True

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28. Time Value of Money b. False 12. 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. a. True b. False 13. 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.) a. True b. False 14. 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.) a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

15. 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 16. 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 17. 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 18. Your bank offers a 10-year certificate of deposit (CD) that pays 6.5% interest, compounded annually. If you invest

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28. Time Value of Money $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 19. 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 20. 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 21. 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 22. 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 23. 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

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28. Time Value of Money 24. 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 b. $1,181.62 c. $1,240.70 d. $1,302.74 e. $1,367.88

Indicate whether the statement is true or false.

25. If the discount (or interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series. a. True b. False 26. If the discount (or interest) rate is positive, the future value of an expected series of payments will always exceed the present value of the same series. a. True b. False 27. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value. a. True b. False 28. Disregarding risk, if money has time value, it is impossible for the future value of a given sum to exceed its present value. a. True b. False 29. The present value of a future sum decreases as either the discount rate or the number of periods per year increases, other things held constant. a. True b. False 30. The present value of a future sum increases as either the discount rate or the number of periods per year increases, other things held constant. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

31. 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.

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28. Time Value of Money 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.

32. 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.

33. 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 34. 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 35. 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 36. 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

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28. Time Value of Money 37. 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 38. 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

Indicate whether the statement is true or false.

39. If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate. a. True b. False 40. If a bank compounds savings accounts quarterly, the effective annual rate will exceed the nominal rate. a. True b. False 41. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by multiplying the periodic rate by the number of periods per year. a. True b. False 42. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by dividing the periodic rate by the number of periods per year. a. True b. False 43. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or greater than the nominal rate on the deposit (or loan). a. True b. False 44. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or less than the nominal rate on the deposit (or loan). a. True b. False

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Indicate the answer choice that best completes the statement or answers the 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%.

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%.

47. 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).

48. 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 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).

49. 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.

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28. Time Value of Money 50. 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. e. The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually.

51. 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%.

52. 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%.

53. 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.

54. 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.

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28. Time Value of Money 55. 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.

56. 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.

57. 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.

58. 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 59. 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 60. 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

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28. Time Value of Money 61. 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 62. 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% 63. 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% 64. 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% 65. 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% 66. Pacific Bank pays a 4.50% nominal rate on deposits, with monthly compounding. What effective annual rate (EFF%)

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28. Time Value of Money does the bank pay? a. 3.72% b. 4.13% c. 4.59% d. 5.05% e. 5.56% 67. 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% c. 16.88% d. 17.72% e. 18.61% 68. 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 69. 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%

Indicate whether the statement is true or false.

70. A "growing annuity" is a cash flow stream that grows at a constant rate for a specified number of periods. a. True b. False 71. A "growing annuity" is any cash flow stream that grows over time. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

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28. Time Value of Money 72. 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 73. 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 74. 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

Indicate whether the statement is true or false.

75. All other things held constant, the present value of a given annual annuity decreases as the number of periods per year increases. a. True b. False 76. All other things held constant, the present value of a given annual annuity increases as the number of periods per year increases. a. True b. False

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Indicate the answer choice that best completes the statement or answers the question.

77. 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. 78. 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. 79. 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 80. 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 81. 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?

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28. Time Value of Money a. $5,493.71 b. $5,782.85 c. $6,087.21 d. $6,407.59 e. $6,744.83 82. 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 83. 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 84. 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 85. 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 86. 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

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28. Time Value of Money e. $25,289 87. 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 88. 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 89. 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 90. 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 91. 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

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Indicate whether the statement is true or false.

92. When a loan is amortized, a relatively high percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage declines in the loan's later years. a. True b. False 93. When a loan is amortized, a relatively low percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage increases in the loan's later years. a. True b. False 94. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal.

The closer we are to the end of the loan's life, the greater the percentage of the payment that will be a repayment of principal. a. True b. False 95. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal.

The closer we are to the end of the loan's life, the smaller the percentage of the payment that will be a repayment of principal. a. True b. False 96. Midway through the life of an amortized loan, the percentage of the payment that represents interest must be equal to the percentage that represents repayment of principal. This is true regardless of the original life of the loan or the interest rate on the loan. a. True b. False 97. 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. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

98. 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.

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28. Time Value of Money 99. 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 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.

100. 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.

101. 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.

102. 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%.

103. Which of the following statements regarding a 20-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT?

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28. Time Value of Money 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%.

104. 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. $4,502.26 105. 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. $905.91 106. 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. $4,947.01 107. 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. $1,470.00 108. 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

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28. Time Value of Money b. $2,099.46 c. $2,209.96 d. $2,326.27 e. $2,442.59 109. 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. $9,177 110. 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. $2,930.51 111. 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. $12,468.51 112. Your business has just taken out a 1-year installment loan for $72,500 at a nominal rate of 11.0% but with equal endof-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% 113. 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 for the first year of the loan? (Assume she took out the loan on January 1.) a. $17,419.55 b. $17,593.75 c. $17,769.68 d. $17,947.38 e. $18,126.85

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28. Time Value of Money 114. 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.

115. 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.

116. 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.

117. 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.

118. 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 b. $29,959 c. $31,457 d. $33,030

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28. Time Value of Money e. $34,681 119. 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. $35,323.58 120. 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. $34,502.10 121. 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. $30,218 122. 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. $27,675.82 123. 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

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28. Time Value of Money e. 26 124. 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. 16 125. 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 c. 20 d. 21 e. 22 126. 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. 17 127. 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% 128. 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?

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28. Time Value of Money a. 3.44% b. 3.79% c. 4.17% d. 4.58% e. 5.04% 129. 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% 130. 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 e. 14.33 131. 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% 132. 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.

133. Which of the following statements is CORRECT?

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28. Time Value of Money 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.

134. 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.

135. 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. 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.

136. 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% 137. 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%

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28. Time Value of Money c. 5.46% d. 5.75% e. 6.05% 138. 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% 139. 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% d. 5.24% e. 5.77% 140. 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% 141. 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% 142. 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. 29.46 143. Your bank pays 4% interest annually. You have $2,500 invested in the bank. How long will it take for your funds to double?

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28. Time Value of Money a. 14.39 b. 15.15 c. 15.95 d. 16.79 e. 17.67 144. 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. 14.02 145. 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. 7.84 146. 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. 18.85 147. 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 d. $13,930 e. $14,626 148. 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

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28. Time Value of Money d. $17,754 e. $18,642 149. 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. $22,327 150. 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. $19,584 151. 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. $25,645 152. 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. $291,687 153. 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

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28. Time Value of Money d. $5,513 e. $5,788 154. 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% 155. 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. $94.06 156. What is the present value of the following cash flow stream at a rate of 6.25%?

a. $411.57 b. $433.23 c. $456.03 d. $480.03 e. $505.30 157. What is the present value of the following cash flow stream at a rate of 12.0%?

a. $9,699 b. $10,210 c. $10,747 d. $11,284 e. $11,849 158. What is the present value of the following cash flow stream at a rate of 8.0%?

a. $7,917 b. $8,333

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28. Time Value of Money c. $8,772 d. $9,233 e. $9,695 159. 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%?

a. $5,987 b. $6,286 c. $6,600 d. $6,930 e. $7,277 160. At a rate of 6.5%, what is the future value of the following cash flow stream?

a. $526.01 b. $553.69 c. $582.83 d. $613.51 e. $645.80 161. 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. $146.87 162. 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. $6,294.00 163. 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.

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28. Time Value of Money a. 23 b. 27 c. 32 d. 38 e. 44 164. 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. 58.57 165. 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% 166. 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. $71,588 167. 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?

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28. Time Value of Money a. $3,726 b. $3,912 c. $4,107 d. $4,313 e. $4,528 168. 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

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28. Time Value of Money Answer Key 1. True 2. False 3. True 4. False 5. True 6. False 7. True 8. False 9. True 10. False 11. False 12. True 13. True 14. False 15. d 16. d 17. a 18. a 19. c 20. c 21. b 22. b 23. b 24. b 25. False

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28. Time Value of Money 26. True 27. True 28. False 29. True 30. False 31. c 32. c 33. a 34. a 35. e 36. e 37. b 38. b 39. False 40. True 41. True 42. False 43. True 44. False 45. d 46. e 47. a 48. d 49. e 50. a 51. d

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28. Time Value of Money 52. e 53. b 54. c 55. a 56. e 57. e 58. c 59. d 60. b 61. d 62. b 63. d 64. a 65. e 66. c 67. b 68. b 69. d 70. True 71. False 72. b 73. c 74. e 75. True 76. False

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28. Time Value of Money 77. e 78. b 79. e 80. e 81. e 82. e 83. b 84. a 85. c 86. c 87. d 88. d 89. b 90. b 91. e 92. False 93. True 94. True 95. False 96. False 97. True 98. d 99. e 100. c 101. a 102. c

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28. Time Value of Money 103. c 104. a 105. c 106. e 107. d 108. d 109. b 110. b 111. e 112. e 113. a 114. c 115. e 116. d 117. e 118. a 119. d 120. c 121. c 122. d 123. a 124. b 125. e 126. c 127. b

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28. Time Value of Money 128. a 129. e 130. e 131. a 132. e 133. d 134. d 135. a 136. c 137. e 138. d 139. d 140. b 141. b 142. e 143. e 144. d 145. e 146. e 147. c 148. c 149. a 150. a 151. c 152. d 153. b

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28. Time Value of Money 154. a 155. b 156. e 157. c 158. d 159. a 160. e 161. a 162. a 163. d 164. b 165. d 166. c 167. a 168. c

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29. Basic Financial Tools: A Review

Indicate whether the statement is true or false.

1. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. a. True b. False 2. Some of the cash flows shown on a time line can be in the form of annuity payments while others can be uneven amounts. a. True b. False 3. If the discount (or interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series. a. True b. False 4. Disregarding risk, if money has time value, it is impossible for the future value of a given sum to exceed its present value. a. True b. False 5. If a bank compounds savings accounts quarterly, the effective annual rate will exceed the nominal rate. a. True b. False 6. A "growing annuity" is a cash flow stream that grows at a constant rate for a specified number of periods. a. True b. False 7. 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. a. True b. False 8. 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. a. True b. False 9. For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures. a. True b. False 10. 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.) a. True

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29. Basic Financial Tools: A Review b. False 11. 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. a. True b. False 12. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. a. True b. False 13. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return. a. True b. False 14. When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk. a. True b. False 15. Diversification will normally reduce the riskiness of a portfolio of stocks. a. True b. False 16. An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held. a. True b. False 17. Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return. a. True b. False 18. One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM. a. True b. False 19. According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a welldiversified portfolio. a. True

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29. Basic Financial Tools: A Review b. False 20. According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. a. True b. False 21. 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. a. True b. False 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.) a. True b. False 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. a. True b. False 24. All other things held constant, the present value of a given annual annuity decreases as the number of periods per year increases. a. True b. False 25. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by dividing the periodic rate by the number of periods per year. a. True b. False 26. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or less than the nominal rate on the deposit (or loan). a. True b. False 27. When a loan is amortized, a relatively low percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage increases in the loan's later years. a. True b. False 28. 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.

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29. Basic Financial Tools: A Review a. True b. False 29. 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%. a. True b. False 30. 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%. a. True b. False 31. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant. a. True b. False 32. 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. a. True b. False 33. Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk. a. True b. False 34. A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms. a. True b. False 35. A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. a. True b. False 36. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False 37. 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.

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29. Basic Financial Tools: A Review a. True b. False 38. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky. a. True b. False 39. 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. a. True b. False 40. A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios. a. True b. False 41. 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. a. True b. False 42. 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. a. True b. False 43. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM. a. True b. False 44. Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return. a. True b. False 45. Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant. a. True b. False 46. The slope of the SML is determined by the value of beta. a. True

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29. Basic Financial Tools: A Review b. False 47. If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a welldiversified investor, assuming that the observed relationship is expected to continue in the future. a. True b. False 48. If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the riskfree rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future. a. True b. False 49. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate. a. True b. False 50. 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. a. True b. False 51. Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk. a. True b. False 52. Midway through the life of an amortized loan, the percentage of the payment that represents interest must be equal to the percentage that represents repayment of principal. This is true regardless of the original life of the loan or the interest rate on the loan. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

53. 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.

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29. Basic Financial Tools: A Review 54. 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.

55. 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.

56. 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.

57. 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. e. A 10-year $100 annuity.

58. 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.

59. 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

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29. Basic Financial Tools: A Review 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.

60. 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.

61. 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.

62. 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%.

63. 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.

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29. Basic Financial Tools: A Review 64. 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.

65. 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%.

66. 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).

67. 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 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).

68. 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.

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29. Basic Financial Tools: A Review e. The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually.

69. 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%.

70. 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.

71. 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. 72. 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.

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29. Basic Financial Tools: A Review e. Bond A's current yield will increase each year.

73. 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.

74. 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.

75. 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.

76. 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.

77. You are considering investing in one of 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 held as part of a well-diversified portfolio.

if it is to be held in isolation and Stock

if it is to be

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29. Basic Financial Tools: A Review a. A; B. b. B; A. c. C; A. d. C; B. e. A; A. 78. Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio? a. Standard deviation; correlation coefficient. b. Beta; variance. c. Coefficient of variation; beta. d. Beta; beta. e. Variance; correlation coefficient.

79. 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.

80. 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. 81. 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.

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29. Basic Financial Tools: A Review 82. 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. 83. 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.

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

85. 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.

86. 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 all of the market risk from the portfolio.

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29. Basic Financial Tools: A Review 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.

87. 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.

88. 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%.

89. 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. 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.

90. 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.

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29. Basic Financial Tools: A Review 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.

91. 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.

92. 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%. 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%.

93. 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.

94. 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.

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29. Basic Financial Tools: A Review 95. 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%.

96. 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.

97. 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? a. Portfolio P's expected return is equal to the expected return on Stock A. b. Portfolio P's expected return is less than the expected return on Stock B. c. Portfolio P's expected return is equal to the expected return on Stock B. d. Portfolio P's expected return is greater than the expected return on Stock C. e. Portfolio P's expected return is greater than the expected return on Stock B. 98. 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, r A,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%.

99. 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).

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29. Basic Financial Tools: A Review 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%.

100. 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.

101. 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%. 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%.

102. 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.

103. 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%.

104. Which of the following statements is CORRECT?

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29. Basic Financial Tools: A Review 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.

105. 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.

106. 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. 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. 107. 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.

108. 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.

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29. Basic Financial Tools: A Review 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.

109. Which of the following statements is CORRECT? a. The slope of the Security Market Line is beta. 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.

110. 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 likelihoods 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.

111. 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.

112. 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.

113. If a stock's dividend is expected to grow at a constant rate of 5% a year, which of the following statements is

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29. Basic Financial Tools: A Review 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.

114. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Required return 10% 12% Market price $25 $40 Expected growth 7% 9% a. These two stocks must have the same dividend yield. b. These two stocks should have the same expected return. c. These two stocks must have the same expected capital gains yield. d. These two stocks must have the same expected year-end dividend. e. These two stocks should have the same price.

115. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $40 Expected growth 7% 9% Expected return 10% 12% a. The two stocks could not be in equilibrium with the numbers given in the question. b. A's expected dividend is $0.50. c. B's expected dividend is $0.75. d. A's expected dividend is $0.75 and B's expected dividend is $1.20. e. The two stocks should have the same expected dividend.

116. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $25 Expected growth (constant) 10% 5% Required return 15% 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. 117. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium,

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29. Basic Financial Tools: A Review which of the following statements is CORRECT? X Y Price $30 $30 Expected growth (constant) 6% 4% Required return 12% 10% a. Stock Y has a higher dividend yield than Stock X. b. One year from now, Stock X's price is expected to be higher than Stock Y's price. c. Stock X has the higher expected year-end dividend. d. Stock Y has a higher capital gains yield. e. Stock X has a higher dividend yield than Stock Y. 118. 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? $3.00 Expected dividend, D1 $50 Current Price, P0 Expected constant growth rate 6.0% a. The stock's expected dividend yield and growth rate are equal. b. The stock's expected dividend yield is 5%. c. The stock's expected capital gains yield is 5%. d. The stock's expected price 10 years from now is $100.00. e. The stock's required return is 10%.

119. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $25 $25 Expected dividend yield 5% 3% Required return 12% 10% a. Stock X pays a higher dividend per share than Stock Y. b. One year from now, Stock X should have the higher price. c. Stock Y has a lower expected growth rate than Stock X. d. Stock Y has the higher expected capital gains yield. e. Stock Y pays a higher dividend per share than Stock X. 120. 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%.

121. 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?

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29. Basic Financial Tools: A Review 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.

122. 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.

123. 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.

124. 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 B Beta 1.10 0.90 Constant growth rate 7.00% 7.00% a. Stock A must have a higher dividend yield than Stock B. b. Stock B's dividend yield equals its expected dividend growth rate. c. Stock B must have the higher required return. d. Stock B could have the higher expected return. e. Stock A must have a higher stock price than Stock B. 125. 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

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29. Basic Financial Tools: A Review 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.

126. 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.

127. 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.

128. 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%.

129. 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.

130. 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.

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29. Basic Financial Tools: A Review 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. 131. 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. $252.08 132. 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. $2,165.46 133. 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. $331.96 134. 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. $15.28 135. 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. $2,735.75 136. Suppose a State of New Mexico bond will pay $1,000 eight years from now. If the going interest rate on these 8-year

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29. Basic Financial Tools: A Review bonds is 5.5%, how much is the bond worth today? a. $651.60 b. $684.18 c. $718.39 d. $754.31 e. $792.02 137. 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. $1,311.17 138. 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. $3,435.74 139. 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% d. 5.24% e. 5.77% 140. 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% 141. 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 d. $13,930

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29. Basic Financial Tools: A Review e. $14,626 142. 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. $22,327 143. 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. $25,645 144. 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. $20,633 145. 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. $62,311 146. 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. $13,690.10 147. What's the present value of a perpetuity that pays $250 per year if the appropriate interest rate is 5%? a. $4,750

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29. Basic Financial Tools: A Review b. $5,000 c. $5,250 d. $5,513 e. $5,788 148. 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% 149. 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. $1,019.06 150. 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. $917.01 151. 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% 152. 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% 153. Sentry Corp. bonds have an annual coupon payment of 7.25%. The bonds have a par value of $1,000, a current price

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29. Basic Financial Tools: A Review 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% 154. 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. $983.49 155. 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% 156. 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. 1.46 157. 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 b. 0.72 c. 0.80 d. 0.89 e. 0.98 158. 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%

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29. Basic Financial Tools: A Review d. 12.25% e. 12.55% 159. 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% c. 6.09% d. 6.25% e. 6.40% 160. 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. $19.22 161. 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. $25.57 162. 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. $18.01 163. 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%

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29. Basic Financial Tools: A Review 164. $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. $41.69 165. 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. $44.46 166. 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? a. 4.12% b. 4.34% c. 4.57% d. 4.81% e. 5.05% 167. 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% 168. 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% 169. 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?

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29. Basic Financial Tools: A Review a. 7.54% b. 7.73% c. 7.93% d. 8.13% e. 8.34% 170. 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% 171. 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. $1,725.94 172. 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. $1,011,374 173. 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. $346,795 174. 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

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29. Basic Financial Tools: A Review d. $261,545 e. $274,622 175. 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. $10,446 176. 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. $35,323.58 177. 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. $30,218 178. 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% 179. 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%

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29. Basic Financial Tools: A Review e. 8.41% 180. 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. $94.06 181. What is the present value of the following cash flow stream at a rate of 6.25%?

a. $411.57 b. $433.23 c. $456.03 d. $480.03 e. $505.30 182. 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%?

a. $5,987 b. $6,286 c. $6,600 d. $6,930 e. $7,277 183. At a rate of 6.5%, what is the future value of the following cash flow stream?

a. $526.01 b. $553.69 c. $582.83 d. $613.51 e. $645.80 184. 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?

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29. Basic Financial Tools: A Review a. 6.77% b. 7.13% c. 7.50% d. 7.88% e. 8.27% 185. 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. $2,223 186. 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. $1,873.76 187. 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. $1,187 188. 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% 189. 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%

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29. Basic Financial Tools: A Review e. 0.24% 190. 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% 191. 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. $146.87 192. 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. $6,294.00 193. 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. $4,502.26 194. 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. $905.91 195. Your cousin will sell you his coffee shop for $250,000, with "seller financing," at a 6.0% nominal annual rate. The

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29. Basic Financial Tools: A Review 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. $4,947.01 196. 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. $1,470.00 197. 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. $2,442.59 198. 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. 44 199. 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% 200. 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?

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29. Basic Financial Tools: A Review a. $1,077.01 b. $1,104.62 c. $1,132.95 d. $1,162.00 e. $1,191.79 201. 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. 1,174.93 202. 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 Total debt and equity

$10,000,000 2,000,000 10,000,000 4,000,000 $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. $7,898,650 203. Macintosh Lumber believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock?

State of the Economy Boom Normal Recession a. 0.2839 b. 0.3069 c. 0.3299 d. 0.3547 e. 0.3813

Probability of State Occurring 0.45 0.50 0.05

Stock's Expected Return 25% 15% 5%

204. Martin Ortner holds a $200,000 portfolio consisting of the following stocks: Stock

Investment

Beta

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29. Basic Financial Tools: A Review A B C D Total

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

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. 1.143 205. 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. 1.56 206. 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. −0.286 207. 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?

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29. Basic Financial Tools: A Review a. 1.286 b. 1.255 c. 1.224 d. 1.194 e. 1.165 208. 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% 209. 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? a. 13.51% b. 13.86% c. 14.21% d. 14.58% e. 14.95% 210. 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. 9.58% b. 10.09% c. 10.62% d. 11.18% e. 11.77%

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

Beta 1.50 −0.50 1.25 0.75

211. 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

1.00 10.20% 6.00% 30.00% 2.00%

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29. Basic Financial Tools: A Review a. 14.00% b. 14.70% c. 15.44% d. 16.21% e. 17.02% 212. 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% 213. 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. $31.90 214. 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. $20.55 215. 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 riskfree 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. $16.03 216. 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

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29. Basic Financial Tools: A Review b. $1.05 c. $1.16 d. $1.27 e. $1.40 217. 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. $3.25 218. 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 ? a. $37.52 b. $39.40 c. $41.37 d. $43.44 e. $45.61 219. 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% 220. 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% 221. 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

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29. Basic Financial Tools: A Review c. 10.35 d. 12.18 e. 14.33 222. 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. $18,563.53 223. 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% 224. 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. $2,930.51 225. 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. $12,468.51 226. 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

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29. Basic Financial Tools: A Review c. $64,932 d. $68,179 e. $71,588 227. 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% 228. 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. $927.60 229. 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. $1,043.28 230. 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. $45.99 231. 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%

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29. Basic Financial Tools: A Review c. 8.40% d. 8.82% e. 9.26% 232. Your business has just taken out a 1-year installment loan for $72,500 at a nominal rate of 11.0% but with equal endof-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% 233. On January 1, 2016, 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 2016? a. $17,419.55 b. $17,593.75 c. $17,769.68 d. $17,947.38 e. $18,126.85 234. 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. $4,448 235. 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. $98,043 236. 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.

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29. Basic Financial Tools: A Review 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. $4,528 237. 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. $291,687 238. 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. $5,218.30 239. 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

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29. Basic Financial Tools: A Review c. $2,177.51 d. $2,292.12 e. $2,412.76 240. 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. 17.69% b. 18.62% c. 19.55% d. 20.52% e. 21.55%

Prob.

30% 40% 30%

Return 32.0% 10.0% −16.0%

241. 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% 242. 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 e. 2.04 243. 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

Amount $1,075,000 675,000 750,000 500,000

Beta 1.20 0.50 1.40 0.75

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29. Basic Financial Tools: A Review $3,000,000 a. 10.56% b. 10.83% c. 11.11% d. 11.38% e. 11.67% 244. 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% 245. 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. $31.42 246. 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 (r s) 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. $45.92 247. 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 (r s) 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. $41.70 248. The last dividend paid by Coppard Inc. was $1.25. The dividend growth rate is expected to be constant at 15% for 3

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29. Basic Financial Tools: A Review years, after which dividends are expected to grow at a rate of 6% forever. If the firm's required return (r s) is 11%, what is its current stock price? a. $30.57 b. $31.52 c. $32.49 d. $33.50 e. $34.50 249. 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. $9.94 b. $10.19 c. $10.45 d. $10.72 e. $10.99

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

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29. Basic Financial Tools: A Review Answer Key 1. False 2. True 3. False 4. False 5. True 6. True 7. False 8. True 9. True 10. False 11. False 12. False 13. True 14. True 15. True 16. False 17. False 18. True 19. True 20. True 21. False 22. False 23. True 24. True 25. False

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29. Basic Financial Tools: A Review 26. False 27. True 28. True 29. True 30. True 31. True 32. True 33. True 34. False 35. False 36. True 37. True 38. True 39. False 40. False 41. False 42. False 43. False 44. False 45. True 46. False 47. True 48. False 49. True 50. False 51. True

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29. Basic Financial Tools: A Review 52. False 53. c 54. b 55. d 56. c 57. a 58. d 59. d 60. c 61. e 62. d 63. d 64. c 65. c 66. a 67. d 68. e 69. d 70. b 71. e 72. c 73. b 74. a 75. b 76. c

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29. Basic Financial Tools: A Review 77. b 78. c 79. b 80. c 81. b 82. d 83. b 84. d 85. b 86. a 87. a 88. c 89. a 90. c 91. e 92. a 93. e 94. c 95. d 96. a 97. c 98. a 99. d 100. b 101. e 102. a

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29. Basic Financial Tools: A Review 103. e 104. d 105. c 106. e 107. d 108. c 109. d 110. c 111. e 112. d 113. d 114. a 115. d 116. e 117. b 118. a 119. a 120. c 121. e 122. a 123. e 124. a 125. d 126. a 127. e

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29. Basic Financial Tools: A Review 128. c 129. e 130. b 131. d 132. a 133. c 134. b 135. b 136. a 137. e 138. b 139. d 140. b 141. c 142. a 143. c 144. e 145. e 146. a 147. b 148. a 149. a 150. d 151. e 152. b 153. b

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29. Basic Financial Tools: A Review 154. a 155. c 156. a 157. e 158. c 159. a 160. c 161. e 162. d 163. e 164. e 165. e 166. d 167. b 168. a 169. e 170. e 171. c 172. d 173. b 174. b 175. e 176. d 177. c 178. b

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29. Basic Financial Tools: A Review 179. e 180. b 181. e 182. a 183. e 184. c 185. c 186. b 187. d 188. b 189. d 190. a 191. a 192. a 193. a 194. c 195. e 196. d 197. d 198. d 199. d 200. e 201. c 202. b 203. b 204. b

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29. Basic Financial Tools: A Review 205. b 206. d 207. e 208. e 209. e 210. e 211. a 212. a 213. a 214. a 215. a 216. b 217. b 218. a 219. e 220. e 221. e 222. b 223. d 224. b 225. e 226. c 227. e 228. c 229. c

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29. Basic Financial Tools: A Review 230. d 231. a 232. e 233. a 234. b 235. c 236. a 237. d 238. c 239. e 240. b 241. a 242. b 243. c 244. c 245. c 246. b 247. a 248. d 249. d

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30. Pension Plan Management

Indicate whether the statement is true or false.

1. Under a defined contribution plan, employees agree to contribute some percentage of their salaries, up to 20 percent, to the firm's pension fund. a. True b. False 2. If employees have a right to receive pension benefits even if they leave the company prior to retirement, their pension rights are said to be vested. a. True b. False 3. From a pure cost standpoint, a firm with a defined contribution plan would be more likely to hire older workers than a firm with a defined benefit plan. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

4. Ms. Lloyd, who is 25 and expects to retire at age 60, has just been hired by the Chambers Corporation. Ms. Lloyd's current salary is $30,000 per year, but her wages are expected to increase by 5 percent annually over the next 35 years.

Chambers has a defined benefit pension plan in which workers receive 2 percent of their final year's wages for each year of employment. Assume a world of certainty. Further, assume that all payments occur at year-end. What is Ms. Lloyd's expected annual retirement benefit, rounded to the nearest thousands of dollars? a. $35,000 b. $57,000 c. $89,000 d. $116,000 e. $132,000 5. Arnold Rossiter is a 40-year-old employee of the Barrington Company who will retire at age 60 and expects to live to age 75. The firm has promised a retirement income of $20,000 at the end of each year following retirement until death.

The firm's pension fund is expected to earn 7 percent annually on its assets and the firm uses 7% to discount pension benefits. What is Barrington's annual pension contribution to the nearest dollar for Mr. Rossiter? (Assume certainty and end-of-year cash flows.) a. $2,756 b. $3,642 c. $4,443 d. $4,967 e. $5,491

Indicate whether the statement is true or false.

6. The performance measurement of stock portfolio managers must recognize the risk inherent in the investment portfolio.

One way to incorporate risk into performance measurement is to examine the portfolio's alpha, which measures the vertical distance of the portfolio's return above or below the Security Market Line. a. True

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30. Pension Plan Management b. False

Indicate the answer choice that best completes the statement or answers the question.

7. Which of the following statements about pension plan portfolio performance is incorrect? a. Alpha analysis, which relies on the Capital Asset Pricing Model, considers the risk of the portfolio when measuring performance. b. Peer comparison examines the relative performance of portfolio managers with similar investment objectives. c. A portfolio annual return of 12 percent from one investment advisor is not necessarily better than a return of 10 percent from another advisor. d. In managing the retiree portfolio, fund managers often use immunization techniques such as alpha analysis to eliminate, or at least significantly reduce, the risk associated with changing interest rates. e. Pension fund sponsors must evaluate the performance of their portfolio managers periodically as a basis for future asset allocations.

8. Which of the following statements about pension plans if any, is incorrect? a. Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefit, such as $500 per month or 50 percent of the employee's final salary. b. A portable pension plan is one that an employee can carry from one employer to another. c. An employer's obligation is satisfied under a defined contribution plan when it makes the required contributions to the plan. The risk of inadequate investment returns is borne by the employee. d. If assets exceed the present value of benefits, the pension plan is fully funded. e. A defined contribution plan is, in effect, a savings plan that is funded by employers, although many plans also permit additional contributions by employees.

9. Which of the following statements about defined contribution plans is incorrect? a. In general, employees can choose the investment vehicle under a defined contribution plan. Thus, highly riskaverse employees can choose low-risk investments, while more risk-tolerant employees can choose high-risk investments. b. In a defined contribution plan, the employer must make larger-than-average contributions to the pension plan when investment returns have been below expectations. c. Defined benefit plans are used more often by large corporations than by small companies. d. The PBGC insures a portion of pension benefits. e. A defined contribution plan places the risk of poor pension portfolio performance on the employee.

10. Kumar Consulting operates several stock investment portfolios that are used by firms for investment of pension plan assets. Last year, one portfolio had a realized return of 12.6 percent and a beta coefficient of 1.15. The average T-bond rate was 7 percent and the realized rate of return on the S&P 500 was 12 percent. What was the portfolio's alpha? a. −0.75% b. −0.15% c. 0% d. 0.15% e. 0.75%

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30. Pension Plan Management Answer Key 1. False 2. True 3. True 4. d 5. c 6. True 7. d 8. d 9. b 10. b

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31. Financial Management in Not-for-Profit Businesses

Indicate whether the statement is true or false.

1. The primary goal of investor-owned firms is shareholder wealth maximization, while the primary goal of not-for-profit firms is typically stated in terms of some mission; for example, to provide health care services to the communities served. a. True b. False 2. Since not-for-profit firms do not pay taxes, they receive no tax benefits whatsoever from using debt financing. a. True b. False 3. Not-for-profit firms have fund capital in place of equity capital. Since fund capital does not have to provide a return to stockholders, the appropriate cost of fund capital in a cost of capital estimate is zero. a. True b. False 4. The net present social value model formally recognizes that not-for-profit firms must consider the social value along with the financial value of proposed new projects. a. True b. False

Indicate the answer choice that best completes the statement or answers the question.

5. Which of the following statements about project risk analysis in not-for-profit firms is incorrect? a. A project's corporate beta measures the contribution of the project to the overall corporate risk of the firm. b. A project's corporate beta is found (at least conceptually) by regressing returns on the project against returns on the market portfolio. c. A project's corporate beta is defined as (σP/σF)rPF, where σP is the standard deviation of the project's returns, σF is the standard deviation of the firm's returns, and rPF is the correlation among the two sets of returns. d. In practice, it is usually difficult, if not impossible, to directly measure a project's corporate risk, so project risk analysis typically focuses on stand-alone risk. e. The market risk of a project is not relevant to not-for-profit firms.

6. Which of the following statements about municipal bond financing is most correct? a. Whereas the vast majority of Treasury and corporate bonds are held by institutions, no municipal bonds are held by individual investors. b. The primary attraction of municipal bonds to individual investors is their high before-tax yields. c. Municipal bonds usually pay higher coupon rates than corporate bonds with similar ratings. d. Municipal bonds are risk-free. e. In contrast to corporate bonds, municipal bond issues are not required to be registered with the Securities and Exchange Commission.

7. Which of the following statements about a not-for-profit firm's ownership is most correct? a. The residual earnings (profits) of not-for-profit firms can be distributed to the firm's top managers. b. Not-for-profit firms are exempt from federal taxes, but they must pay state and local taxes, including property taxes.

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31. Financial Management in Not-for-Profit Businesses c. Upon liquidation of a not-for-profit firm, the proceeds from the sale of its assets are distributed, on a pro rata basis, to the firm's employees. d. None of the profits are used for private inurement. e. Not-for-profit firms are governed by a board of trustees whose members are elected by the community at large.

8. Which of the following statements about a not-for-profit firm's cost of capital estimate is most correct? a. The capital structure weights for a not-for-profit firm are set at 50/50, because such firms can raise $1 of debt financing for each dollar of retained earnings. b. The cost of tax-exempt debt issued by not-for-profit firms is increased ("grossed up") by 1 − T in the WACC estimate to reflect the fact that such firms do not pay taxes. c. Equity (fund) capital has a cost that is roughly equivalent to the cost of retained earnings to similar investorowned companies. d. Not-for-profit firms have a zero cost of capital. e. Since a not-for-profit firm has no shareholders, its WACC estimate does not include a cost of equity (fund capital) estimate.

9. Which of the following statements about a not-for-profit firm's fund capital is most correct? a. The sole source of fund capital is the excess of revenues over expenses. b. Fund capital has a zero opportunity cost. c. Fund capital can only come from donations. d. Fund capital does not change over time. e. Fund capital is equivalent to equity capital in investor-owned firms.

10. Which of the following statements about a not-for-profit firm's sources of capital is most correct? a. Fund capital is obtained by retaining earnings⎯if all earnings are paid out as dividends, no fund capital is created. b. Preferred stock is never used by not-for-profit firms. c. Not-for-profit firms are not allowed to raise capital by borrowing. d. Not-for-profit firms usually have high dividend payouts. e. Since not-for-profit firms are tax exempt, there is no tax advantage to debt capital.

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31. Financial Management in Not-for-Profit Businesses Answer Key 1. True 2. False 3. False 4. True 5. e 6. e 7. d 8. c 9. e 10. b

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