TEST BANK Intermediate Financial Management 12th Edition by Eugene Brigham | All Chapters 1-30 by ACADEMIAMILL

CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Knowledge 2. The major advantage of a regular partnership or a corporation as a form of business organization is the fact that both offer their owners limited liability, whereas proprietorships do not. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Knowledge 3. There are three primary disadvantages of a regular partnership: (1) unlimited liability, (2) limited life of the organization, and (3) difficulty of transferring ownership. These combine to make it difficult for partnerships to attract large amounts of capital and thus to grow to a very large size. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Partnership Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT KEYWORDS:

Bloom’s: Knowledge

4. Two disadvantages of a proprietorship are (1) the relative difficulty of raising new capital and (2) the owner's unlimited personal liability for the business' debts. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Proprietorship KEYWORDS: Bloom’s: Knowledge 5. One key value of limited liability is that it lowers owners' risks and thereby enhances a firm's value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Limited liability KEYWORDS: Bloom’s: Knowledge 6. If a firm's goal is to maximize its earnings per share, this is the best way to maximize the price of the common stock and thus shareholders' wealth. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.2 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Value maximization Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT KEYWORDS:

Bloom’s: Knowledge

7. If Firm A's business is to obtain savings from individuals and then invest them in financial assets issued by other firms or individuals, Firm A is a financial intermediary. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.3 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial intermediaries KEYWORDS: Bloom’s: Knowledge 8. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Partnership KEYWORDS: Bloom’s: Comprehension 9. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Proprietorship Bloom’s: Comprehension

10. Which of the following statements is CORRECT? a. One of the disadvantages of incorporating a business is that the owners then become subject to liabilities in the event the firm goes bankrupt. b. Sole proprietorships are subject to more regulations than corporations. c. In any type of partnership, every partner has the same rights, privileges, and liability exposure as every other partner. d. Sole proprietorships and partnerships generally have a tax advantage over many corporations, especially large ones. e. Corporations of all types are subject to the corporate income tax. ANSWER: d Sole proprietorships and partnerships pay personal income tax, but they avoid the corporate RATIONALE: income tax. Small corporations that meet certain requirements can elect to be classified as S Corporations, and then the business is taxed as a partnership.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 11. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT KEYWORDS: OTHER:

Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual

12. 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. ANSWER: d Corporations have limited liability; however, they face more regulations than the other forms RATIONALE: of organization.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 13. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT KEYWORDS: OTHER:

Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 15. Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership? a. Corporations generally find it relatively difficult to raise large amounts of capital. b. Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership. c. Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization. d. Corporate investors are exposed to unlimited liability. e. Corporations generally face relatively few regulations. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate form of organization KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT OTHER:

TYPE: Multiple Choice: Conceptual

16. 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 ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.3 - LO: 1-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial transactions KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 17. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.4 - LO: 1-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 18. One drawback of switching from a partnership to the corporate form of organization is the following: a. It subjects the firm to additional regulations. Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate form of organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 19. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate form of organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 20. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Partnership form of organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 21. Which of the following statements is CORRECT? a. Corporations are at a disadvantage relative to partnerships because they have to file more reports to state and federal agencies, including the Securities and Exchange Administration, even if they are not publicly owned. b. In a regular partnership, liability for the firm's debts is limited to the amount a particular partner has invested in the business. c. A fast-growth company would be more likely to set up as a partnership for its business organization than would a slow-growth company. d. Partnerships have difficulty attracting capital in part because of their unlimited liability, the lack of impermanence of the organization, and difficulty in transferring ownership. e. A major disadvantage of a partnership relative to a corporation as a form of business organization is the high cost and practical difficulty of its formation. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Partnership form of organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 22. Which of the following statements is CORRECT? a. Most businesses (by number and total dollar sales) are organized as partnerships or proprietorships because it Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 23. 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. ANSWER: b The S corporation would allow her to take early losses as deductions against her other RATIONALE: income, hence save some taxes. Then, when the firm became profitable, she would receive dividends and pay taxes on them, but the firm itself would avoid corporate taxes and double taxation.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Firm organization Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

24. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.1 - LO: 1-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate charter and bylaws KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 25. 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. ANSWER: c It is important to have a specific set of rules that all employees are expected to follow. This RATIONALE: helps constrain actions, and it is also important to "prove" that the company is trying to do Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT right if some employee does something wrong.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.2 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Ethics STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Business ethics KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 26. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.2 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Goal of firm KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 27. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.2 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate goals and control KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 28. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.4 - LO: 1-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Security prices and interest rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 29. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.4 - LO: 1-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

and interest rates United States - OH - Default City - TBA Interest rates Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

30. 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. ANSWER: e An increase in the demand for capital by businesses will increase interest rates in the RATIONALE: economy.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.4 - LO: 1-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial markets, institu - DISC: Financial markets, institutions, and interest rates LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 31. Which of the following statements is CORRECT? a. Corporations generally are subject to more favorable tax treatment and fewer regulations than partnerships and sole proprietorships, which is why corporations do most of the business in the United States. b. Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value than are managers who do not face the threat of hostile takeovers. c. One advantage of the corporate form of organization is that liability of the owners of the firm is limited to their investment in the firm. d. Because of their simplified organization, it is easier for sole proprietorships and partnerships to raise large amounts of outside capital than it is for corporations. e. Bond covenants are an effective way to resolve conflicts between shareholders and managers. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.2 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Miscellaneous concepts Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

32. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.2 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 33. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.2 - LO: 1-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Goals of the firm, role of - DISC: Goals of the firm, role of finance, and analysis of public information Cengage Learning Testing, Powered by Cognero

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CHAPTER 1—AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Miscellaneous concepts Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 1. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.5 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Standard deviation KEYWORDS: Bloom’s: Knowledge 2. Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom’s: Knowledge 3. When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Knowledge 4. Diversification will normally reduce the riskiness of a portfolio of stocks. a. True Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Knowledge 5. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in ex ante (future) data. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Knowledge 6. The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio return KEYWORDS: Bloom’s: Knowledge 7. Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0. a. True b. False ANSWER: True POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk KEYWORDS: Bloom’s: Knowledge 8. An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk KEYWORDS: Bloom’s: Knowledge 9. Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and expected returns KEYWORDS: Bloom’s: Knowledge 10. One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and risk KEYWORDS: Bloom’s: Knowledge 11. According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a welldiversified portfolio. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and risk KEYWORDS: Bloom’s: Knowledge 12. If investors become less averse to risk, the slope of the Security Market Line (SML) will increase. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML and risk aversion KEYWORDS: Bloom’s: Knowledge 13. If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Stock market equilibrium Bloom’s: Knowledge

14. If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock market equilibrium KEYWORDS: Bloom’s: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock market equilibrium KEYWORDS: Bloom’s: Knowledge 16. Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium. a. True b. False ANSWER: False If one condition holds, then the other must also hold. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Stock market equilibrium Bloom’s: Knowledge

17. Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, its standard deviation. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.5 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Variance KEYWORDS: Bloom’s: Comprehension 18. "Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom’s: Comprehension 19. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the low standard deviation. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I TOPICS: KEYWORDS:

Risk aversion Bloom’s: Comprehension

20. Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk prem. and risk aversion KEYWORDS: Bloom’s: Comprehension 21. A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension 22. A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 23. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension 24. A stock with a beta equal to −1.0 has zero systematic (or market) risk. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension 25. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension 26. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Comprehension 27. Portfolio A has but one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value. Because of its diversification, Portfolio B will by definition be riskless. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Comprehension 28. A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Comprehension 29. The distributions of rates of return for Companies AA and BB are given below: State of the Economy Boom Normal Recession

Probability of This State Occurring 0.2 0.6 0.2

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AA 30% 10% −5%

BB −10% 5% 50% Page 9

CHAPTER 2—RISK AND RETURN: PART I We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB. a. True b. False ANSWER: False The stocks have the same expected returns, but BB does badly in booms and well in RATIONALE: recessions. Therefore, it would do more to reduce risk.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.5 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Comprehension 30. Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cor. coefficient and risk KEYWORDS: Bloom’s: Comprehension 31. Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Company-specific risk KEYWORDS: Bloom’s: Comprehension 32. We would generally find that the beta of a single security is more stable over time than the beta of a diversified Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I portfolio. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Comprehension 33. We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Comprehension 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Diversification effects KEYWORDS: Bloom’s: Comprehension 35. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM. a. True Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.9 - LO: 2-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom’s: Comprehension 36. Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Comprehension 37. A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in beta KEYWORDS: Bloom’s: Comprehension 38. Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant. a. True b. False ANSWER: True Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in beta KEYWORDS: Bloom’s: Comprehension 39. The slope of the SML is determined by the value of beta. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 40. The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 41. If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a welldiversified investor, assuming that the observed relationship is expected to continue in the future. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 42. If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the riskfree rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 43. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 44. The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions. a. True b. False ANSWER: False The slope and intercept of the SML are determined by the market, generally not the actions RATIONALE: of a single firm. However, managers can influence their firms' beta, and thus their firms' required returns.

POINTS:

Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 45. The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 46. If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM − rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and inflation KEYWORDS: Bloom’s: Comprehension 47. Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk. a. True b. False ANSWER: True POINTS: 1 Cengage Learning Testing, Powered by Cognero

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POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension 49. The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk. a. True b. False ANSWER: False The CAPM is a single-period model, and it does not take account of securities' maturities. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom’s: Comprehension 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: a Statement a is true, because if the expected return does not equal the required return, then RATIONALE: markets are not in equilibrium.

Standard Deviation 20% 10% 12%

Beta 0.59 0.61 1.29

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: b With only 4 stocks in the portfolio, unsystematic risk matters, and B has less. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Standard deviation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 53. Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE? a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta. b. The beta of an "average stock," or "the market," can change over time, sometimes drastically. c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. d. All of the statements above are true. e. The fact that a security or project may not have a past history that can be used as the basis for calculating beta. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 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. ANSWER: c Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 55. Which of the following statements is CORRECT? a. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. b. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future. c. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks. d. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF. e. The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 56. Which of the following statements is CORRECT? a. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of −0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 57. Which of the following statements is CORRECT? a. Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities. b. The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically. c. If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm. d. During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future. e. If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 58. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct. a. In equilibrium, the expected return on Stock B will be greater than that on Stock A. b. When held in isolation, Stock A has more risk than Stock B. c. Stock B would be a more desirable addition to a portfolio than A. d. In equilibrium, the expected return on Stock A will be greater than that on B. e. Stock A would be a more desirable addition to a portfolio then Stock B. ANSWER: d Cengage Learning Testing, Powered by Cognero

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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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I ANSWER: RATIONALE:

c First, note that B's beta must be zero, so either a or c must be correct. Second, note that A's returns are highest when the market's returns are negative and lowest when the market's returns are positive. This indicates that A's beta is negative. Thus, c must be correct.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 62. Which of the following statements is CORRECT? a. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one. b. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I e. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 63. Recession, inflation, and high interest rates are economic events that are best characterized as being a. company-specific risk factors that can be diversified away. b. among the factors that are responsible for market risk. c. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. d. irrelevant except to governmental authorities like the Federal Reserve. e. systematic risk factors that can be diversified away. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 64. Which of the following statements is CORRECT? a. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. b. The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. c. Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. d. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock. e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock. ANSWER: d POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and port. divers. KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 65. Which of the following statements is CORRECT? a. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk. b. A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0. c. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8. d. If you add enough randomly selected stocks to a portfolio, you can completely eliminate 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and port. divers. KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 66. Which of the following statements is CORRECT? a. A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations. b. A two-stock portfolio will always have a lower beta than a one-stock portfolio. c. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. d. A stock with an above-average standard deviation must also have an above-average beta. e. A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.7 - LO: 2-5 Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk, return, and beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 67. Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1. Stock A B C

Expected Return 10% 10% 12%

Standard Deviation 20% 10% 12%

Beta 1.0 1.0 1.4

Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT? a. Portfolio AB's coefficient of variation is greater than 2.0. b. Portfolio AB's required return is greater than the required return on Stock A. c. Portfolio ABC's expected return is 10.66667%. d. Portfolio ABC has a standard deviation of 20%. e. Portfolio AB has a standard deviation of 20%. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 68. Which of the following statements is CORRECT? a. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable. b. If a stock has a negative beta, its expected return must be negative. 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. ANSWER: a Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. return, CAPM, and beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 69. Which of the following is most likely to be true for a portfolio of 40 randomly selected stocks? a. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. b. The beta of the portfolio is less than the average of the betas of the individual stocks. c. The beta of the portfolio is equal to the average of the betas of the individual stocks. d. The beta of the portfolio is larger than the average of the betas of the individual stocks. e. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 70. If you randomly select stocks and add them to your portfolio, which of the following statements best describes what you should expect? a. Adding more such stocks will increase the portfolio's expected rate of return. b. Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk. c. Adding more such stocks will have no effect on the portfolio's risk. d. Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk. e. Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 71. Charlie and Lucinda each have $50,000 invested in stock portfolios. Charlie's has a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Lucinda's has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Charlie's and Lucinda's portfolios is zero. If Charlie and Lucinda marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio? a. The combined portfolio's beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%. b. The combined portfolio's expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. 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%. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 72. The two stocks in your portfolio, X and Y, have independent returns, so the correlation between them, rXY is zero. Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. Which of the following statements best describes the characteristics of your 2-stock portfolio? a. Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6. b. Your portfolio has a beta equal to 1.6, and its expected return is 15%. c. Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%. d. Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6. e. Your portfolio has a standard deviation of 30%, and its expected return is 15%. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I OTHER:

TYPE: Multiple Choice: Conceptual

73. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks? a. The expected return of your portfolio is likely to decline. b. The diversifiable risk will remain the same, but the market risk will likely decline. c. Both the diversifiable risk and the market risk of your portfolio are likely to decline. d. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline. e. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 74. Ann has a portfolio of 20 average stocks, and Tom has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. The required return on Ann's portfolio will be lower than that on Tom's portfolio because Ann's portfolio will have less total risk. b. Tom's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Ann's portfolio, but the required (and expected) returns will be the same on both portfolios. c. If the two portfolios have the same beta, their required returns will be the same, but Ann's portfolio will have less market risk than Tom's. d. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified. e. Ann's portfolio will have less diversifiable risk and also less market risk than Tom's portfolio. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 75. Stocks A and B are quite similar: Each has an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT? Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 76. Stocks A, B, and C are similar in some respects: Each has an expected return of 10% and a standard deviation of 25%. Stocks A and B have returns that are independent of one another; i.e., their correlation coefficient, r, equals zero. Stocks A and C have returns that are negatively correlated with one another; i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in Stock C. Which of the following statements is CORRECT? a. Portfolio AC has an expected return that is greater than 25%. b. Portfolio AB has a standard deviation that is greater than 25%. c. Portfolio AB has a standard deviation that is equal to 25%. d. Portfolio AC has a standard deviation that is less than 25%. e. Portfolio AC has an expected return that is less than 10%. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 77. Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. Your portfolio consists of 50% A and 50% B. Which of the following statements is CORRECT? a. The portfolio's expected return is 15%. b. The portfolio's standard deviation is greater than 20%. c. The portfolio's beta is greater than 1.2. d. The portfolio's standard deviation is 20%. e. The portfolio's beta is less than 1.2. Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 78. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT? 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 79. In a portfolio of three randomly selected stocks, which of the following could NOT be true; i.e., which statement is false? a. The standard deviation of the portfolio is greater than the standard deviation of one or two of the stocks. b. The beta of the portfolio is lower than the lowest of the three betas. c. The beta of the portfolio is equal to one of the three stock's betas. d. The beta of the portfolio is equal to 1. e. The standard deviation of the portfolio is less than the standard deviation of each of the stocks if they were held in isolation. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA Portfolio risk and return Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

80. Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT? a. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A. b. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2. c. If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B. d. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B. e. Stock B's required return is double that of Stock A's. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 81. Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $300,000 invested in Stock A and $100,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is CORRECT? a. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. c. Portfolio AB's expected return is 11.0%. d. Portfolio AB's beta is less than 1.2. e. Portfolio AB's standard deviation is 17.5%. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom’s: Analysis Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I OTHER:

TYPE: Multiple Choice: Conceptual

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%. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 83. Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.) a. The effect of a change in the market risk premium depends on the slope of the yield curve. b. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. c. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0. d. The effect of a change in the market risk premium depends on the level of the risk-free rate. e. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk premium KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 84. In historical data, we see that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last? Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 85. Suppose that during the coming year, the risk free rate, rRF, is expected to remain the same, while the market risk premium (rM − rRF), is expected to fall. Given this forecast, which of the following statements is CORRECT? a. The required return on all stocks will remain unchanged. b. The required return will fall for all stocks, but it will fall more for stocks with higher betas. c. The required return for all stocks will fall by the same amount. d. The required return will fall for all stocks, but it will fall less for stocks with higher betas. e. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 86. The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive. Which of the following statements is CORRECT? a. Stock B's required rate of return is twice that of Stock A. b. If Stock A's required return is 11%, then the market risk premium is 5%. Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 87. Assume that in recent years both expected inflation and the market risk premium (rM − rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes? a. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas. b. The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0. c. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. d. The required returns on all stocks have fallen by the same amount. e. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 88. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? a. If a stock's beta doubled, its required return under the CAPM would also double. b. If a stock's beta doubled, its required return under the CAPM would more than double. c. If a stock's beta were 1.0, its required return under the CAPM would be 5%. 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%. ANSWER: e Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 89. Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT? a. If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB. b. If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks will increase by the same amount. c. Since the market is in equilibrium, the required returns of the two stocks should be the same. d. If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock HB will decline but the required return of Stock LB will increase. e. If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 90. Portfolio P has equal amounts invested in each of the three stocks, A, B, and C. Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT? a. The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium. b. The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease. c. The required returns on all three stocks will increase by the amount of the increase in the market risk premium. d. The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase. e. The required return of all stocks will remain unchanged since there was no change in their betas. ANSWER: a Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 91. Which of the following statements is CORRECT? a. Other things held constant, if investors suddenly become convinced that there will be deflation in the economy, then the required returns on all stocks should increase. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 92. Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? a. If a stock has a negative beta, its required return must also be negative. b. An index fund with beta = 1.0 should have a required return less than 11%. c. If a stock's beta doubles, its required return must also double. d. An index fund with beta = 1.0 should have a required return greater than 11%. e. An index fund with beta = 1.0 should have a required return of 11%. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA CAPM, beta, and req. return Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

93. Which of the following statements is CORRECT? a. Lower beta stocks have higher required returns. b. A stock's beta indicates its diversifiable risk. c. Diversifiable risk cannot be completely diversified away. d. Two securities with the same stand-alone risk must have the same betas. e. The slope of the security market line is equal to the market risk premium. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 94. Which of the following statements is CORRECT? a. If the risk-free rate rises, then the market risk premium must also rise. b. If a company's beta is halved, then its required return will also be halved. c. If a company's beta doubles, then its required return will also double. d. The slope of the security market line is equal to the market risk premium, (rM − rRF). e. Beta is measured by the slope of the security market line. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 95. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.) a. Stock B has a higher required rate of return than Stock A. b. Portfolio P has a standard deviation of 22.5%. Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 96. Dixon Food's stock has a beta of 1.4, while Clark Café's stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM − rRF), equals 4%. Which of the following statements is CORRECT? a. If the market risk premium increases but the risk-free rate remains unchanged, Dixon's required return will increase because it has a beta greater than 1.0 but Clark's required return will decline because it has a beta less than 1.0. b. Since Dixon's beta is twice that of Clark's, its required rate of return will also be twice that of Clark's. c. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase. d. If the market risk premium decreases but the risk-free rate remains unchanged, Dixon's required return will decrease because it has a beta greater than 1.0 and Clark's will also decrease, but by more than Dixon's because it has a beta less than 1.0. e. If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Dixon since it has a higher beta. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 97. Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT? a. Stock Y must have a higher expected return and a higher standard deviation than Stock X. b. If expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount. c. If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y. d. If expected inflation declines but the market risk premium is unchanged, then the required return on both Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 98. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur? a. The required return would decrease by the same amount for both Stock A and Stock B. b. The required return would increase for Stock A but decrease for Stock B. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 99. Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant? a. The required return on both stocks would increase by 1%. b. The required return on Portfolio P would remain unchanged. c. The required return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%. d. The required return for Stock A would fall, but the required return for Stock B would increase. e. The required return on Portfolio P would increase by 1%. ANSWER: e POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 100. Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur? a. The required return on a stock with beta > 1.0 will increase. b. The return on "the market" will remain constant. c. The return on "the market" will increase. d. The required return on a stock with beta < 1.0 will decline. e. The required return on a stock with beta = 1.0 will not change. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 101. Which of the following statements is CORRECT? a. The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by its managers. b. Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming investors expect the observed relationship to continue on into the future. c. If investors become less risk averse, the slope of the Security Market Line will increase. d. If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock. e. The slope of the SML is determined by the value of beta. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA SML Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

102. How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse? a. The x-axis intercept would decline, and the slope would increase. b. The y-axis intercept would increase, and the slope would decline. c. The SML would be affected only if betas changed. d. Both the y-axis intercept and the slope would increase, leading to higher required returns. e. The y-axis intercept would decline, and the slope would increase. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 103. Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines, with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is CORRECT? a. The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. b. Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. c. The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. d. The required return of all stocks will fall by the amount of the decline in the market risk premium. e. The required return of all stocks will increase by the amount of the increase in the risk-free rate. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML, CAPM, and beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 106. Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur? a. The required rate of return will decline for stocks whose betas are less than 1.0. b. The required rate of return on the market, rM, will not change as a result of these changes. Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML and risk aversion KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 107. Which of the following statements is CORRECT? a. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt. b. If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations. c. If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks. d. An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant. e. A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML, CAPM, and port. risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 108. For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels, a. The past realized rate of return must be equal to the expected future rate of return; that is, . b. The required rate of return must equal the past realized rate of return; that is, r = . 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 = . Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I e. None of the above statements is correct. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market equilibrium KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 109. Which of the following statements is CORRECT? a. Portfolio diversification reduces the variability of returns on an individual stock. b. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events. c. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs. d. A stock with a beta of −1.0 has zero market risk if held in a 1-stock portfolio. e. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 110. You observe the following information regarding Companies X and Y: ∙ Company X has a higher expected return than Company Y. ∙ Company X has a lower standard deviation of returns than Company Y. ∙ Company X has a higher beta than Company Y. Given this information, which of the following statements is CORRECT? a. Company X has a lower coefficient of variation than Company Y. b. Company X has less market risk than Company Y. c. Company X's returns will be negative when Y's returns are positive. d. Company X's stock is a better buy than Company Y's stock. e. Company X has more diversifiable risk than Company Y. ANSWER: a Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk measures KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 111. Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P has 50% invested in Stock A and 50% invested in B. Which of the following statements is CORRECT? a. Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium. b. Portfolio P has more market risk than Stock A but less market risk than B. c. Stock A should have a higher expected return than Stock B as viewed by the marginal investor. d. Portfolio P has a coefficient of variation equal to 2.5. e. Portfolio P has a standard deviation of 25% and a beta of 1.0. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 112. For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then a. the past realized return must be equal to the expected return during the same period. b. the required return must equal the realized return in all periods. c. the expected return must be equal to both the required future return and the past realized return. d. the expected future returns must be equal to the required return. e. the expected future return must be less than the most recent past realized return. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I TOPICS: KEYWORDS: OTHER: NOTES:

Market equilibrium Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

113. Which of the following are the factors for the Fama-French model? a. The excess market return, a debt factor, and a book-to-market factor. b. The excess market return, a size factor, and a debt. c. A debt factor, a size factor, and a book-to-market factor. d. The excess market return, an industrial production factor, and a book-to-market factor. e. The excess market return, a size factor, and a book-to-market factor. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.10 - LO: 2-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Fama-French model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 114. Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT? a. The required return on the market is 10%. b. The portfolio's required return is less than 11%. c. If the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's required return will increase by more than 2%. d. If the market risk premium remains unchanged but expected inflation increases by 2%, Gretta's portfolio's required return will increase by more than 2%. e. If the stock market is efficient, Gretta's portfolio's expected return should equal the expected return on the market, which is 11%. ANSWER: c c is correct. The portfolio's beta is 1.08. Therefore, if the market risk premium increases by RATIONALE: 2.0% the portfolio's required return will increase by 2.16%.

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: e e is correct. Stock A's required return is 10% = 5% + b(6%), so b = 5%/6% = 0.83333. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 116. Portfolio AB was created by investing in a combination of Stocks A and B. Stock A has a beta of 1.2 and a standard deviation of 25%. Stock B has a beta of 1.4 and a standard deviation of 20%. Portfolio AB has a beta of 1.25 and a standard deviation of 18%. Which of the following statements is CORRECT? a. Stock A has more market risk than Stock B but less stand-alone risk. b. Portfolio AB has more money invested in Stock A than in Stock B. c. Portfolio AB has the same amount of money invested in each of the two stocks. d. Portfolio AB has more money invested in Stock B than in Stock A. e. Stock A has more market risk than Portfolio AB. ANSWER: b b is correct. Beta P = %A(1.2) + %B(1.4) = 1.25. If 50% is in each stock, then we would have RATIONALE: Beta P = 0.5(1.2) + 0.5(1.4) = 1.3. But beta P < 1.3, so more money must be invested in the low beta stock, A.

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CHAPTER 2—RISK AND RETURN: PART I 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 118. Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a −28% return. What is the firm's expected rate of return? a. 9.41% b. 9.65% c. 9.90% d. 10.15% e. 10.40% ANSWER: c RATIONALE: Prob

Conditions Good Average Poor

Prob. 0.50 0.30 0.20 1.00

Return 25.0% 10.0% −28.0%

× Return 12.50% 3.00% −5.60% 9.90%

= Expected return

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CHAPTER 2—RISK AND RETURN: PART I LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Expected return Bloom’s: Application TYPE: Multiple Choice: Problem

119. Bloome Co.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return? a. 7.72% b. 8.12% c. 8.55% d. 9.00% e. 9.50% ANSWER: d RATIONALE: Prob.

Conditions Good Average Poor

Prob. 0.25 0.50 0.25 1.00

Return 30.0% 12.0% −18.0%

× Return 7.50% 6.00% −4.50% 9.00%

= Expected return

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.5 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 120. Donald Gilmore has $100,000 invested in a 2-stock portfolio. $35,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta? a. 0.65 b. 0.72 c. 0.80 d. 0.89 e. 0.98 ANSWER: e RATIONALE: Weight

Company X Y

Investment $ 35,000 $ 65,000 $100,000

Weight 0.35 0.65 1.00

Beta 1.50 0.70

× beta 0.53 0.46 0.98

= Portfolio beta

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 121. Shirley Paul's 2-stock portfolio has a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is her portfolio's beta? a. 1.17 b. 1.23 c. 1.29 d. 1.35 e. 1.42 ANSWER: a RATIONALE: Port. Weight

Company Stock A Stock B

Investment $ 37,500 $ 62,500 $100,000

weight 0.375 0.625 1.00

Beta 0.75 1.42

× beta 0.28 0.89 1.17

= Portfolio beta

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 122. Ivan Knobel holds a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. He is in the process of buying 1,000 shares of Syngine Corp at $10 a share and adding it to his portfolio. Syngine has an expected return of 13.0% and a beta of 1.50. The total value of Ivan's current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Syngine stock? a. 10.64%; 1.17 b. 11.20%; 1.23 c. 11.76%; 1.29 d. 12.35%; 1.36 e. 12.97%; 1.42 ANSWER: b RATIONALE: Old portfolio return 11.0%

Old portfolio beta New stock return New stock beta % of portfolio in new stock = $ in New/($ in Old + $ in New) = Cengage Learning Testing, Powered by Cognero

1.20 13.0% 1.50 Page 50

CHAPTER 2—RISK AND RETURN: PART I $10,000/$100,000 = New expected portfolio return = rp = 0.1 × 13% + 0.9 × 11% = New expected portfolio beta = bp = 0.1 × 1.50 + 0.9 × 1.20 =

10% 11.20% 1.23

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 123. Calculate the required rate of return for Everest Expeditions Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. a. 10.29% b. 10.83% c. 11.40% d. 12.00% e. 12.60% ANSWER: d RATIONALE: Real rate (r*): 3.00%

IP: RPM: Beta: Required return = rRF + b(RPM) = r* + IP + b(RPM) =

4.00% 5.00% 1.00 12.00%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 124. Zacher Co.'s stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return? a. 11.36% b. 11.65% c. 11.95% d. 12.25% Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I e. 12.55% ANSWER: RATIONALE:

Beta Risk-free rate Market risk premium Required return

1.40 4.25% 5.50% 11.95%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 125. Nystrand Corporation's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium? a. 5.80% b. 5.95% c. 6.09% d. 6.25% e. 6.40% ANSWER: a Use the SML to determine the market risk premium with the given data. RATIONALE:

rs= rRF + bStock × RPM 12.25%= 5.00% + 1.25 × RPM 7.25%= RPM × 1.25 5.80%= RPM POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk premium KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 126. Martin Ortner holds a $200,000 portfolio consisting of the following stocks: Stock A B C

Investment $50,000 50,000 50,000

Beta 0.95 0.80 1.00

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CHAPTER 2—RISK AND RETURN: PART I D Total

50,000 $200,000

1.20

What is the portfolio's beta? a. 0.938 b. 0.988 c. 1.037 d. 1.089 e. 1.143 ANSWER: b RATIONALE: Stock

A B C D Total

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

Percentage 25.00% 25.00% 25.00% 25.00% 100.00%

Beta 0.95 0.80 1.00 1.20

Product 0.238 0.200 0.250 0.300 0.988

= Portfolio beta

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 127. Sherrie Hymes holds a $200,000 portfolio consisting of the following stocks. The portfolio's beta is 0.875. Stock A B C D 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 ANSWER: b RATIONALE: Original Portfolio

Stock A B C Cengage Learning Testing, Powered by Cognero

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

Percentage 25.00% 25.00% 25.00%

Beta 0.50 0.80 1.00

Product 0.125 0.200 0.250 Page 53

CHAPTER 2—RISK AND RETURN: PART I D E Total Stock A B C D E Total

$ 50,000

25.00%

$200,000

100.00%

Percentage

1.20

0.300 0.875

New Portfolio Product

Beta

25.00% 0.80 25.00% 1.00 25.00% 1.20 25.00% 1.50 New Portfolio beta =

0.200 0.250 0.300 0.375 1.125

Alternative solution: (bE − bA)(%A) + bOld = 1.125

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 ANSWER: b RATIONALE: Stock

A B C D Total POINTS: DIFFICULTY:

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

Percentage 40.00% 13.33% 26.67% 20.00% 100.00%

Beta 1.40 0.80 1.00 1.20

Product 0.56 0.11 0.27 0.24 1.17

= Portfolio beta

1 Difficulty: Moderate

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CHAPTER 2—RISK AND RETURN: PART I LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 129. Paul McLaren holds the following portfolio: Stock A B C D Total

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

Beta 1.40 0.80 1.00 1.20

Paul plans to sell Stock A and replace it with Stock E, which has a beta of 0.75. By how much will the portfolio beta change? a. −0.190 b. −0.211 c. −0.234 d. −0.260 e. −0.286 ANSWER: d RATIONALE: Original New

Stock Investment Percentage A $150,000 40.00% B $ 50,000 13.33% C $100,000 26.67% D $ 75,000 20.00% Total

$375,000

100.00%

Beta 1.400 0.800 1.000 1.200

Product 0.560 0.107 0.267 0.240

Old b = 1.173

Beta Product 0.750 0.300 0.800 0.107 1.000 0.267 1.200 0.240 New b 0.913 =

Change in beta = New − Old = −0.260 Alternative solution: (bE − bA) × %A = −0.260

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CHAPTER 2—RISK AND RETURN: PART I a. 1.286 b. 1.255 c. 1.224 d. 1.194 e. 1.165 ANSWER: RATIONALE:

% in each stock: Old stock's beta: New stock's beta: Old port. beta:

5% 0.90 1.80 1.12

New beta = (bNew − bOld) × %A + bOld = 1.165

Old market risk premium Old required return b = (Old return − rRF)/Old RPM New market risk premium New required return = rRF + b(RPM) =

4.75% 11.75% 1.32 6.75% 14.38%

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CHAPTER 2—RISK AND RETURN: PART I KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Problem

132. Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.) a. 2.75% b. 2.89% c. 3.05% d. 3.21% e. 3.38% ANSWER: e RATIONALE: Beta: A 0.70

Beta: B Market return Risk-free rate Market risk premium Required return A = rRF + bA(RPM) = Required return B = rRF + bB(RPM) = Difference

1.20 11.00% 4.25% 6.75% 8.98% 12.35% 3.38%

Beta: B A's required return Risk-free rate RPM = (A's return − rRF)/betaA = B's required return = rRF + b(RPM) = Cengage Learning Testing, Powered by Cognero

0.80 12.00% 4.75% 5.58% 9.21% Page 57

Expected inflation, IP Market risk premium, RPM Beta, b Risk-free rate = r* + IP = Required return = rRF + b(RPM) =

3.00% 4.70% 1.10 5.00% 10.17%

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CHAPTER 2—RISK AND RETURN: PART I short-term T-bills.

rs= rRF + RPM 13.00%= 6.50% + RPM 6.50%= RPM Use the SML to determine the firm's required return using the RPM calculated above.

rs= rRF + RPM × b = 6.50% + 6.50% × 1.30 = 14.95% POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 136. Gardner Electric has a beta of 0.88 and an expected dividend growth rate of 4.00% per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual return on the stock market during the past 4 years was 10.25%. Investors expect the average annual future return on the market to be 12.50%. Using the SML, what is the firm's required rate of return? a. 11.34% b. 11.63% c. 11.92% d. 12.22% e. 12.52% ANSWER: b RATIONALE: Use SML to determine the market risk premium. Note that rRF is based on T-bonds, not short-term T-bills. Also, note that the dividend growth rate is not needed.

rs= rRF + RPM 12.50%= 5.25% + RPM RPM= 7.25% Use SML to determine the firm's required return using RPM calculated above.

rs= rRF + RPM × b = 5.25% + 7.25% × 0.88 = 11.63% POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom’s: Analysis Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I OTHER:

TYPE: Multiple Choice: Problem

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% ANSWER: e RATIONALE: rM

Beta 1.50 −0.50 1.25 0.75

rRF

13.25% 7.00%

Find portfolio beta:

$ 200,000 $ 300,000 $ 500,000 $1,000,000 $2,000,000

Weight 0.100 0.150 0.250 0.500 1.000

Beta 1.50 −0.50 1.25 0.75

Product 0.1500 −0.0750 0.3125 0.3750 0.7625

= portfolio beta

Find RPM = rM − rRF = 6.25% rs = rRF + b(RPM) = 11.77%

1.00 10.20% 6.00% 30.00% 2.00%

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CHAPTER 2—RISK AND RETURN: PART I c. 15.44% d. 16.21% e. 17.02% ANSWER: RATIONALE:

Old beta Old rs = rRF + b(RPM) RPM Percentage increase in beta Increase in IP Find new beta after increase = Find old rRF: Old rs = rRF+ b(RPM): 10.2% = rRF + 1.0(6.0%): rRF = 10.2% − 6.0% = Find new rRF: Old rRF + increase in IP = Find new rs = new rRF + new beta(RPM)

1.00 10.20% 6.00% 30.00% 2.00% 1.30 4.20% 4.20% 6.20% 14.00%

Risk-free rate Required return on stock RPM = (rStock − rRF)/beta Required return on market = rRF + RPM =

4.30% 11.75% 6.06% 10.36%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 2—RISK AND RETURN: PART I STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA Return on the market Bloom’s: Analysis TYPE: Multiple Choice: Problem

140. Suppose Stan holds a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose Stan decided to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be? a. 1.17 b. 1.23 c. 1.29 d. 1.36 e. 1.43 ANSWER: c RATIONALE: Number of stocks 8

Percent in each stock = 1/number of stocks = Portfolio beta Stock that's sold Stock that's bought Change in portfolio's beta = 0.125 × (b2 − b1) = New portfolio beta

12.500% 1.25 1.00 1.35 0.0438 1.29

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.6 - LO: 2-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 141. Returns for the Alcoff Company over the last 3 years are shown below. What's the standard deviation of the firm's returns? (Hint: This is a sample, not a complete population, so the sample standard deviation formula should be used.) Year 2010 2009 2008 a. 20.08% b. 20.59% c. 21.11% d. 21.64% e. 22.18% ANSWER: RATIONALE:

Return 21.00% −12.50% 25.00%

b This is a relatively technical problem. It should be used only if calculations are emphasized in

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CHAPTER 2—RISK AND RETURN: PART I class or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions.

Year 2010 2009 2008

Return 21.00% −12.50% 25.00%

Deviation Squared from Mean Deviation 9.83% 0.97% −23.67% 5.60% 13.83% 1.91%

11.17%

8.48%

Expected return

4.24%

Sum sqd deviations Sum/(N − 1)

20.59% with SQRT = α = 20.59% Excel POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.11 - LO: 2-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Std. dev., historical returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 142. Stuart Company's manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns will have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.) Economic Conditions Strong Normal Weak a. 17.69% b. 18.62% c. 19.55% d. 20.52% e. 21.55% ANSWER: RATIONALE:

Prob. 30% 40% 30%

Return 32.0% 10.0% −16.0%

b This is a relatively technical problem. It should be used only if calculations are emphasized in class, or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions.

Economic Conditions Strong Normal Weak α = Sqrt of variance Cengage Learning Testing, Powered by Cognero

Prob. 30% 40% 30% 100%

Return This state 32.0% 10.0% −16.0% 8.8%

Dev. from Squared Sqd. dev. × Prob Mean Dev. 23.20% 10.24% 3.07% 1.20% 0.01% 0.01% −24.80% 6.15% 1.85% Variance 4.92%

18.62% 18.62% by Excel Page 63

CHAPTER 2—RISK AND RETURN: PART I POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.5 - LO: 2-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Std. dev., prob. data KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 143. Assume that your cousin holds just one stock, Eastman Chemical Bonding (ECB), which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for Wilder's Creations and Buildings (WCB). Both companies have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) Year 2011 2012 2013 2014 2015 Average return = Standard deviation = a. 3.29% b. 3.46% c. 3.65% d. 3.84% e. 4.03% ANSWER: RATIONALE:

ECB 40.00% −10.00% 35.00% −5.00% 15.00%

15.00% 22.64%

WCB 40.00% 15.00% −5.00% −10.00% 35.00% 15.00% 22.64%

d This is a relatively technical problem. It should be used only if calculations are emphasized in class or on a take-home exam where students have time to look up formulas or to use Excel or their calculator functions.

Year

ECB

WCB

2011 2012 2013 2014 2015

40.00% −10.00% 35.00% −5.00% 15.00%

40.00% 15.00% −5.00% −10.00% 35.00%

Average return = Standard deviation =

15.00% 22.64%

Reduction in the SD vs. ECB's SD:

3.84%

% ECB: 60%

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Portfolio ECB/WCB 40.00% 0.00% 19.00% −7.00% 23.00%

15.00% 18.80%

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CHAPTER 2—RISK AND RETURN: PART I POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.11 - LO: 2-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk reduction KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 144. The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50% required return. The risk-free rate is 4.20%. Henry now receives another $5.00 million, which he invests in stocks with an average beta of 0.65. What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then find the new portfolio beta.) a. 8.83% b. 9.05% c. 9.27% d. 9.51% e. 9.74% ANSWER: a RATIONALE: % of New

Old funds (millions) New funds (millions) Total portfolio Req'd return, old stocks Risk-free rate Market risk premium:

$10.00 $5.00 $15.00 9.50% 4.20% rP = rRF + b(RPM) >> 9.5% = 4.2% + 1.05(RPM) RPM = (9.5% − 4.2%)/1.05 = 5.05%

New portfolio: Old portfolio's beta New stocks' beta New portfolio beta New portfolio required return = rRF + New beta(RPM) =

Port. 66.67% 33.33% 100.00%

5.30%

1.05 0.65 0.9167 8.8270%

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CHAPTER 2—RISK AND RETURN: PART I TOPICS: KEYWORDS: OTHER:

Portfolio beta Bloom’s: Analysis TYPE: Multiple Choice: Problem

145. Hazel Morrison, a mutual fund manager, has a $40 million portfolio with a beta of 1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%. Hazel expects to receive an additional $60 million, which she plans to invest in additional stocks. After investing the additional funds, she wants the fund's required and expected return to be 13.00%. What must the average beta of the new stocks be to achieve the target required rate of return? a. 1.68 b. 1.76 c. 1.85 d. 1.94 e. 2.04 ANSWER: b RATIONALE: Old funds (millions) $ 40.00 40.00%

New funds (millions) Total new funds

$ 60.00 $100.00

Beta on existing portfolio Risk-free rate Market risk premium

1.00 4.25% 6.00%

Desired required return

13.00%

Required new bp Required beta, new stocks

60.00% 100.00%

13% = rRF + b(RPM); b = (13% − rRF)/RPM 1.4583beta = (Return − Risk-free)/RPM 1.76Req. b = (Old$/Total$) × Old b + (New$/Total$) × New b

Beta on new stocks = (Req. b − (Old$/Total$) × Old b)/(New$/Total$)

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 146. Joel Foster is the portfolio manager of the SF Fund, a $3 million hedge fund that contains the following stocks. The required rate of return on the market is 11.00% and the risk-free rate is 5.00%. What rate of return should investors expect (and require) on this fund? Stock A B C D

Amount $1,075,000 675,000 750,000 500,000

Beta 1.20 0.50 1.40 0.75

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CHAPTER 2—RISK AND RETURN: PART I $3,000,000 a. 10.56% b. 10.83% c. 11.11% d. 11.38% e. 11.67% ANSWER: RATIONALE:

Wt × beta 0.43 0.11 0.35 0.13

Company

Amount

Weight

Beta

Stock A Stock B Stock C Stock D

$1,075,000 675,000 750,000 500,000

0.358 0.225 0.250 0.167

$3,000,000

1.000

1.20 0.50 1.40 0.75 bPortfolio 1.02 Intermediate step =

Required market return Risk free rate Market risk premium = rMarket − rRF = Portfolio's required return = rRF + b(RPM) =

11.00% 5.00% 6.00%

11.11%

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.8 - LO: 2-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. beta and req. ret. KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 147. DHF Company has a beta of 1.5 and is currently in equilibrium. The required rate of return on the stock is 12.00% versus a required return on an average stock of 10.00%. Now the required return on an average stock increases by 30.0% (not percentage points). Neither betas nor the risk-free rate change. What would DHF's new required return be? a. 14.89% b. 15.68% c. 16.50% d. 17.33% e. 18.19% ANSWER: c This problem requires some algebra: RATIONALE:

CCC's beta CCC's initial required return Cengage Learning Testing, Powered by Cognero

1.50 12.00% Page 67

CHAPTER 2—RISK AND RETURN: PART I Percentage increase in required market return Initial required return on the market New required return on the market

30.0% 10.00% 13.00%

Now for the algebra: rStock = rRF + b(RPM) = rRF + 1.5(RPM) rMarket = rRF + b(RPM) = rRF + 1.0(RPM) Now insert known data and transpose: 12% = rRF + 1.5(RPM) >> 12% − rRF = 1.5(RPM) 10% = rRF + (RPM) >> 10% − rRF = 1.0(RPM) Now subtract the second equation from the first. rRF and one of the RPMs cancel, leaving: 2% = 0.5(RPM)

Now solve for RPM: RPM = 2%/0.5 Now find the risk-free rate: rRF = Initial rMarket − RPM = 10% − 4% = New RPM = New required return on the market − rRF Now find the new return on CCC = rRF + b(new RPM) =

4.00% 6.00% 7.00% 16.50%

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CHAPTER 3—RISK AND RETURN: PART II 1. The slope of the SML is determined by the value of beta. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.12 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.12 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Knowledge 3. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Knowledge 4. A stock with a beta equal to −1.0 has zero systematic (or market) risk. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Knowledge 5. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Knowledge 6. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom’s: Knowledge 7. 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 low standard deviation stock. a. True b. False ANSWER: True POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.14 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom’s: Comprehension 8. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.15 - LO: 3-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom’s: Comprehension 9. 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 ANSWER: False Managers can influence the firm's beta coefficient by changing such things as the capital RATIONALE: structure (more debt will increase beta) and changing the type of assets held by the firm (riskier assets will tend to increase beta). However, managers cannot control the risk-free rate or the return on the market.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.12 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 10. 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 ANSWER: False Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.12 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom’s: Comprehension 11. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Comprehension 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.16 - LO: 3-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Arbitrage pricing theory KEYWORDS: Bloom’s: Comprehension 13. 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 ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II a. A; B. b. B; C. c. C; A. d. C; B. e. A; A. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 14. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk measures KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 15. 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. ANSWER: b POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 16. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 17. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.14 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market equilibrium KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II 18. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.12 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CML KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 19. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 20. 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

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Stock B 0.05 0.05 0.05 0.05 0.05 Page 7

CHAPTER 3—RISK AND RETURN: PART II b. bA = 0; bB = −1. c. bA < 0; bB = 0. d. bA < −1; bB = 1. e. bA > 0; bB = 1. ANSWER: RATIONALE:

c B's returns are independent of the market, hence its beta is zero. If you plot A's returns against those of the market, you see a negative slope, hence B's beta is negative. Therefore, d is the correct answer.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 21. 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. e. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta calculation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 22. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Characteristic line KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 23. 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 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.17 - LO: 3-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Tests of the CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 24. 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%. ANSWER: b Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II RATIONALE:

Percent A 100 75 50 25 0

Percent B 0 25 50 75 100

rp 10.00% 11.25 12.50 13.75 15.00

rp = xrA + (1 − x)rB.

σp 10.00% 9.01 11.18 15.20 20.00 . But ρAB = 0, so,

. For our investor, rp = 14.75% and σp = 14.25%.

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1.00 Page 10

CHAPTER 3—RISK AND RETURN: PART II Mineral beta: Old beta:

2.00 1.12 =0.95X + 0.05(1.00) where X is the portfolio's average beta w/o Mineral. X =1.12/0.95 − 0.05 = 1.1263

New beta = 0.95X + 0.05(2.00) = 0.95 × 1.1263 + 0.05 × 2.00 = 1.1700

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 26. 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 ANSWER: RATIONALE:

Old portfolio return Old portfolio beta New stock return New stock beta Percent of portfolio in new stock:

12.0% 1.20 15.0% 2.00 10%

New expected portfolio return = rp = 0.1 × 15% + 0.9 × 12% = 12.30% New expected portfolio beta = bp = 0.1 × 2.00 + 0.9 × 1.20 = 1.28

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 27. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II 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% ANSWER: d RATIONALE: IP:

Real rate: RPM: Beta:

4.00% 3.00% 5.00% 1.00

Required return = 3% + 4% + 1.0(5%) = 12.00%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required rate of return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 28. 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% b. 38.00% c. 40.00% d. 42.00% e. 44.10% ANSWER: c RATIONALE: Beta: 2.00

Required return on stock: Required return on market: Increase in required market return:

15.0% 10.0% 30.0%

Find risk-free rate:

rs = rRF + b(rM − rRF) = rRF + b(rM) − b(rRF); rRF = b(rM) − rs rRF = b(rM) − rs = 2.0(10%) − 15% = Find new return on average stock = 10.0%(1.3) Find new market risk premium = 13% − 5% = New req. return on our stock = rs = rRF + b(rM − rRF) = 5% + 2(8%) = % increase in stock's req. return = (21% − 15%)/15% = POINTS:

5.00% 13.00% 8.00% 21.00% 40.00%

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CHAPTER 3—RISK AND RETURN: PART II DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required rate of return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 29. 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% ANSWER: RATIONALE:

Beta 1.50 −0.50 1.25 0.75

15.0% rM: rRF: 7.0% Find portfolio beta: $200,000 $300,000 $500,000 $1,000,000 $2,000,000

Weight 0.100 0.150 0.250 0.500 1.000

Beta 1.50 −0.50 1.25 0.75

Product 0.1500 −0.0750 0.3125 0.3750 0.7625

Find RPM = rM − rRF = 8.00% rs = rRF + b(RPM) = 13.10%

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CHAPTER 3—RISK AND RETURN: PART II Beta: Required return (rs) RPM: Percentage increase in beta: a. 14.00% b. 14.70% c. 15.44% d. 16.21% e. 17.02% ANSWER: a RATIONALE: Old beta:

1.50 10.20% 6.00% 20%

Old rs = rRF + b(RPM) RPM Percentage increase in beta:

1.50 10.20% 6.00% 20%

Find new beta after increase = 1.80

Find old rRF:

Old rs = rRF + b(RPM): 10.2% = rRF + 1.5(6.0%): rRF = 10.2% − 9.0% = 1.20%

Find new rRF:

Old rRF + 2.0% increase in inflation = 3.20%

Find new rs = new rRF + new beta(RPM) = 14.00%

Market −9% 11% 15% 5% −1%

UF −14% 16% 22% 7% −2%

rUnited: 15.00%

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CHAPTER 3—RISK AND RETURN: PART II e. 12.95% ANSWER: RATIONALE:

d The following graph shows that United's returns are perfectly correlated with the market.

7.00% rRF: rUnited: 15.00% Find beta: We found beta using Excel, but it could be found with a 1. calculator or using the rise-over-run method as shown below:

2. Now find RPM : rs = 15% = 7% + 1.5(RPM) RPM = (15 − 7)/1.5 = 5.33% 3. Find rM: rM = rRF + RPM = 12.33% POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 32. 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

Market 6.10% 12.90%

Stock F 6.50% −3.70%

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CHAPTER 3—RISK AND RETURN: PART II 3 16.20% a. 7.89 b. 8.30 c. 8.74 d. 9.20 e. 9.66 ANSWER: RATIONALE:

21.71%

Year Market 1 6.10% 2 12.90% 3 16.20% Years 1 and 2, beta 1 = Rise/Run = Years 2 and 3, beta 2 = Rise/Run = Difference:

Stock F 6.50% −3.70% 21.71% (−3.7 − 6.5)/(12.9 − 6.1) = −1.50 (21.71 − −3.7)/(16.2 − 12.9) = 7.70 Beta 2 − Beta 1 = 9.20

You would get the same result using a calculator to find the two betas.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.13 - LO: 3-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta's sensitivity to the base year KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 33. 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.) b. What are the beta coefficients of A and B? Calculations are necessary. c. If the risk-free rate is 6%, what is the value of rM? ANSWER: 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 a. market⎯ holding B in a diversified portfolio lowers the riskiness of the portfolio. Although it is not necessary for 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II 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: .

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

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.14 - LO: 3-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolios and risk–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Short Answer: Problem 34. You plan to invest in Stock X, Stock Y, or some combination of the two. The expected return for X is 10% and σX = 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 part of the attainable set is efficient? Also, draw in a set of hypothetical indifference curves b. 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%. Now suppose we add a riskless asset to the investment possibilities. What effects will this c. have on the construction of portfolios? Suppose rM = 12%, σM = 4%, and rRF = 6%. What would be the required and expected d. return on a portfolio with σP = 10%? e. Suppose the correlation of Stock X with the market, rXM, is 0.8, while rYM = 0.9. Use this information, along with data given previously, to determine Stock X's and Stock Y's beta Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II coefficients. What is the required rate of return on Stocks X and Y? Do these stocks appear to be in f. equilibrium? If not, what would happen to bring about an equilibrium? ANSWER:

rp = X(rX) + (1 − X)(rY)

a. X 1.00 0.75 0.50 0.25 0.00

+ rX 10% 10 10 10 10

(1 − X) 0.00 0.25 0.50 0.75 1.00

rY 12% 12 12 12 12

rp 10.0% 10.5 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:

Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II

At 0% Stock X:

b Portfoli Percen Percen . o t in X t in Y rp A B C D E

100% 0% 75 50 25 0

25 50 75 100

10.0 % 10.5 11.0 11.5 12.0

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

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.

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

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVE INTE.GENE.16.13 - LO: 3-5 S: NATIONAL STANDARDS United States - BUSPROG: Analytic : Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Risk and return United States - OH - Default City - TBA Portfolios and risk–nonalgorithmic Bloom’s: Analysis TYPE: Short Answer: Problem

35. 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. Explain what would happen to the CML if the two stocks had (a) a positive correlation b. 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? ANSWER:

ABCDE = feasible set. BCDE = efficient set of risky assets. rRFD = efficient set including riskless asset. The table below shows the returns and standard deviations for various portfolios of Securities A and B.

a. Percent of Portfolio in Security A (x) 100 75 50 25 0

Percent of Portfolio Expected Portfolio Standard Deviation of Portfolio in Security B Return Return (1 − x) 0 25 50 75 100

rr (%) 10.0 11.0 12.0 13.0 14.0

σp (%) 10.00 8.39 9.01 11.52 15.00

Calculations: rp = xrA + (1 − x)rB. Cengage Learning Testing, Powered by Cognero

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CHAPTER 3—RISK AND RETURN: PART II . rA = 10%; σA = 10%; rB = 14%; σB = 15%; rAB = 0%. 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.

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. 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.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.12 - LO: 3-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Efficient portfolios–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Short Answer: Problem

Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Issuing bonds KEYWORDS: Bloom’s: Knowledge 2. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Call provision KEYWORDS: Bloom’s: Knowledge 3. Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sinking funds KEYWORDS: Bloom’s: Knowledge 4. A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially) at par. These bonds Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION provide compensation to investors in the form of capital appreciation. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Zero coupon bond KEYWORDS: Bloom’s: Knowledge 5. The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Floating-rate debt KEYWORDS: Bloom’s: Knowledge 6. The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.19 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discounted cash flows KEYWORDS: Bloom’s: Knowledge 7. For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.19 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond prices and interest rates KEYWORDS: Bloom’s: Knowledge 8. As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Mortgage bond KEYWORDS: Bloom’s: Knowledge 9. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt coupon rate KEYWORDS: Bloom’s: Knowledge 10. There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. a. True b. False ANSWER: True POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond ratings and required returns KEYWORDS: Bloom’s: Knowledge 11. A bond that had a 20-year original maturity with 1 year left to maturity has more interest rate price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and they cannot be called.) a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Knowledge 12. Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more interest rate price risk if you purchased a 30-day bond than if you bought a 30-year bond. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Knowledge 13. Junk bonds are high risk, high yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.22 - LO: 4-15 Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Junk bond KEYWORDS: Bloom’s: Knowledge 14. A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond. a. True b. False ANSWER: False The callable bond will be called if rates fall far enough below the coupon rate, but it will not be RATIONALE: called otherwise. Thus, the call provision can only harm bondholders. Therefore, callable bonds sell at higher yields than noncallable bonds, regardless of the slope of the yield curve.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Callable bonds KEYWORDS: Bloom’s: Comprehension 15. Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income bond KEYWORDS: Bloom’s: Comprehension 16. You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investment-grade rating), both mature in 20 years, both have a 10% coupon, neither can be called except for sinking fund purposes, and both are offered to you at their $1,000 par values. However, Bond SF has a sinking fund while Bond NSF does not. Under the sinking fund, the company must call and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would generally be expected to have a higher yield than Bond NSF. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION ANSWER: RATIONALE:

False The sinking fund would give Bond SF a lower average maturity, and it would also lower its risk. Therefore, Bond SF should have a lower, not a higher, yield.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Floating-rate debt KEYWORDS: Bloom’s: Comprehension 18. A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are below 10% and at a discount if interest rates are greater than 10%. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.19 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond premiums and discounts KEYWORDS: Bloom’s: Comprehension 19. You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION bonds with this risk is 12%. a. True b. False ANSWER: True The bonds expected return (YTM) is 13.81%, which exceeds the 12% required return, so buy RATIONALE: the bond.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.19 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond value–annual payment KEYWORDS: Bloom’s: Comprehension 20. If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain above that rate, then the market value of the bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.) a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.23 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond value KEYWORDS: Bloom’s: Comprehension 21. "Restrictive covenants" are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Restrictive covenants KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 22. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant. a. True b. False ANSWER: True The reason for this is that more of the cash flows of a low-coupon bond comes late in the RATIONALE: bond's life (as the maturity payment), and later cash flows are impacted most heavily by changing market rates.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Prices and interest rates KEYWORDS: Bloom’s: Comprehension 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.23 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 24. Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds? a. Market interest rates rise sharply. b. Market interest rates decline sharply. c. The company's financial situation deteriorates significantly. Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION d. Inflation increases significantly. e. The company's bonds are downgraded. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.23 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Callable bonds KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 25. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT? a. The bond is selling below its par value. b. The bond is selling at a discount. c. If the yield to maturity remains constant, the bond's price one year from now will be lower than its current price. d. The bond's current yield is greater than 9%. e. If the yield to maturity remains constant, the bond's price one year from now will be higher than its current price. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 26. Which of the following statements is CORRECT? a. An indenture is a bond that is less risky than a mortgage bond. b. The expected return on a corporate bond will generally exceed the bond's yield to maturity. c. If a bond's coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity. d. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated. e. All else equal, senior debt generally has a lower yield to maturity than subordinated debt. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION LEARNING OBJECTIVES: INTE.GENE.16.25 - LO: 4-16 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bonds, default risk KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 27. Ranger Inc. would like to issue new 20-year bonds. Initially, the plan was to make the bonds non-callable. If the bonds were made callable after 5 years at a 5% call premium, how would this affect their required rate of return? a. There is no reason to expect a change in the required rate of return. b. The required rate of return would decline because the bond would then be less risky to a bondholder. c. The required rate of return would increase because the bond would then be more risky to a bondholder. d. It is impossible to say without more information. e. Because of the call premium, the required rate of return would decline. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Call provision KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 28. Under normal conditions, which of the following would be most likely to increase the coupon rate required to enable a bond to be issued at par? a. Adding a call provision. b. The rating agencies change the bond's rating from Baa to Aaa. c. Making the bond a first mortgage bond rather than a debenture. d. Adding a sinking fund. e. Adding additional restrictive covenants that limit management's actions. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.19 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond coupon rate KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 29. Which of the following bonds would have the greatest percentage increase in value if all interest rates fall by 1%? a. 20-year, 10% coupon bond. b. 20-year, 5% coupon bond. c. 1-year, 10% coupon bond. d. 20-year, zero coupon bond. e. 10-year, zero coupon bond. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 30. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the largest percentage increase in price? a. A 1-year bond with a 15% coupon. b. A 3-year bond with a 10% coupon. c. A 10-year zero coupon bond. d. A 10-year bond with a 10% coupon. e. An 8-year bond with a 9% coupon. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 31. Which of the following bonds has the greatest interest rate price risk? a. A 10-year, $1,000 face value, zero coupon bond. b. A 10-year, $1,000 face value, 10% coupon bond with annual interest payments. c. All 10-year bonds have the same price risk since they have the same maturity. d. A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 32. If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in value? a. A 1-year bond with an 8% coupon. b. A 10-year bond with an 8% coupon. c. A 10-year bond with a 12% coupon. d. A 10-year zero coupon bond. e. A 1-year zero coupon bond. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 33. Which of the following statements is CORRECT? a. Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature. b. A sinking fund provision makes a bond more risky to investors at the time of issuance. c. Sinking fund provisions never require companies to retire their debt; they only establish "targets" for the company to reduce its debt over time. d. If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price. e. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sinking funds KEYWORDS: Bloom’s: Analysis Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION OTHER:

TYPE: Multiple Choice: Conceptual

34. Nicholas Industries can issue a 20-year bond with a 6% annual coupon. This bond is not convertible, is not callable, and has no sinking fund. Alternatively, Nicholas could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Nicholas would have to pay on the convertible, callable bond? a. It could be less than, equal to, or greater than 6%. b. Greater than 6%. c. Exactly equal to 8%. d. Less than 6%. e. Exactly equal to 6%. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.18 - LO: 4-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertible, callable bonds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 35. The YTMs of three $1,000 face value bonds that mature in 10 years and have the same level of risk are equal. Bond A has an 8% annual coupon, Bond B has a 10% annual coupon, and Bond C has a 12% annual coupon. Bond B sells at par. Assuming interest rates remain constant for the next 10 years, which of the following statements is CORRECT? a. Since the bonds have the same YTM, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until maturity. b. Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next year. c. Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year. d. Over the next year, Bond A's price is expected to decrease, Bond B's price is expected to stay the same, and Bond C's price is expected to increase. e. Bond A's current yield will increase each year. ANSWER: c Note that Bond B sells at par, so the required return on all these bonds is 10%. B's price will RATIONALE: remain constant; A will sell initially at a discount and will rise, and C will sell initially at a premium and will decline. Note too that since it has larger cash flows from its higher coupons, Bond C would be less sensitive to interest rate changes; i.e., it has less interest rate risk. Perhaps it has less default risk.

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CHAPTER 4—BOND VALUATION KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

36. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is NOT CORRECT? a. The bond's yield to maturity is 9%. b. The bond's current yield is 9%. c. If the bond's yield to maturity remains constant, the bond will continue to sell at par. d. The bond's current yield exceeds its capital gains yield. e. The bond's expected capital gains yield is positive. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 37. Which of the following statements is CORRECT? a. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at par. b. All else equal, if a bond's yield to maturity increases, its price will fall. c. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at a premium over par. d. All else equal, if a bond's yield to maturity increases, its current yield will fall. e. A zero coupon bond's current yield is equal to its yield to maturity. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION e. The bond's coupon rate exceeds its current yield. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 39. A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following statements is CORRECT? a. If the yield to maturity remains at 8%, then the bond's price will decline over the next year. b. The bond's coupon rate is less than 8%. c. If the yield to maturity increases, then the bond's price will increase. d. If the yield to maturity remains at 8%, then the bond's price will remain constant over the next year. e. The bond's current yield is less than 8%. ANSWER: a Answers b, c, and d are clearly wrong, and answer a is clearly correct. Answer e is also RATIONALE: wrong, but this is not obvious to most people. We can demonstrate that e is incorrect by using the following example.

Par YTM Maturity Price Payment Coupon rate Current yield

$1,000 8.00% 10 $1,100 $94.90 9.49% 8.63%The current yield is greater than 8%.

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CHAPTER 4—BOND VALUATION 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 41. A 15-year bond has an annual coupon rate of 8%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 6%. Which of the following statements is CORRECT? a. The bond is currently selling at a price below its par value. b. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today. c. The bond should currently be selling at its par value. d. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today. e. If market interest rates decline, the price of the bond will also decline. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.23 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates and bond prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 42. An 8-year Treasury bond has a 10% coupon, and a 10-year Treasury bond has an 8% coupon. Both bonds have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following statements would be CORRECT? a. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price. b. The prices of both bonds would increase by the same amount. c. One bond's price would increase, while the other bond's price would decrease. d. The prices of the two bonds would remain constant. e. The prices of both bonds will decrease by the same amount. ANSWER: a We can tell by inspection that b, c, d, and e are all incorrect. That leaves answer a as the RATIONALE: only possibly correct statement. Recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 10-year, 8% coupon bond should be more sensitive to a decline in rates. You could Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION also do some calculations to confirm that a is correct.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.23 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates and bond prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 43. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT? a. The prices of both bonds will remain unchanged. b. The price of Bond A will decrease over time, but the price of Bond B will increase over time. c. The prices of both bonds will increase by 7% per year. d. The prices of both bonds will increase over time, but the price of Bond A will increase by more. e. The price of Bond B will decrease over time, but the price of Bond A will increase over time. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.23 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields and prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 44. Assume that interest rates on 15-year noncallable Treasury and corporate bonds with different ratings are as follows: T-bond = 7.72% AAA = 8.72%

A = 9.64% BBB = 10.18%

The differences in rates among these issues were most probably caused primarily by: a. Tax effects. b. Default risk differences. c. Maturity risk differences. d. Inflation differences. e. Real risk-free rate differences. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.26 - LO: 4-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Interest rates Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

45. Which of the following statements is CORRECT? a. All else equal, long-term bonds have less interest rate price risk than short-term bonds. b. All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds. c. All else equal, short-term bonds have less reinvestment rate risk than long-term bonds. d. All else equal, long-term bonds have less reinvestment rate risk than short-term bonds. e. All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest vs. reinvestment rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 46. Which of the following statements is CORRECT? a. Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds. b. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk. c. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk. d. Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds. e. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest vs. reinvestment rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 47. Which of the following statements is CORRECT? Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.27 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Term structure of interest rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 48. Which of the following statements is CORRECT? a. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity. b. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond. c. If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium. d. If a coupon bond is selling at a premium, its current yield equals its yield to maturity. e. If a coupon bond is selling at par, its current yield equals its yield to maturity. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 49. A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of the following statements is CORRECT? a. The bond has a current yield greater than 8%. b. The bond sells at a discount. c. The bond's required rate of return is less than 7.5%. d. If the yield to maturity remains constant, the price of the bond will decline over time. e. The bond sells at a price below par. Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 50. Bonds A and B are 15-year, $1,000 face value bonds. Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain constant for the next 15 years. Which of the following statements is CORRECT? a. One year from now, Bond A's price will be higher than it is today. b. Bond A's current yield is greater than 8%. c. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. d. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature. e. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 51. Which of the following statements is NOT CORRECT? a. All else equal, bonds with longer maturities have more interest rate (price) risk than bonds with shorter maturities. b. If a bond is selling at its par value, its current yield equals its yield to maturity. c. If a bond is selling at a premium, its current yield will be greater than its yield to maturity. d. All else equal, bonds with larger coupons have greater interest rate (price) risk than bonds with smaller coupons. e. If a bond is selling at a discount to par, its current yield will be less than its yield to maturity. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Bond concepts Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

52. Which of the following statements is CORRECT? a. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value. b. Other things held constant, a corporation would rather issue noncallable bonds than callable bonds. c. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond. d. Reinvestment rate risk is worse from an investor's standpoint than interest rate price risk if the investor has a short investment time horizon. e. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 53. Which of the following statements is CORRECT? a. The total yield on a bond is derived from dividends plus changes in the price of the bond. b. Bonds are riskier than common stocks and therefore have higher required returns. c. Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies. d. The market value of a bond will always approach its par value as its maturity date approaches, provided the bond's required return remains constant. e. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

54. Which of the following statements is CORRECT? a. If rates fall after its issue, a zero coupon bond could trade at a price above its par value. b. If rates fall rapidly, a zero coupon bond's expected appreciation could become negative. c. If a firm moves from a position of strength toward financial distress, its bonds' yield to maturity would probably decline. d. If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon rate. e. If a coupon bond is selling at par, its current yield equals its yield to maturity. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 55. You are considering three different bonds for your portfolio. Each bond has a 10-year maturity and a yield to maturity of 10%. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Which of the following statements is CORRECT? a. Bond X has the greatest reinvestment rate risk. b. If market interest rates decline, all of the bonds will have an increase in price, and Bond Z will have the largest percentage increase in price. c. If market interest rates remain at 10%, Bond Z's price will be 10% higher one year from today. d. If market interest rates increase, Bond X's price will increase, Bond Z's price will decline, and Bond Y's price will remain the same. e. If the bonds' market interest rates remain at 10%, Bond Z's price will be lower one year from now than it is today. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 56. Bonds A, B, and C all have a maturity of 15 years and a yield to maturity of 9%. Bond A's price exceeds its par value, Bond B's price equals its par value, and Bond C's price is less than its par value. Which of the following statements is Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 57. Which of the following statements is CORRECT? a. A 10-year, 10% coupon bond has less reinvestment rate risk than a 10-year, 5% coupon bond (assuming all else equal). b. The total return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year. c. The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond. d. A $1,000 bond with $100 annual interest payments that has 5 years to maturity and is not expected to default would sell at a discount if interest rates were below 9% and at a premium if interest rates were greater than 11%. e. 10-year, zero coupon bonds have higher reinvestment rate risk than 10-year, 10% coupon bonds. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 58. Which of the following statements is CORRECT? a. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm has filed for bankruptcy. b. Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 59. Which of the following statements is CORRECT? a. If a coupon bond is selling at a discount, then the bond's expected capital gains yield is negative. b. If a bond is selling at a discount, the yield to call is a better measure of the expected return than the yield to maturity. c. The current yield on Bond A exceeds the current yield on Bond B. Therefore, Bond A must have a higher yield to maturity than Bond B. d. If a coupon bond is selling at par, its current yield equals its yield to maturity. e. If a coupon bond is selling at a premium, then the bond's current yield is zero. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 60. Which of the following statements is CORRECT? a. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. b. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. c. If the maturity risk premium (MRP) equals zero, the yield curve must be flat. d. The yield curve can never be downward sloping. e. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the yield curve will have an upward slope. Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION ANSWER: RATIONALE:

e The slope of the yield curve depends primarily on expected inflation and the MRP. The greater the expected increase in inflation, and the higher the MRP, the steeper the slope of the yield curve. If inflation is expected to decline, then even if the MRP is positive, the curve could still have a downward slope.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.27 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield curve KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 61. Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that a. The economy is not in a recession. b. Long-term bonds are a better buy than short-term bonds. c. Maturity risk premiums could help to explain the yield curve's upward slope. d. Long-term interest rates are more volatile than short-term rates. e. Inflation is expected to decline in the future. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.27 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield curve KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 62. Which of the following statements is CORRECT? a. The most likely explanation for an inverted yield curve is that investors expect inflation to increase. b. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. c. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. d. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted. e. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.27 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Yield curve Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

63. Bonds for two companies were just issued: Short Corp.'s bonds will mature in 5 years, and Long Corp.'s bonds will mature in 15 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further, assume that the Treasury yield curve is based only on expectations about future inflation, i.e., that the maturity risk premium is zero for T-bonds. Under these conditions, which of the following statements is correct? a. If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield. b. If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds. c. If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds. d. If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal. e. If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must under all conditions have the lower yield. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.27 - LO: 4-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate yield curve KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 64. Bond A has a 9% annual coupon, while Bond B has a 7% annual coupon. Both bonds have the same maturity, a face value of $1,000, and an 8% yield to maturity. Which of the following statements is CORRECT? a. Bond A trades at a discount, whereas Bond B trades at a premium. b. If the yield to maturity for both bonds remains at 8%, Bond A's price one year from now will be higher than it is today, but Bond B's price one year from now will be lower than it is today. c. If the yield to maturity for both bonds immediately decreases to 6%, Bond A's bond will have a larger percentage increase in value. d. Bond A's current yield is greater than that of Bond B. e. Bond A's capital gains yield is greater than Bond B's capital gains yield. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond rates and prices Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

65. Which of the following statements is CORRECT? a. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond. b. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used. c. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate. d. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond. e. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Callable bonds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 66. Cornwall Corporation is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT? a. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds. b. If two tiers of debt are used (with one senior and one subordinated debt class), the subordinated debt will carry a lower interest rate. c. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond. d. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan. e. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future. ANSWER: a On statement a, note that if only $500,000 of 1st mortgage bonds were secured by $1 million RATIONALE: of property, each of those bonds would be less risky than if there were $1 million of bonds backed by the $1 million of property. Note too that the cost of the total $1 million of debt would be an average of the cost of the mortgage bonds and the debentures, and that cost could be higher, lower, or the same as if only mortgage bonds or debentures were used.

POINTS:

Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Costs of types of debt KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 67. Which of the following statements is CORRECT? a. Subordinated debt has less default risk than senior debt. b. Convertible bonds have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains. c. Junk bonds typically provide a lower yield to maturity than investment-grade bonds. d. A debenture is a secured bond that is backed by some or all of the firm's fixed assets. e. Junior debt is debt that has been more recently issued, and in bankruptcy it is paid off after senior debt because the senior debt was issued first. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.22 - LO: 4-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Types of debt KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 68. Which of the following statements is CORRECT? a. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond. b. Once a firm declares bankruptcy, it must then be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and lawyer fees. c. Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds. d. A firm with a sinking fund that gave it the choice of calling the required bonds at par or buying the bonds in the open market would generally choose the open market purchase if the coupon rate exceeded the going interest rate. e. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the debt until the bonds mature. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.25 - LO: 4-16 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Miscellaneous concepts Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

69. Which of the following statements is CORRECT? a. All else equal, a bond that has a coupon rate of 10% will sell at a discount if the required return for bonds of similar risk is 8%. b. The price of a discount bond will increase over time, assuming that the bond's yield to maturity remains constant. c. For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds. d. When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized. e. The total return on a bond during a given year consists only of the coupon interest payments received. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.25 - LO: 4-16 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 70. Which of the following statements is NOT CORRECT? a. The expected return on a corporate bond must be less than its promised return if the probability of default is greater than zero. b. All else equal, senior debt has less default risk than subordinated debt. c. A company's bond rating is affected by its financial ratios and provisions in its indenture. d. Under Chapter 11 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off its debt according to the seniority of the debt as spelled out in the Act. e. All else equal, secured debt is less risky than unsecured debt. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.25 - LO: 4-16 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Default and bankruptcy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 71. Which of the following statements is CORRECT? a. A bond is likely to be called if its market price is below its par value. b. Even if a bond's YTC exceeds its YTM, an investor with an investment horizon longer than the bond's maturity would be worse off if the bond were called. c. A bond is likely to be called if its market price is equal to its par value. d. A bond is likely to be called if it sells at a discount below par. e. A bond is likely to be called if its coupon rate is below its YTM. ANSWER: b A bond would not be called unless the current rate was below the YTM. The investor would RATIONALE: get the funds, then reinvest at the new market rate. Thus, the investor would end up earning less than the YTM, even after receiving the call premium.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Call provision KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 72. Which of the following statements is CORRECT? a. A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate. b. If a bond sells at par, then its current yield will be less than its yield to maturity. c. If a bond sells for less than par, then its yield to maturity is less than its coupon rate. d. A discount bond's price declines each year until it matures, when its value equals its par value. e. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond. ANSWER: a Answer b is incorrect because a bond selling at par must have a current yield equal to its RATIONALE: YTM. Answer c is incorrect because a bond selling at below par must have a YTM > the coupon rate. Answer d is incorrect because a discount bond's price must rise over time. Answer e is incorrect because a premium bond must have a negative capital gains yield. That leaves Answer a as the only possibly correct answer. Note that YTM = Cur Yld +/− Cap gains Yld., so Cur Yld = YTM +/− Cap gain yld. The cap gains yld will be positive or negative depending on whether the coupon rate is above or below the YTM. That means that the Cur yld must either equal the YTM or be between the YTM and the coupon rate. a's correctness is also demonstrated below:

Par Maturity Coup rate YTM Ann coup Price Cur Yield Cengage Learning Testing, Powered by Cognero

Par bond 1000 10 10% 10.00% $100.00 $1,000.00 10.00%

Premium 1000 10 11% 10.00% $110.00 $1,061.45 10.36%

Discount 1000 10 9% 10.00% $90.00 $938.55 9.59%Equal to or between Page 30

CHAPTER 4—BOND VALUATION Cap gain

0.00%

−0.36%

YTM and coupon rate. 0.41%

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current yield and yield to maturity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 73. Assume that a 10-year Treasury bond has a 12% annual coupon, while a 15-year T-bond has an 8% annual coupon. Assume also that the yield curve is flat, and all Treasury securities have a 10% yield to maturity. Which of the following statements is CORRECT? a. If interest rates decline, the prices of both bonds will increase, but the 10-year bond would have a larger percentage increase in price. b. The 10-year bond would sell at a discount, while the 15-year bond would sell at a premium. c. The 10-year bond would sell at a premium, while the 15-year bond would sell at par. d. If the yield to maturity on both bonds remains at 10% over the next year, the price of the 10-year bond would increase, but the price of the 15-year bond would fall. e. If interest rates decline, the prices of both bonds will increase, but the 15-year bond would have a larger percentage increase in price. ANSWER: e We can tell by inspection that b, c, and d are all incorrect. That leaves answers a and e as RATIONALE: the only possibly correct statements. Also, recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 15-year, 8% coupon bond should be more sensitive to a decline in rates. Finally, we can do some calculations to confirm that e is the correct answer:

Par Maturity Coup rate YTM Ann coup Price % Gain

Current situation 10-year 1000 10 12% 10.00% 120 $1,122.89

Rates decline 15-year 10-year 1000 1000 15 10 8% 12% 10.00% 9.00% 80 120 $847.88 $1,192.53 6.2%

15-year 1000 15 8% 9.00% 80 $919.39 8.4%

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CHAPTER 4—BOND VALUATION OTHER:

TYPE: Multiple Choice: Conceptual

74. Listed below are some provisions that are often contained in bond indentures. Which of these provisions, viewed alone, would tend to reduce the yield to maturity that investors would otherwise require on a newly issued bond? 1. 2. 3. 4. 5. 6.

Fixed assets are used as security for a bond. A given bond is subordinated to other classes of debt. The bond can be converted into the firm's common stock. The bond has a sinking fund. The bond has a call provision. The indenture contains covenants that prevent the use of additional debt. a. 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 ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond indenture KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 75. Suppose International Digital Technologies decides to raise a total of $200 million, with $100 million as long-term debt and $100 million as common equity. The debt can be mortgage bonds or debentures, but by an iron-clad provision in its charter, the company can never raise any additional debt beyond the original $100 million. Given these conditions, which of the following statements is CORRECT? a. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of debentures. b. In this situation, we cannot tell for sure how, or whether, the firm's total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two. c. The higher the percentage of debentures, the greater the risk borne by each debenture, and thus the higher the required rate of return on the debentures. d. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds. e. The higher the percentage of debt represented by mortgage bonds, the riskier both types of bonds will be and, consequently, the higher the firm's total dollar interest charges will be. ANSWER: b The higher the percentage of mortgage bonds, the less the collateral backing each bond, so RATIONALE: Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION the bonds' risk and thus required return would be higher. Also, the higher the percentage of mortgage bonds, the less free assets would be backing the debentures, so their risk and required return would also be higher. However, mortgage bonds are less risky than debentures, so mortgage bond rates are lower than rates on debentures. We end up with a situation where the greater the percentage of mortgage bonds, the higher the rate on both types of bonds, but the average cost to the company could be higher, lower, or constant. Note that we could draw a graph of the situation, with % mortgage on the horizontal axis and rates on the vertical axis, then the graph would look like the WACC graph in the cost of capital chapter.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Types of debt and their relative costs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 76. Which of the following statements is CORRECT? a. If their maturities and other characteristics were the same, a 5% coupon bond would have more interest rate price risk than a 10% coupon bond. b. A 10-year coupon bond would have more reinvestment rate risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of reinvestment rate risk. c. A 10-year coupon bond would have more interest rate price risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of interest rate price risk. d. If their maturities and other characteristics were the same, a 5% coupon bond would have less interest rate price risk than a 10% coupon bond. e. A zero coupon bond of any maturity will have more interest rate price risk than any coupon bond, even a perpetuity. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate and reinvestment rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 77. Which of the following statements is CORRECT? a. All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds. b. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds. c. If a bond's yield to maturity exceeds its coupon rate, the bond's price must be less than its maturity value. Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields and prices KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 78. Assuming all else is constant, which of the following statements is CORRECT? a. For any given maturity, a 1.0 percentage point decrease in the market interest rate would cause a smaller dollar capital gain than the capital loss stemming from a 1.0 percentage point increase in the interest rate. b. From a corporate borrower's point of view, interest paid on bonds is not tax-deductible. 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. ANSWER: d It is relatively easy to eliminate b, c, and e. When choosing between a and d, think about the RATIONALE: graph that shows the relationship between a bond's price and the going interest rate. This curve is concave, indicating that at any interest rate, the decline in price from an increase in rates is less than the gain in price from a similar interest rate decline. It would be easy to confirm this statement with an example.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.21 - LO: 4-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 79. Kessen Inc.'s bonds mature in 7 years, have a par value of $1,000, and make an annual coupon payment of $70. The market interest rate for the bonds is 8.5%. What is the bond's price? a. $923.22 b. $946.30 c. $969.96 d. $994.21 Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION e. $1,019.06 ANSWER: RATIONALE:

N I/YR PMT FV PV

7 8.5% $70 $1,000 $923.22

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.19 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 80. Noncallable bonds that mature in 10 years were recently issued by Sternglass Inc. They have a par value of $1,000 and an annual coupon of 5.5%. If the current market interest rate is 7.0%, at what price should the bonds sell? a. $829.21 b. $850.47 c. $872.28 d. $894.65 e. $917.01 ANSWER: d RATIONALE: Coupon rate 5.5%

PMT N I/YR FV PV

$55 10 7.0% $1,000 $894.65

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.19 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 81. Curtis Corporation's noncallable bonds currently sell for $1,165. They have a 15-year maturity, an annual coupon of $95, and a par value of $1,000. What is their yield to maturity? a. 6.20% b. 6.53% Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION c. 6.87% d. 7.24% e. 7.62% ANSWER: RATIONALE:

N PV PMT FV I/YR

15 $1,165 $95 $1,000 7.62%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 82. Sommers Co.'s bonds currently sell for $1,080 and have a par value of $1,000. They pay a $100 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,125. What is their yield to maturity (YTM)? a. 8.56% b. 9.01% c. 9.46% d. 9.93% e. 10.43% ANSWER: b RATIONALE: N 15

PV PMT FV I/YR

$1,080 $10 $1,000 9.01%= YTM

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 83. Sentry Corp. bonds have an annual coupon payment of 7.25%. The bonds have a par value of $1,000, a current price of $1,125, and they will mature in 13 years. What is the yield to maturity on these bonds? a. 5.56% Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION b. 5.85% c. 6.14% d. 6.45% e. 6.77% ANSWER: RATIONALE:

Coupon rate N PV = Price PMT FV = Par I/YR

7.25% 13 $1,125 $72.50 $1,000 5.85%= YTM

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 84. Meacham Enterprises' bonds currently sell for $1,280 and have a par value of $1,000. They pay a $135 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,050. What is their yield to call (YTC)? a. 6.39% b. 6.72% c. 7.08% d. 7.45% e. 7.82% ANSWER: d RATIONALE: N 5

PV PMT FV I/YR = YTC

$1,280 $135 $1,050 7.45%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to call KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 85. Perry Inc.'s bonds currently sell for $1,150. They have a 6-year maturity, an annual coupon of $85, and a par value of Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION $1,000. What is their current yield? a. 7.39% b. 7.76% c. 8.15% d. 8.56% e. 8.98% ANSWER: a RATIONALE: N

PV PMT FV Current yield =

6 $1,150 $85 $1,000 7.39%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.24 - LO: 4-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current yield KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 86. Rogoff Co.'s 15-year bonds have an annual coupon rate of 9.5%. Each bond has face value of $1,000 and makes semiannual interest payments. If you require an 11.0% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. $891.00 b. $913.27 c. $936.10 d. $959.51 e. $983.49 ANSWER: a RATIONALE: Par value $1,000

Coupon rate Periods/year Yrs to maturity N = periods Annual rate Periodic rate PMT/period FV PV

9.5% 2 15 30 11.0% 5.50% $47.50 $1,000 $891.00

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.28 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Bond valuation: semiannual coupons Bloom’s: Application TYPE: Multiple Choice: Problem

87. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 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% c. 2.30% d. 2.53% e. 2.78% ANSWER: a RATIONALE: T-bond yield 6.20%

Corporate yield MRP LP DRP

Included in both bonds Included in corporate

8.50% 1.30% 0.40% 1.90%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Default risk premium (DRP) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 88. One year ago Lerner and Luckmann Co. issued 15-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 14 years to maturity? a. $1,077.01 b. $1,104.62 c. $1,132.95 d. $1,162.00 e. $1,191.79 ANSWER: e RATIONALE: Par value $1,000

Coupon rate N I/YR PMT FV Cengage Learning Testing, Powered by Cognero

7.5% 14 5.5% $75 $1,000 Page 39

CHAPTER 4—BOND VALUATION PV

$1,191.79

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.19 - LO: 4-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: annual coupons KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 89. Currently, Bruner Inc.'s bonds sell for $1,250. They pay a $120 annual coupon, have a 15-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC? (Subtract the YTC from the YTM.) a. 2.11% b. 2.32% c. 2.55% d. 2.80% e. 3.09% ANSWER: a RATIONALE: If held to maturity: If called in 5 years:

N = Maturity PV PMT FV = Par I/YR = YTM

15N = Call $1,250PV $120PMT $1,000FV = Call Price 8.91%I/YR = YTC

Difference:

2.11%

5 $1,250 $120 $1,050 6.81%

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CHAPTER 4—BOND VALUATION b. 4.12% c. 4.34% d. 4.57% e. 4.81% ANSWER: RATIONALE:

e If the coupon rate exceeds the YTM, then it is likely that the bonds will be called and replaced with new, lower coupon bonds. In that case, the YTC will be earned. Otherwise, one should expect to earn the YTM.

If held to maturity Par value Coupon N PV PMT FV I/YR

If called $1,000 6.75% 15 $1,150.00 $67.50 $1,000.00 5.28%YTM

Expected rate of return:

4.81%YTC

Par value Coupon N PV PMT FV I/YR

$1,000 6.75% 6 $1,150.00 $67.50 $1,067.50 4.81%YTC

Coupon rate Periods/year Yrs to maturity N = periods Annual rate Periodic rate PMT/period FV Cengage Learning Testing, Powered by Cognero

6.25% 2 10 20 4.75% 2.38% $31.25 $1,000 Page 41

CHAPTER 4—BOND VALUATION PV

$1,118.31

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.28 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: semiannual coupons KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 92. CMS Corporation's balance sheet as of today is as follows: Long-term debt (bonds, at par) Preferred stock Common stock ($10 par) Retained earnings 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 ANSWER: b Calculate the price of each bond: RATIONALE:

Coupon rate Par value Maturity (Yrs) Periods/Yr. YTM

4.0% $1,000 10 2 12.0%

N I/YR PMT FV PV

20 6.0% $20.00 $1,000 $541.20

Determine the number of bonds:

Book value on balance sheet Par value Number of bonds = Book value/Par value Calculate the market value of bonds: Mkt value = PV × Number of bonds = POINTS:

$10,000,000 $1,000 10,000

$5,412,032

Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.28 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market value of semiannual bonds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 93. 5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5year bonds is 0.4%. What is the real risk-free rate, r*? a. 2.59% b. 2.88% c. 3.20% d. 3.52% e. 3.87% ANSWER: c RATIONALE: 5.50% rT-bond

IP MRP r*

Included in both bonds Included in both bonds

1.90% 0.40% 3.20%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.29 - LO: 4-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Real risk-free rate KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 94. The Gergen Group's 5-year bonds yield 6.85%, and 5-year T-bonds yield 4.75%. The real risk-free rate is r* = 2.80%, the default risk premium for Gergen's bonds is DRP = 0.85% versus zero for T-bonds, the liquidity premium on Gergen's bonds is LP = 1.25%, and the maturity risk premium for all bonds is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on 5-year bonds? a. 1.40% b. 1.55% c. 1.71% d. 1.88% e. 2.06% ANSWER: b RATIONALE: Maturity 5

rKrockett rT-bond Cengage Learning Testing, Powered by Cognero

6.85% 4.75% Page 43

CHAPTER 4—BOND VALUATION r* LP DRP MRP IP

Included in both bonds Included in corp. only Included in corp. only Included in both bonds

2.80% 1.25% 0.85% 0.40% 1.55%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.30 - LO: 4-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inflation premium (IP) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 95. Chandler Co.'s 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Chandler's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Chandler's bonds? a. 0.99% b. 1.10% c. 1.21% d. 1.33% e. 1.46% ANSWER: b RATIONALE: Maturity 5

rKeys' rT-bond r* IP LP MRP DRP

Included in both bonds Included in both bonds Included in corp. only Included in both bonds

7.00% 5.15% 3.00% 1.75% 0.75% 0.40% 1.10%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.20 - LO: 4-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Default risk premium (DRP) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 96. Squire Inc.'s 5-year bonds yield 6.75%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Squire's bonds is DRP = 1.20% versus Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION 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% ANSWER: e RATIONALE: Maturity 5

rNie rT-bond r* IP DRP MRP LP

Included in both bonds Included in both bonds Included in corp. only Included in both bonds

6.75% 4.80% 2.75% 1.65% 1.20% 0.40% 0.75%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.31 - LO: 4-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity premium (LP) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 97. Field Industries' outstanding bonds have a 25-year maturity and $1,000 par value. Their nominal yield to maturity is 9.25%, they pay interest semiannually, and they sell at a price of $850. What is the bond's nominal (annual) coupon interest rate? a. 6.27% b. 6.60% c. 6.95% d. 7.32% e. 7.70% ANSWER: e First, use the data provided to find the dollar coupon payment per 6 months, then multiply by RATIONALE: 2 to get the annual coupon, and then divide by the par value to find the coupon rate. One could use the indicated data and solve for the price. It would be $850, which confirms the rate.

Par value Maturity Periods/year N YTM Periodic rate PV Cengage Learning Testing, Powered by Cognero

$1,000 25 2 50 9.25% 4.63% $850.00 Page 45

CHAPTER 4—BOND VALUATION PMT Coupon rate =

$38.50 7.70%

Coupon rate YTM Maturity Par value Periods/year Determine the bond's price PMT/period N I/YR FV PV = Price

8.75%Yrs to call 6.50%Call price 15 $1,000 Determine the bond's 2 YTC

6 $1,050.00

N $43.75PV 30PMT 3.25%FV $1,000.00I/YR $1,213.55Nom. YTC

12 $1,213.55 $43.75 $1,050.00 2.64% 5.27%

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CHAPTER 4—BOND VALUATION 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 ANSWER: c First find the YTM at this time, then use the YTM with the other data to find the bond's price 5 RATIONALE: years hence.

Par value Coupon rate N PV PMT FV I/YR

$1,000 8.50%Value in 5 years 25N $875I/YR $85PMT $1,000FV 9.86%PV

20 9.86% $85 $1,000 $882.90

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.23 - LO: 4-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond value in future time periods KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 100. McCurdy Co.'s Class Q bonds have a 12-year maturity, $1,000 par value, and a 5.75% coupon paid semiannually (2.875% each 6 months), and those bonds sell at their par value. McCurdy's Class P bonds have the same risk, maturity, and par value, but the P bonds pay a 5.75% annual coupon. Neither bond is callable. At what price should the annual payment bond sell? a. $943.98 b. $968.18 c. $993.01 d. $1,017.83 e. $1,043.28 ANSWER: c These two bonds should provide the same EFF%. Therefore, we can find the EFF% for the RATIONALE: semiannual bond and then use it as the YTM for the annual payment bond. At the calculated price, the two bonds will have YTMs with the same EFF%. Note too that the semiannual payment bond must have a higher price than the annual bond because then it receives the same cash flow, but faster. Therefore Bond A must sell at a price below the $1,000 par value at which S sells.

Semiannual bond Par value Coupon rate = Nominal rate Payment per period Cengage Learning Testing, Powered by Cognero

Annual bond $1,000Par value

$1,000

5.75%Coupon rate

5.75%

$28.75Pmt/Period

$57.50 Page 47

CHAPTER 4—BOND VALUATION Years to maturity Periods/year Total periods EFF% Price

12Yrs to maturity 2Periods/year 24Total periods 5.833%EFF% = YTM $1,000.00Price

12 1 12 5.833% $993.01

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.28 - LO: 4-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: effective rates KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 101. Reinegar Corporation is planning two new issues of 25-year bonds. Bond Par will be sold at its $1,000 par value, and it will have a 10% semiannual coupon. Bond OID will be an Original Issue Discount bond, and it will also have a 25-year maturity and a $1,000 par value, but its semiannual coupon will be only 6.25%. If both bonds are to provide investors with the same effective yield, how many of the OID bonds must Reinegar issue to raise $3,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds. a. 4,228 b. 4,337 c. 4,448 d. 4,562 e. 4,676 ANSWER: d The par bond has a coupon rate of 10% and a periodic rate of 5%, and it sells at par. RATIONALE: Therefore, the going nominal rate must be 10%. The OID bond must provide the same EFF%, because it is equally risky. Therefore, it must be evaluated with the parameters shown below to find its price, which is then used to find the number of bonds issued.

Par value Coupon rate Maturity yrs Periods/year N Periodic rate PMT PV = Price

Bond B: Issued at a discount (OID bonds) $1,000Par value $1,000 10.00%Coupon rate 6.25% 25Maturity yrs 25 2Periods/year 2 50N 50 5.00%Periodic rate 5.00% $50.00PMT $31.25 $1,000.00PV = Price $657.70

Funds needed Number of bonds Rounded up

$3,000,000 4,561.34 4,562

Bond A: Issued at par

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.28 - LO: 4-5 Cengage Learning Testing, Powered by Cognero

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CHAPTER 4—BOND VALUATION NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: original issue discount bonds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem

Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Options KEYWORDS: Bloom’s: Knowledge 2. The strike price is the price that must be paid for a share of common stock when it is bought by exercising a warrant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Strike price KEYWORDS: Bloom’s: Knowledge 3. The exercise value is the positive difference between the current price of the stock and the call option’s strike price. The exercise value is zero if the stock's price is below the strike price a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exercise value KEYWORDS: Bloom’s: Knowledge 4. The exercise value is also called the strike price, but this term is generally used when discussing convertibles rather than financial options. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Exercise value KEYWORDS: Bloom’s: Knowledge 5. As the price of a stock rises above the strike price, the value investors are willing to pay for a call option increases because both (1) the immediate capital gain that can be realized by exercising the option and (2) the likely exercise value of the option when it expires have both increased. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option time value KEYWORDS: Bloom’s: Knowledge 6. If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge 7. If the market is in equilibrium, then an option must sell at a price that is exactly equal to the difference between the stock's current price and the option's strike price. a. True b. False ANSWER: False POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge 8. Since investors tend to dislike risk and like certainty, the more volatile a stock, the less valuable will be an option to purchase the stock, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge 9. Because of the time value of money, the longer before an option expires, the less valuable the option will be, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge 10. If we define the "premium" on an option to be the difference between the price at which an option sells and the exercise value (or the difference between the stock's current market price and the strike price), then we would expect the premium to increase as the stock price increases, other things held constant. a. True b. False ANSWER: False See Figure 8−1, which shows that the premium becomes smaller and smaller as the price of RATIONALE: the stock increases. One factor that produces this result is the fact that the amount of leverage inherent in the option diminishes as the stock price increases. Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option pricing KEYWORDS: Bloom’s: Knowledge 11. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock, provided the strike prices for the put and call are the same. a. True b. False ANSWER: False Recognize that if a stock is selling far above the strike price, the call option will be quite RATIONALE: valuable, but the put option will be worth very little because the probability is low that the stock's market price will fall below the put's strike price.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.33 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Put-call parity KEYWORDS: Bloom’s: Knowledge 12. If a company announces a change in its dividend policy from a zero target payout ratio to a 100% payout policy, this action could be expected to increase the value of long-term options (say 5-year options) on the firm's stock. a. True b. False ANSWER: False Dividends do not enter into the OPM pricing formula. We would expect the stock of a firm that RATIONALE: retains all of its earnings to grow over time due to the reinvestment of its earnings, whereas a firm that retains zero earnings should not grow much if any. Therefore, the value of the firm's long-term options should decline if it announces a change from a zero to a 100% payout policy.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.33 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Put-call parity KEYWORDS: Bloom’s: Comprehension 13. An option that gives the holder the right to sell a stock at a specified price at some future time is Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS a. a put option. b. an out-of-the-money option. c. a naked option. d. a covered option. e. a call option. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option terms KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 14. Other things held constant, the value of an option depends on the stock's price, the risk-free rate, and the a. Variability of the stock price. b. Option's time to maturity. c. Strike price. d. All of the above. e. None of the above. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option value KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 15. Which of the following statements is most correct, holding other things constant, for XYZ Corporation's traded call options? a. The higher the strike price on XYZ's options, the higher the option's price will be. b. Assuming the same strike price, an XYZ call option that expires in one month will sell at a higher price than one that expires in three months. c. If XYZ's stock price stabilizes (becomes less volatile), then the price of its options will increase. d. If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the option will be reduced by the amount of the dividend. e. The price of these call options is likely to rise if XYZ's stock price rises. ANSWER: e POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 16. BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant? a. The exercise price of the option is increased. b. The life of the option is increased, i.e., the time until it expires is lengthened. c. The Federal Reserve takes actions that increase the risk-free rate. d. BLW's stock price becomes more risky (higher variance). e. BLW's stock price suddenly increases. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 17. Which of the following statements is CORRECT? a. Call options give investors the right to sell a stock at a certain strike price before a specified date. b. Options typically sell for less than their exercise value. c. LEAPS are very short-term options that were created relatively recently and now trade in the market. d. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend. e. Put options give investors the right to buy a stock at a certain strike price before a specified date. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous option concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS 18. An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of options? a. Put b. Naked c. Covered d. Out-of-the-money e. In-the-money ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Options KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 19. Cazden Motors' stock is trading at $30 a share. Call options on the company's stock are also available, some with a strike price of $25 and some with a strike price of $35. Both options expire in three months. Which of the following best describes the value of these options? a. The options with the $25 strike price will sell for less than the options with the $35 strike price. b. The options with the $25 strike price have an exercise value greater than $5. c. The options with the $35 strike price have an exercise value greater than $0. d. If Cazden's stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5. e. The options with the $25 strike price will sell for $5. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 20. Braddock Construction Co.'s stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $1.50. Which of the following will occur if the stock price increases 10%, to $22 a share? a. The price of the call option will increase by more than $2. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Option value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 21. Which of the following statements is CORRECT? a. Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be. b. Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be. c. Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be. d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock. e. If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.33 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous option concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 22. Which of the following statements is CORRECT? a. Call options generally sell at a price less than their exercise value. b. If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value. c. Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be. d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock. e. If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS soon as the stock's price exceeds the strike price by about 10%, because this permits the option holder to lock in an immediate profit. ANSWER: c Answer c is correct. See Figure 8−1 and the related discussion. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.33 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous option concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 23. Which of the following statements is CORRECT? a. As the stock's price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Options KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 24. Suppose you believe that Basso Inc.'s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $3.10 you can buy a 5-month call option giving you the right to buy 1 share at a price of $25 per share. If you buy this option for $3.10 and Basso's stock price actually rises to $45, what would your pre-tax net profit be? a. −$3.10 b. $16.90 c. $17.75 d. $22.50 e. $25.60 ANSWER: b The call option will be exercised only if the final price is above the strike price. If the final RATIONALE: Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS price is below the strike price, there will simply be a loss equal to the cost of the option.

Strike price: $25.00 Final price: $45.00

No. of options: 1 Option cost: $3.10

Profit per share = Final price − Strike price = $45 − $25 or zero: $20.00 Total profit = Profit/option × No. of options − Cost of options = $16.90

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Call options KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 25. Suppose you believe that Florio Company's stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $5.10 you could buy a 5-month put option giving you the right to sell 1 share at a price of $85 per share. If you bought this option for $5.10 and Florio's stock price actually dropped to $60, what would your pretax net profit be? a. −$5.10 b. $19.90 c. $20.90 d. $22.50 e. $27.60 ANSWER: b The put option will be exercised only if the final price is below the strike price. If the final price RATIONALE: exceeds the strike price, there will simply be a loss equal to the cost of the option.

Strike price: $85.00 Final price: $60.00

No. of options: 1 Option cost: $5.10

Profit per share = Strike price − Final price = $85 − $60 or zero: $25.00 Total profit = Profit/option × No. of options − Cost of options = $19.90

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.32 - LO: 5-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Put options KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 26. The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binomial model, what is the option's value? (Hint: Use daily compounding.) a. $2.43 b. $2.70 Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS c. $2.99 d. $3.29 e. $3.62 ANSWER: RATIONALE:

Current price $22.00 Exercise price $22.00 6.00% rRF Step Payoff range, stock: 1. Step 2. If stock is high: If stock is low: Option range: Step 3. Option range/Stock range = $5/$10 = shares of stock = Step The payoff from 0.5 shares of 4. stock will be either: The payoff from the option will be either: The portfolio's payoff will be either:

Price at end of year: High $27.00 Low $17.00 $27.00 − $17.00 =

$10.00

Payoff range, option: Price − Exercise = 27 − 22 = (Price − Exercise) or $0 = $5 − $0 =

$5.00 0.00 $5.00

Equalize the ranges to find the number of shares of stock: 0.5

$13.50 or

$8.50

5.00 or

0.00

$ 8.50 or

$8.50

So the portfolio's payoff is riskless, $8.50 regardless of which choice materializes. Step 5.

Step 6.

The present value of $8.50 at the daily compounded risk-free rate is: PV = $8.50/(1 + (0.06/365))365 = $8.005. The option price is the cost of the stock purchased for the portfolio minus the PV of the payoff: V = 0.5($22) −$8.01 = $2.99

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.34 - LO: 5-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS TOPICS: KEYWORDS: OTHER:

Option price based on binomial model Bloom’s: Analysis TYPE: Multiple Choice: Problem

27. The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option? a. $7.33 b. $7.71 c. $8.12 d. $8.55 e. $9.00 ANSWER: e RATIONALE: Stock price: $50.00

Strike price: $55.00 Call option price: $7.20 Risk-free rate: 6.0% Value of put = Value of call − Stock price + (Exercise price × e−rt) = $7.20 − $50.00 + $55 × e−rt = $7.20 − $50.00 + $51.80 = $9.00 POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.33 - LO: 5-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Put-call parity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 28. An analyst wants to use the Black-Scholes model to value call options on the stock of Heath Corporation based on the following data: ∙ ∙ ∙ ∙ ∙

The price of the stock is $40. The strike price of the option is $40. The option matures in 3 months (t = 0.25). The standard deviation of the stock's returns is 0.40, and the variance is 0.16. The risk-free rate is 6%.

Given this information, the analyst then calculated the following necessary components of the Black-Scholes model: ∙ ∙ ∙ ∙

d1 = 0.175 d2 = −0.025 N(d1) = 0.56946 N(d2) = 0.49003

N(d1) and N(d2) represent areas under a standard normal distribution function. Using the Black-Scholes model, what is Cengage Learning Testing, Powered by Cognero

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CHAPTER 5—FINANCIAL OPTIONS the value of the call option? a. $2.81 b. $3.12 c. $3.47 d. $3.82 e. $4.20 ANSWER: c RATIONALE: Stock price:

Strike price: Option maturity: Variance of stock returns: Risk-free rate:

$40.00N(d1) = 0.56946 $40.00N(d2) = 0.49003 0.25 0.16 6.0%

The Black-Scholes model calculates the value of the call option as: V= P[N(d1)] − Xe−rt[N(d2)] rt

= $40(0.56946) − $40e− (0.49003) = $22.78 − $19.31 = $3.47

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.35 - LO: 5-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Black-Scholes model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem

Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.36 - LO: 6-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual report KEYWORDS: Bloom’s: Knowledge 2. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends, and the riskiness of those cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.36 - LO: 6-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annual report and expectations KEYWORDS: Bloom’s: Knowledge 3. Consider the balance sheet of Wilkes Industries as shown below. Because Wilkes has $800,000 of retained earnings, the company would be able to pay cash to buy an asset with a cost of $200,000. Cash Inventory Accounts receivable Total CA Net fixed assets

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

Total assets a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 Cengage Learning Testing, Powered by Cognero

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

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retained earnings versus cash KEYWORDS: Bloom’s: Knowledge 4. On the balance sheet, total assets must always equal total liabilities and equity. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Knowledge 5. Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be higher or lower than the values at which these assets are carried on the books. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet: non-cash assets KEYWORDS: Bloom’s: Knowledge 6. The income statement shows the difference between a firm's income and its costs⎯ i.e., its profits⎯ during a specified period of time. However, not all reported income comes in the form or cash, and reported costs likewise may not correctly reflect cash outlays. Therefore, there may be a substantial difference between a firm's reported profits and its actual cash flow for the same period. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT LEARNING OBJECTIVES: INTE.GENE.16.38 - LO: 6-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement KEYWORDS: Bloom’s: Knowledge 7. Net operating working capital is equal to operating current assets minus operating current liabilities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating working capital KEYWORDS: Bloom’s: Knowledge 8. Total net operating capital is equal to net fixed assets. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total net operating capital KEYWORDS: Bloom’s: Knowledge 9. Net operating profit after taxes (NOPAT) is the amount of net income a company would generate from its operations if it had no interest income or interest expense. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Net operating profit after taxes (NOPAT) Bloom’s: Knowledge

10. The fact that 70% of the interest income received by a corporation is excluded from its taxable income encourages firms to use more debt financing than they would in the absence of this tax law provision. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income taxes: interest income KEYWORDS: Bloom’s: Knowledge 11. If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a taxdeductible expense, this would probably encourage companies to use more debt financing than they presently do, other things held constant. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income taxes: interest expense KEYWORDS: Bloom’s: Knowledge 12. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income taxes: interest expense and dividends KEYWORDS: Bloom’s: Knowledge 13. The balance sheet is a financial statement that measures the flow of funds into and out of various accounts over time, while the income statement measures the firm's financial position at a point in time. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.38 - LO: 6-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statements KEYWORDS: Bloom’s: Knowledge 14. Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts and, thus, these cash accounts, when added together, will always be equal to the firm's total retained earnings. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.41 - LO: 6-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retained earnings KEYWORDS: Bloom’s: Comprehension 15. The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of stockholders' claims against the firm's existing assets. This implies that retained earnings are in fact stockholders' reinvested earnings. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT LEARNING OBJECTIVES: INTE.GENE.16.41 - LO: 6-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retained earnings KEYWORDS: Bloom’s: Comprehension 16. In accounting, emphasis is placed on determining net income in accordance with generally accepted accounting principles. In finance, the primary emphasis is also on net income because that is what investors use to value the firm. However, a secondary financial consideration is cash flow, because cash is needed to operate the business. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.42 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow and net income KEYWORDS: Bloom’s: Comprehension 17. To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash charge that has been deducted from revenue. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Comprehension 18. The current cash flow from existing assets is highly relevant to the investor. However, since the value of the firm depends primarily upon its growth opportunities, profit projections from those opportunities are the only relevant future flows with which investors are concerned. a. True b. False ANSWER: False Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Future cash flows KEYWORDS: Bloom’s: Comprehension 19. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income taxes: interest expense and dividends KEYWORDS: Bloom’s: Comprehension 20. The time dimension is important in financial statement analysis. The balance sheet shows the firm's financial position at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects changes in the firm's accounts over that period of time. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial stmts: time dimension KEYWORDS: Bloom’s: Comprehension 21. Which of the following statements is CORRECT? a. The statement of cash needs tells us how much cash the firm will require during some future period, generally a month or a year. b. The four most important financial statements provided in the annual report are the balance sheet, income Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.36 - LO: 6-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statements KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 22. Which of the following statements is CORRECT? a. A typical industrial company's balance sheet lists the firm's assets that will be converted to cash first, and then goes on down to list the firm's longest lived assets last. b. The balance sheet for a given year 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 23. Other things held constant, which of the following actions would increase the amount of cash on a company's balance sheet? a. The company purchases a new piece of equipment. b. The company repurchases common stock. c. The company pays a dividend. d. The company issues new common stock. e. The company gives customers more time to pay their bills. Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 24. Which of the following items is NOT included in current assets? a. Short-term, highly liquid, marketable securities. b. Accounts receivable. c. Inventory. d. Bonds. e. Cash. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current assets KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 25. Which of the following items cannot be found on a firm's balance sheet under current liabilities? a. Accrued payroll taxes. b. Accounts payable. c. Short-term notes payable to the bank. d. Accrued wages. e. Cost of goods sold. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT TOPICS: KEYWORDS: OTHER:

Current liabilities Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual

26. 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 flow. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.38 - LO: 6-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 27. Below are the year-end balance sheets for Wolken Enterprises: Assets: Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets

2015 $ 200,000 864,000 2,000,000 $3,064,000 6,000,000 $9,064,000

2014 $ 170,000 700,000 1,400,000 $2,270,000 5,600,000 $7,870,000

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

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

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

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 2014. As of the end of 2015, none of the principal on this debt had been repaid. Assume that the company's sales in Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT 2014 and 2015 were the same. Which of the following statements must be CORRECT? a. Wolken increased its short-term bank debt in 2015. b. Wolken issued long-term debt in 2015. c. Wolken issued new common stock in 2015. d. Wolken repurchased some common stock in 2015. e. Wolken had negative net income in 2015. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 28. On its 2014 balance sheet, Barngrover Books showed $510 million of retained earnings, and exactly that same amount was shown the following year in 2015. Assuming that no earnings restatements were issued, which of the following statements is CORRECT? a. Dividends could have been paid in 2015, but they would have had to equal the earnings for the year. b. If the company lost money in 2015, they must have paid dividends. c. The company must have had zero net income in 2015. d. The company must have paid out half of its earnings as dividends. e. The company must have paid no dividends in 2015. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 29. Below is the common equity section (in millions) of Fethe Industries' last two year-end balance sheets: Common stock Retained earnings Total common equity

2015 $2,000 2,000 $4,000

2014 $1,000 2,340 $3,340

The company has never paid a dividend to its common stockholders. Which of the following statements is CORRECT? Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT a. The company's net income in 2014 was higher than in 2015. b. The company issued common stock in 2015. c. The market price of the company's stock doubled in 2015. d. The company had positive net income in both 2014 and 2015, but the company's net income in 2014 was lower than it was in 2015. e. The company has more equity than debt on its balance sheet. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 30. Which of the following statements is CORRECT? a. The more depreciation a firm has in a given year, the higher its EPS, other things held constant. b. Typically, a firm's DPS should exceed its EPS. c. Typically, a firm's EBIT should exceed its EBITDA. d. If a firm is more profitable than average (e.g., Google), we would normally expect to see its stock price exceed its book value per share. e. If a firm is more profitable than most other firms, we would normally expect to see its book value per share exceed its stock price, especially after several years of high inflation. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.38 - LO: 6-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EPS, DPS, BVPS, and stock price KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 31. Which of the following statements is CORRECT? a. Depreciation and amortization are not cash charges, so neither of them has an effect on a firm's reported profits. b. The more depreciation a firm reports, the higher its tax bill, other things held constant. c. People sometimes talk about the firm's net cash flow, which is shown as the lowest entry on the income statement, hence it is often called "the bottom line." d. Depreciation reduces a firm's cash balance, so an increase in depreciation would normally lead to a reduction Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT in the firm's net cash flow. e. Net cash flow (NCF) is often defined as follows: Net Cash Flow = Net Income + Depreciation and Amortization Charges. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.42 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation, amortization, and net cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 32. Which of the following would be most likely to occur in the year after Congress, in an effort to increase tax revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume that sales, other operating costs, and tax rates are not affected, and assume that the same depreciation method is used for tax and stockholder reporting purposes. a. Companies' reported net incomes would decline. b. Companies' net operating profits after taxes (NOPAT) would decline. c. Companies' physical stocks of fixed assets would increase. d. Companies' net cash flows would increase. e. Companies' cash positions would decline. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.42 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 33. Which of the following factors could explain why Regal Industrial Fixtures had a negative net cash flow last year, even though the cash on its balance sheet increased? a. The company repurchased 20% of its common stock. b. The company sold a new issue of bonds. c. The company made a large investment in new plant and equipment. d. The company paid a large dividend. e. The company had high amortization expenses. ANSWER: b POINTS: 1 Cengage Learning Testing, Powered by Cognero

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Retained earnings at the end of 2014 were $700,000, but retained earnings at the end of 2015 had declined to $320,000. The company does not pay dividends. The company's depreciation expense is its only non-cash expense; it has no amortization charges. The company has no non-cash revenues. The company's net cash flow (NCF) for 2015 was $150,000.

On the basis of this information, which of the following statements is CORRECT? a. Prestopino had negative net income in 2015. b. Prestopino's depreciation expense in 2015 was less than $150,000. c. Prestopino had positive net income in 2015, but its income was less than its 2014 income. d. Prestopino's NCF in 2015 must be higher than its NCF in 2014. e. Prestopino's cash on the balance sheet at the end of 2015 must be lower than the cash it had on the balance sheet at the end of 2014. Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net cash flow and net income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 36. Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its net cash flow from operations declined. Which of the following could explain this performance? a. The company's operating income declined. b. The company's expenditures on fixed assets declined. c. The company's cost of goods sold increased. d. The company's depreciation and amortization expenses declined. e. The company's interest expense increased. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net cash flow and net income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 37. Which of the following statements is CORRECT? a. The statement of cash flows shows how much the firm's cash⎯ the total of currency, bank deposits, and 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 38. Which of the following statements is CORRECT? a. In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash. b. Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity. c. In the statement of cash flows, a decrease in accounts payable is reported as a use of cash. d. In the statement of cash flows, depreciation charges are reported as a use of cash. e. In the statement of cash flows, a decrease in inventories is reported as a use of cash. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 39. For managerial purposes, i.e., making decisions regarding the firm's operations, the standard financial statements as prepared by accountants under Generally Accepted Accounting Principles (GAAP) are often modified and used to create alternative data and metrics that provide a somewhat different picture of a firm's operations. Related to these modifications, which of the following statements is CORRECT? a. The standard statements make adjustments to reflect the effects of inflation on asset values, and these adjustments are normally carried into any adjustment that managers make to the standard statements. b. The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, for valuation purposes we need to discount cash flows, not accounting income. Moreover, since many firms have a number of separate divisions, and since division managers should be compensated on their divisions' performance, not that of the entire firm, information that focuses on the divisions is needed. These factors have led to the development of information that is focused on cash flows and the operations of individual units. c. The standard statements provide useful information on the firm's individual operating units, but management needs more information on the firm's overall operations than the standard statements provide. d. The standard statements focus on cash flows, but managers are less concerned with cash flows than with accounting income as defined by GAAP. e. The best feature of standard statements is that, if they are prepared under GAAP, the data are always consistent from firm to firm. Thus, under GAAP, there is no room for accountants to "adjust" the results to make earnings look better. Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Modifying acct data for managerial purposes KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 40. Which of the following statements is CORRECT? a. Net cash flow (NCF) is defined as follows: NCF = Net income - Depreciation and Amortization. b. Changes in working capital have no effect on free cash flow. c. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 − T) + Depreciation and Amortization − Capital expenditures required to sustain operations − Required changes in net operating working capital. d. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 − T)+ Depreciation and Amortization + Capital expenditures. e. Net cash flow is the same as free cash flow (FCF). ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Depreciation, amortization, and free cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 41. Which of the following statements is CORRECT? a. The primary difference between EVA and accounting net income is that when net income is calculated, a deduction is made to account for the cost of common equity, whereas EVA represents net income before deducting the cost of the equity capital the firm uses. b. MVA gives us an idea about how much value a firm's management has added during the last year. c. MVA stands for market value added, and it is defined as follows: MVA = (Shares outstanding)(Stock price) + Book value of common equity. d. EVA stands for economic value added, and it is defined as follows: EVA = EBIT(1 − T) − (Investor-supplied op. capital) × (A − T cost of capital). e. EVA gives us an idea about how much value a firm's management has added over the firm's life. Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.44 - LO: 6-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MVA and EVA KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 42. Which of the following statements is CORRECT? a. The maximum federal tax rate on personal income in 2014 was 50%. b. Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies' debt ratios to be lower than they would be if interest and dividends were both deductible. c. Interest paid to an individual is counted as income for tax purposes and taxed at the individual's regular tax rate, which in 2014 could go up to 35%, but dividends received were taxed at a maximum rate of 15%. d. The maximum federal tax rate on corporate income in 2014 was 50%. e. Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income tax system KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 43. Which of the following statements is CORRECT? a. All corporations other than non-profit corporations are subject to corporate income taxes, which are 15% for the lowest amounts of income and 35% for the highest amounts of income. b. The income of certain small corporations that qualify under the Tax Code is completely exempt from corporate income taxes. Thus, the federal government receives no tax revenue from these businesses. c. All businesses, regardless of their legal form of organization, are taxed under the Business Tax Provisions of the Internal Revenue Code. d. Small businesses that qualify under the Tax Code can elect not to pay corporate taxes, but then their owners must report their pro rata shares of the firm's income as personal income and pay taxes on that income. e. Congress recently changed the tax laws to make dividend income received by individuals exempt from income Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Federal income tax system KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 44. Danielle's Sushi Shop last year had (1) a negative net cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation? a. The company had a sharp increase in its depreciation and amortization expenses. b. The company had a sharp increase in its inventories. c. The company had a sharp increase in its accrued liabilities. d. The company sold a new issue of common stock. e. The company made a large capital investment early in the year. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: NCF, FCF, and cash KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 45. Assume that Congress recently passed a provision that will enable Barton's Rare Books (BRB) to double its depreciation expense for the upcoming year but will have no effect on its sales revenue or tax rate. Prior to the new provision, BRB's net income after taxes was forecasted to be $4 million. Which of the following best describes the impact of the new provision on BRB's financial statements versus the statements without the provision? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. a. Net fixed assets on the balance sheet will decrease. b. The provision will reduce the company's net cash flow. c. The provision will increase the company's tax payments. d. Net fixed assets on the balance sheet will increase. e. The provision will increase the company's net income. ANSWER: a Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 46. The LeMond Corporation just purchased a new production line. Assume that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. a. LeMond's tax liability for the year will be lower. b. LeMond's taxable income will be lower. c. LeMond's net fixed assets as shown on the balance sheet will be higher at the end of the year. d. LeMond's cash position will improve (increase). e. LeMond's reported net income after taxes for the year will be lower. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 47. Lucy's Music Emporium opened its doors on January 1, 2015, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes. The company planned to depreciate its fixed assets over 20 years, but in December 2015 management realized that the assets would last for only 15 years. The firm's accountants plan to report the 2015 financial statements based on this new information. How would the new depreciation assumption affect the company's financial statements? a. The firm's net liabilities would increase. b. The firm's reported net fixed assets would increase. c. The firm's EBIT would increase. d. The firm's reported 2015 earnings per share would increase. e. The firm's cash position in 2015 and 2016 would increase. ANSWER: e POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 48. DeYoung Devices Inc., a new high-tech instrumentation firm, is building and equipping a new manufacturing facility. Assume that currently its equipment must be depreciated on a straight-line basis over 10 years, but Congress is considering legislation that would require the firm to depreciate the equipment over 7 years. If the legislation becomes law, which of the following would occur in the year following the change? a. The firm's reported net income would increase. b. The firm's operating income (EBIT) would increase. c. The firm's taxable income would increase. d. The firm's net cash flow would increase. e. The firm's tax payments would increase. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in depreciation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 49. Which of the following statements is CORRECT? a. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year's balance. b. Dividends paid reduce the net income that is reported on a company's income statement. c. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, this will cause a decline in its current assets as shown on the balance sheet. d. If a company issues new long-term bonds during the current year, this will increase its reported current liabilities at the end of the year. e. Accounts receivable are reported as a current liability on the balance sheet. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Financial statements Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

50. Which of the following statements is CORRECT? a. One way to increase EVA is to achieve the same level of operating income but with more investor-supplied capital. b. If a firm reports positive net income, its EVA must also be positive. c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free. d. One way to increase EVA is to generate the same level of operating income but with less investor-supplied capital. e. Actions that increase reported net income will always increase net cash flow. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.44 - LO: 6-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EVA, CF, and net income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 51. Which of the following statements is CORRECT? a. If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet will be negative. b. Since depreciation is a source of funds, the more depreciation a company has, the larger its retained earnings will be, other things held constant. c. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments. d. Common equity includes common stock and retained earnings, less accumulated depreciation. e. The retained earnings account as shown on the balance sheet shows the amount of cash that is available for paying dividends. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT TOPICS: KEYWORDS: OTHER:

Retained earnings Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

52. Olivia Hardison, CFO of Impact United Athletic Designs, plans to have the company issue $500 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur? a. The company would have to pay less taxes. b. The company's taxable income would fall. c. The company's interest expense would remain constant. d. The company would have less common equity than before. e. The company's net income would increase. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.40 - LO: 6-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in leverage KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 53. Jessie's Bobcat Rentals' operations provided a negative net cash flow last year, yet the cash shown on its balance sheet increased. Which of the following statements could explain the increase in cash, assuming the company's financial statements were prepared under generally accepted accounting principles? a. The company had high depreciation expenses. b. The company repurchased some of its common stock. c. The company dramatically increased its capital expenditures. d. The company retired a large amount of its long-term debt. e. The company sold some of its fixed assets. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.43 - LO: 6-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT 54. Tucker Electronic System's current balance sheet shows total common equity of $3,125,000. The company has 125,000 shares of stock outstanding, and they sell at a price of $52.50 per share. By how much do the firm's market and book values per share differ? a. $27.50 b. $28.88 c. $30.32 d. $31.83 e. $33.43 ANSWER: a RATIONALE: Shares outstanding 125,000

Price per share Total book common equity Book value per share Difference between book and market values

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet: market value vs. book value KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. 55. Hunter Manufacturing Inc.'s December 31, 2014 balance sheet showed total common equity of $2,050,000 and 100,000 shares of stock outstanding. During 2015, Hunter had $250,000 of net income, and it paid out $100,000 as dividends. What was the book value per share at 12/31/2015, assuming that Hunter neither issued nor retired any common stock during 2015? a. $20.90 b. $22.00 c. $23.10 d. $24.26 e. $25.47 ANSWER: b RATIONALE: 12/31/2014 common equity $2,050,000

2015 net income 2015 dividends 2015 addition to retained earnings 12/31/2015 common equity Shares outstanding 12/31/2015 BVPS Cengage Learning Testing, Powered by Cognero

$250,000 $100,000 $150,000 $2,200,000 100,000 $22.00 Page 24

CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.37 - LO: 6-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet: change in BVPS from RE addition KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. 56. Companies generate income from their "regular" operations and from other sources like interest earned on the securities they hold, which is called non-operating income. Lindley Textiles recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,000 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was Lindley's operating income, or EBIT? a. $3,462 b. $3,644 c. $3,836 d. $4,038 e. $4,250 ANSWER: e RATIONALE: Sales $12,500

Operating costs excluding depr'n Depreciation Operating income (EBIT)

$7,250 $1,000 $4,250

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.38 - LO: 6-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: EBIT KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. 57. Frederickson Office Supplies recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was the firm's Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT 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 ANSWER: b RATIONALE: Bonds

Interest rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.38 - LO: 6-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: taxable income KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. 58. JBS Inc. recently reported net income of $4,750 and depreciation of $885. How much was its net cash flow, assuming it had no amortization expense and sold none of its fixed assets? a. $4,831.31 b. $5,085.59 c. $5,353.25 d. $5,635.00 e. $5,916.75 ANSWER: d RATIONALE: Net income $4,750.00

Depreciation NCF

$885.00 $5,635.00

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.42 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

forecasting, and cash flows United States - OH - Default City - TBA Net cash flow Bloom’s: Application TYPE: Multiple Choice: Problem Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

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

Accounts payable Accrued wages and taxes Net operating working capital

$575 $145 $1,530

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating working capital KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. 60. Over the years, Janjigian Corporation's stockholders have provided $15,250 of capital, part when they purchased new issues of stock and part when they allowed management to retain some of the firm's earnings. The firm now has 1,000 shares of common stock outstanding, and it sells at a price of $42.00 per share. How much value has Janjigian's management added to stockholder wealth over the years, i.e., what is Janjigian's MVA? a. $21,788 b. $22,935 c. $24,142 d. $25,413 Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT e. $26,750 ANSWER: RATIONALE:

Total book value of equity Stock price per share Shares outstanding Market value of equity MVA =

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.44 - LO: 6-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: MVA KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. 61. Meric Mining Inc. recently reported $15,000 of sales, $7,500 of operating costs other than depreciation, and $1,200 of depreciation. The company had no amortization charges, it had outstanding $6,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was the firm's net income after taxes? Meric uses the same depreciation expense for tax and stockholder reporting purposes. a. $3,284.55 b. $3,457.42 c. $3,639.39 d. $3,830.94 e. $4,022.48 ANSWER: d RATIONALE: Bonds $6,500

Interest rate Tax rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income Taxes Net income

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.38 - LO: 6-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Income statement: net after-tax income Bloom’s: Analysis TYPE: Multiple Choice: Problem Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

62. On 12/31/2015, 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 12/31/2014, the company had reported $555,000 of retained earnings. No shares were repurchased during 2015. How much in dividends did Heaton pay during 2015? a. $47,381 b. $49,875 c. $52,500 d. $55,125 e. $57,881 ANSWER: c RATIONALE: 12/31/2015 RE $675,000

12/31/2014 RE Change in RE Net income for 2015 Dividends = net income − change

$555,000 $120,000 $172,500 $52,500

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.41 - LO: 6-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of stockholders' equity: dividends KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. 63. Ullrich Printing Inc. paid out $21,750 of common dividends during the year. It ended the year with $187,500 of retained earnings versus the prior year's retained earnings of $132,250. How much net income did the firm earn during the year? a. $77,000 b. $80,850 c. $84,893 d. $89,137 Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT e. $93,594 ANSWER: RATIONALE:

a Net income = The change in retained earnings plus the dividends paid:

Current RE Previous RE = Current RE − increment Change in RE Plus dividends paid = Net income

$187,500 $132,250 $55,250 $21,750 $77,000

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.41 - LO: 6-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Statement of stockholders' equity: NI KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem NOTES: Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic. 64. NNR Inc.'s balance sheet showed total current assets of $1,875,000 plus $4,225,000 of net fixed assets. All of these assets were required in operations. The firm's current liabilities consisted of $475,000 of accounts payable, $375,000 of 6% short-term notes payable to the bank, and $150,000 of accrued wages and taxes. Its remaining capital consisted of long-term debt and common equity. What was NNR's total investor-provided operating capital? a. $4,694,128 b. $4,941,188 c. $5,201,250 d. $5,475,000 e. $5,748,750 ANSWER: d RATIONALE: Current assets $1,875,000

Net fixed assets Total assets (all are operating assets) Spontaneous "free" capital: Total investor-provided operating capital

Acc'ts payable Accruals

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

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

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

forecasting, and cash flows United States - OH - Default City - TBA Total operating capital Bloom’s: Analysis TYPE: Multiple Choice: Problem Students may need to use a significant amount of simple arithmetic to solve this problem. Although the calculations are simple, it will take them some time to set up the problem and do the arithmetic.

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

Change in depreciation Tax rate Reduction in net income

$750 35% −$487.50

We can also get the answer a longer way, which explains things more clearly:

Item Bonds Interest rate Tax rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income Taxes Net income

Old New $ 5,000.00 $ 5,000.00 6.5% 6.5% 35% 35% $10,500.00 $10,500.00 $ 6,250.00 $ 6,250.00 $ 1,300.00 $ 2,050.00 $ 2,950.00 $ 2,200.00 $ 325.00 $ 325.00 $ 2,625.00 $ 1,875.00 $ 918.75 $ 656.25 $ 1,706.25 $ 1,218.75

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.38 - LO: 6-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: change in net income KEYWORDS: Bloom’s: Analysis Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT OTHER:

TYPE: Multiple Choice: Problem

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

NOPAT = EBIT(1 − T) Total operating capital

$700 $2,000

$925 $2,500

FCF this year = NOPAT − Net investment in new operating capital FCF this year = $925 − $500 FCF this year = $425

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 67. Rao Corporation has the following balance sheet. How much net operating working capital does the firm have? Cash Short-term investments Accounts receivable Inventory Current assets Net fixed assets Total assets a. $54.00 b. $60.00 c. $66.00 d. $72.60 e. $79.86 ANSWER: RATIONALE: POINTS:

$ 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

b Net operating working capital = Operating current assets − Operating current liabilities NOWC = $100.00 − $40.00 NOWC = $60.00

Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating working capital KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 68. Bae Inc. has the following income statement. How much net operating profit after taxes (NOPAT) does the firm have? Sales Costs Depreciation EBIT Interest expense EBT Taxes (35%) Net income a. $370.60 b. $390.11 c. $410.64 d. $432.25 e. $455.00 ANSWER: RATIONALE:

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

EBIT Tax rate NOPAT =

$700.00 35% $455.00

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating profit after taxes (NOPAT) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 69. EP Enterprises has the following income statement. How much net operating profit after taxes (NOPAT) does the firm have? Sales Costs Depreciation EBIT Interest expense Cengage Learning Testing, Powered by Cognero

$1,800.00 1,400.00 250.00 $ 150.00 70.00 Page 33

CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT EBT Taxes (40%) Net income a. $81.23 b. $85.50 c. $90.00 d. $94.50 e. $99.23 ANSWER: RATIONALE:

$ $

80.00 32.00 48.00

EBIT Tax rate NOPAT =

$150.00 40% $90.00

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating profit after taxes (NOPAT) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 70. Tibbs Inc. had the following data for the year ending 12/31/2015: 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% ANSWER: d RATIONALE: NOPAT $400

Total operating capital

$2,300

ROIC = NOPAT/Total operating capital ROIC = $400/$2,300 ROIC = 17.39%

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT 71. Zumbahlen Inc. has the following balance sheet. How much total operating capital does the firm have? Cash Short-term investments Accounts receivable Inventory Current assets Gross fixed assets Accumulated deprec. Net fixed assets Total assets a. $114.00 b. $120.00 c. $126.00 d. $132.30 e. $138.92 ANSWER: RATIONALE:

$ 20.00Accounts payable 50.00Accruals 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 50.00 30.00 $110.00 70.00 30.00 40.00 $ 70.00 $250.00

b Total op. capital = Operating current assets − Operating current liabilities + Net fixed assets Total operating capital = $100.00 − $80.00 + $100.00 Total operating capital = $120.00

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total operating capital KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 72. Barnes' Brothers has the following data for the year ending 12/31/2015: 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 ANSWER: e RATIONALE: NOPAT $700

Total operating capital WACC

$2,100 10.00%

EVA = NOPAT − Total operating capital × WACC EVA = $700.00 − $2,100.00 × 10.00% EVA = $490.00

POINTS:

Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.44 - LO: 6-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Economic Value Added (EVA) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 73. Edwards Electronics recently reported $11,250 of sales, $5,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges, it had $3,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was its net cash flow? a. $3,284.75 b. $3,457.63 c. $3,639.61 d. $3,831.17 e. $4,032.81 ANSWER: e RATIONALE: Bonds $ 3,500.00

Interest rate Tax rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income Taxes Net income Net cash flow = Net income + deprn

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.42 - LO: 6-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: net cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 74. Wells Water Systems recently reported $8,250 of sales, $4,500 of operating costs other than depreciation, and $950 of depreciation. The company had no amortization charges, it had $3,250 of outstanding bonds that carry a 6.75% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to spend $750 to buy new fixed assets and to invest $250 in net operating Cengage Learning Testing, Powered by Cognero

Page 36

CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT working capital. How much free cash flow did Wells generate? a. $1,770.00 b. $1,858.50 c. $1,951.43 d. $2,049.00 e. $2,151.45 ANSWER: a RATIONALE: Bonds

Interest rate Tax rate Required addition to net operating working capital Required capital expenditures (fixed assets) Sales Operating costs excluding depr'n Depreciation Operating income (EBIT)

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

FCF = EBIT(1 − T) + Depr'n − Cap Ex − ΔNet Op WC FCF = $1,820 + $950 − $750 − $250 FCF = $1,770.00

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Income statement: free cash flow KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 75. HHH Inc. reported $12,500 of sales and $7,025 of operating costs (including depreciation). The company had $18,750 of investor-supplied operating assets (or capital), the weighted average cost of that capital (the WACC) was 9.5%, and the federal-plus-state income tax rate was 40%. What was HHH's Economic Value Added (EVA), i.e., how much value did management add to stockholders' wealth during the year? a. $1,357.13 b. $1,428.56 c. $1,503.75 d. $1,578.94 e. $1,657.88 ANSWER: c RATIONALE: Sales $12,500

Operating costs Operating income (EBIT) WACC Tax rate Investor-supplied capital Cengage Learning Testing, Powered by Cognero

$7,025 $5,475 9.5% 40% $18,750 Page 37

CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT EVA = EBIT(1 − T) − Investor Capital × WACC EVA = $3,285.00 − $1,781.25 EVA = $1,503.75

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.44 - LO: 6-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Economic Value Added (EVA) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 76. Last year, Michelson Manufacturing reported $10,250 of sales, $3,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges, it had $3,500 of bonds outstanding that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $725. By how much will the depreciation change cause the firm's net after-tax income and its net cash flow to change? Note that the company uses the same depreciation calculations for tax and stockholder reporting purposes. a. −$383.84; $206.68 b. −$404.04; $217.56 c. −$425.30; $229.01 d. −$447.69; $241.06 e. −$471.25; $253.75 ANSWER: e This problem can be worked very easily⎯ just multiply the increase in depreciation by (1 − T) RATIONALE: to get the decrease in net income, and then add to the change in income the change in depreciation to get the change in net cash flow:

Change in depreciation Tax rate Reduction in net income = Change in Depr'n (1 − Tax rate) Increase in net cash flow = Change in Depr'n − reduction in NI

$725 35.00% −$471.25 $253.75

We can also get the answer the long way, which explains things in more detail:

Bonds Interest rate Tax rate Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income Taxes Net income after taxes Net cash flow Check on NCF: ΔNCF = change in depreciation × tax rate Cengage Learning Testing, Powered by Cognero

Old $3,500 6.50% 35% $10,250 $3,500 $1,250 $5,500 $228 $5,273 $1,845 $3,427 $4,677

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

Change $0.00 $0.00 $0.00 $0.00 $0.00 $725.00 −$725.00 $0.00 −$725.00 −$253.75 −$471.25 $253.75 $253.75 Page 38

CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT We like this problem because it illustrates that an increase in depreciation will decrease the firm's net income yet increase its net cash flow, and cash is king.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in net income and NCF KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 77. Bartling Energy Systems recently reported $9,250 of sales, $5,750 of operating costs other than depreciation, and $700 of depreciation. The company had no amortization charges, it had $3,200 of outstanding bonds that carry a 5% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to make $1,250 of capital expenditures on new fixed assets and to invest $300 in net operating working capital. By how much did the firm's net income exceed its free cash flow? a. $673.27 b. $708.70 c. $746.00 d. $783.30 e. $822.47 ANSWER: c RATIONALE: Bonds $3,200.00

Interest rate Tax rate Required capital expenditures (fixed assets) Required addition to net operating working capital Sales Operating costs excluding depr'n Depreciation Operating income (EBIT) Interest charges Taxable income (EBT) Taxes Net income after taxes

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

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

$970.00

Difference between net income and FCF =

$746.00

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.39 - LO: 6-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 6—ACCOUNTING FOR FINANCIAL MANAGEMENT STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Income stmt: FCF vs. net income Bloom’s: Analysis TYPE: Multiple Choice: Problem

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS 1. Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.45 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Ratio analysis KEYWORDS: Bloom’s: Knowledge 2. The current ratio and inventory turnover ratios both help us measure the firm's liquidity. The current ratio measures the relationship of a firm's current assets to its current liabilities, while the inventory turnover ratio gives us an indication of how long it takes the firm to convert its inventory into cash. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Knowledge 3. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Knowledge Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS 4. High current and quick ratios always indicate that a firm is managing its liquidity position well. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Knowledge 5. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its assets. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Asset management ratios KEYWORDS: Bloom’s: Knowledge 6. A decline in a firm's inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its liquidity position is improving, i.e., it is becoming more liquid. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory turnover ratio KEYWORDS: Bloom’s: Knowledge 7. Debt management ratios show the extent to which a firm's managers are attempting to magnify returns on owners' Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS capital through the use of financial leverage. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt management ratios KEYWORDS: Bloom’s: Knowledge 8. The times-interest-earned ratio is one, but not the only, indication of a firm's ability to meet its long-term and short-term debt obligations. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: TIE ratio KEYWORDS: Bloom’s: Knowledge 9. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Profitability ratios KEYWORDS: Bloom’s: Knowledge 10. Market value ratios provide management with an indication of how investors view the firm's past performance and Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS especially its future prospects. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market value ratios KEYWORDS: Bloom’s: Knowledge 11. Determining whether a firm's financial position is improving or deteriorating requires analyzing more than the ratios for a given year. Trend analysis is one method of measuring changes in a firm's performance over time. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.51 - LO: 7-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trend analysis KEYWORDS: Bloom’s: Knowledge 12. The "apparent," but not the "true," financial position of a company whose sales are seasonal can differ dramatically, depending on the time of year when the financial statements are constructed. a. True b. False ANSWER: True Many of the ratios show sales over some past period such as the last 12 months divided by RATIONALE: an asset such as inventories as of a specific date. Assets like inventories vary at different times of the year for a seasonal business, thus leading to big changes in the ratio.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.45 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Balance sheet changes Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS KEYWORDS:

Bloom’s: Knowledge

13. Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.45 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Limitations of ratio analysis KEYWORDS: Bloom’s: Knowledge 14. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects. a. True b. False ANSWER: False BEP = EBIT/Assets. This is before the effects of leverage (interest) and taxes, so the RATIONALE: statement is false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Basic earning power ratio KEYWORDS: Bloom’s: Knowledge 15. The inventory turnover and current ratio are related. The combination of a high current ratio and a low inventory turnover ratio, relative to industry norms, suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged. a. True b. False ANSWER: True A high current ratio is consistent with a lot of inventory. A low inventory turnover is also RATIONALE: consistent with a lot of inventory. If the CR exceeds industry norms and the turnover is below the norms, then the firm has more inventory than most other firms, given its sales. It could just be carrying a lot of good inventory, but it might also have a normal amount of "good" inventory plus some "bad" inventory that has not been written off. So the statement is true.

POINTS: DIFFICULTY:

1 Difficulty: Moderate

Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory turnover ratio KEYWORDS: Bloom’s: Comprehension 16. It is appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing their fixed assets if and only if all the firms being compared have the same proportion of fixed assets to total assets. a. True b. False ANSWER: False The FA turnover is Sales/FA, and it gives an indication of how effectively the firm utilizes its RATIONALE: FA. The proportion of FA to TA is not relevant to this usage.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Fixed assets turnover KEYWORDS: Bloom’s: Comprehension 17. Since the ROA measures the firm's effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA. a. True b. False ANSWER: False EBIT = Sales revenues − Operating costs Net income = EBIT − Interest − Taxes = (EBIT − RATIONALE:

Interest) × (1 − T) ROA = Net income after taxes/Assets Two firms could have identical EBITs but very different amounts of interest, different tax rates, and different assets, and thus very different ROAs.

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios. a. True b. False ANSWER: False Think about the DuPont equation: ROE = PM × TATO × Equity multiplier. Similar financing RATIONALE: policies will lead to similar Equity multipliers. Moreover, competition in the capital markets will cause ROEs to be similar, because otherwise capital would flow to industries with high ROEs and drive returns down toward the average, given similar risks. To have similar ROEs, firms with relatively high PMs must have relatively low TATOs, and vice versa. Therefore, the statement is false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont equation KEYWORDS: Bloom’s: Comprehension 19. Even though Firm A's current ratio exceeds that of Firm B, Firm B's quick ratio might exceed that of A. However, if A's quick ratio exceeds B's, then we can be certain that A's current ratio is also larger than that of B. a. True b. False ANSWER: False This question can be answered by thinking carefully about the ratios: Demonstration that the RATIONALE: first sentence is true:

CR =

A>B

QR =

B>A

1.67

0.67

1.50

1.00

QR(B) > QR(A) Demonstration that second sentence is false:

CR =

A>B

QR =

B>A

1.0

0.67

1.5

0.50

QR(B) < QR(A) The key is inventory, which is in the CR but not in the QR. The firm with more inventory can have the higher CR but the lower QR.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Comprehension 20. Firms A and B have the same current ratio, 0.75, the same amount of sales and cost of goods sold, and the same amount of current liabilities. However, Firm A has a higher inventory turnover ratio than B. Therefore, we can conclude that A's quick ratio must be smaller than B's. a. True b. False ANSWER: False Firm A has the higher inventory turnover, so given the same cost of goods, it must have less RATIONALE: inventory. Thus, since the two firms have the same CR, then A must have the higher QR, not the lower one. Therefore, the statement is false.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Comprehension 21. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio. a. True b. False ANSWER: True TIE = EBIT/Interest = (Sales − Op cost)/(Debt × Interest rate). If we know the op. costs, the RATIONALE: amount of debt, and the interest rate, then we can solve for the sales level required to achieve the target TIE.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: TIE ratio KEYWORDS: Bloom’s: Comprehension 22. Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate. However, Firm A has a higher debt ratio. If BEP is greater than the Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio. a. True b. False ANSWER: True The easiest way to think about this is to realize that you can borrow at a cost of 10% and RATIONALE: invest the proceeds to earn 11%, you'll earn a surplus. If you were previously earning an ROE of 10%, then after raising and investing additional funds, your income will be higher, your equity will be the same, and thus your ROE will increase. Similarly, if a firm earns more on assets than the interest rate, there will be a surplus after paying interest on the debt that will go to the equity, thus increasing the ROE. So, if BEP > rd, then the firm can increase its expected ROE by using more debt leverage. The answer can also be seen by working out an example. The one below shows that leverage increases ROE if BEP > rd, but it could be varied to show no difference in ROE if interest rates and BEP are the same, and a reduction in ROE if the interest rate exceeds the BEP.

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

Firm B 100%Assets 60%Debt 40%Equity 15%BEP 10%Interest rate, rd 40%Tax rate 15.0EBIT = BEP × Assets 6.0Interest 9.0Taxable income 3.6Taxes 5.4NI 13.50%ROE

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

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: BEP and ROE KEYWORDS: Bloom’s: Comprehension 23. If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must be 0.667. a. True b. False ANSWER: True Equity multiplier = Assets/Equity = 3.0, so Assets/Equity = 1/3.0 = 0.333. By definition, RATIONALE: Equity/Assets + Debt/Assets = 1.00, so 0.333 + Debt/Assets = 1.0. Therefore, Debt/Assets = 1.0 − 0.333 = 0.667. Thus, the statement is true.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Equity multiplier KEYWORDS: Bloom’s: Comprehension 24. One problem with ratio analysis is that relationships can be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase. a. True b. False ANSWER: False The key here is to recognize that if the CR is greater than 1.0, then a given increase in both RATIONALE: current assets and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial CR were less than 1.0. Here the initial CR is greater than 1.0, so borrowing on a short-term basis to build the cash account would lower the CR. For example:

Original CA/CL

New Plus $1 CA/CL

Old CR

New CR 1.33

3/2

1/1

4/3

1.50

2/3

1/1

3/4

0.67

CR falls if initial CR is greater than 1.0 CR rises if initial CR is less than 0.75 1.0

Original New CA/CL Less $1 CA/CL

Old CR

New CR

−1/−1

0.67

0.50

2/3 Cengage Learning Testing, Powered by Cognero

1/2

CR falls if initial CR is less than 1.0 Page 10

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS 3/2

−1/−1

2/1

1.5

2.0

CR rises if initial CR is greater than 1.0

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.45 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Limitations of ratio analysis KEYWORDS: Bloom’s: Comprehension 26. Considered alone, which of the following would increase a company's current ratio? a. An increase in accounts payable. b. An increase in net fixed assets. c. An increase in accrued liabilities. d. An increase in notes payable. e. An increase in accounts receivable. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 27. Which of the following would, generally, indicate an improvement in a company's financial position, holding other things constant? a. The total assets turnover decreases. b. The TIE declines. c. The DSO increases. d. The EBITDA coverage ratio increases. e. The current and quick ratios both decline. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Current ratio Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual

28. A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio? a. Use cash to increase inventory holdings. b. Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. c. Use cash to repurchase some of the company's own stock. d. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year. e. Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 29. Which of the following statements is CORRECT? a. If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will decrease. b. A reduction in inventories held would have no effect on the current ratio. c. An increase in inventories would have no effect on the current ratio. d. If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. e. A reduction in the inventory turnover ratio will generally lead to an increase in the ROE. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventories KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS 30. Companies A and C each reported the same earnings per share (EPS), but Company A's stock trades at a higher price. Which of the following statements is CORRECT? a. Company A trades at a higher P/E ratio. b. Company A probably has fewer growth opportunities. c. Company A is probably judged by investors to be riskier. d. Company A must have a higher market-to-book ratio. e. Company A must pay a lower dividend. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statement analysis KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 31. Which of the following statements is CORRECT? a. If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. b. If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. c. Other things held constant, the higher a firm's expected future growth rate, the lower its P/E ratio is likely to be. d. The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA). e. If a firm has a history of high Economic Value Added (EVA) numbers each year, and if investors expect this situation to continue, then its market/book ratio and MVA are both likely to be below average. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market value ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 32. Which of the following statements is CORRECT? a. "Window dressing" is any action that improves a firm's fundamental, long-run position and thus increases its intrinsic value. Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS 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." ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.45 - LO: 7-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Window dressing KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 33. The Cavendish Company recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company's total assets or operating income. Which of the following effects would occur as a result of this action? a. The company's debt ratio increased. b. The company's current ratio increased. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 34. A firm's new president wants to strengthen the company's financial position. Which of the following actions would make it financially stronger? a. Increase inventories while holding sales and cost of goods sold constant. b. Increase accounts receivable while holding sales constant. Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS c. Increase EBIT while holding sales constant. d. Increase accounts payable while holding sales constant. e. Increase notes payable while holding sales constant. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 35. If the CEO of a large, diversified, firm were filling out a fitness report on a division manager (i.e., "grading" the manager), which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant. a. The division's DSO (days' sales outstanding) is 40, whereas the average for its competitors is 30. b. The division's basic earning power ratio is above the average of other firms in its industry. c. The division's total assets turnover ratio is below the average for other firms in its industry. d. The division's debt ratio is above the average for other firms in the industry. e. The division's inventory turnover is 6, whereas the average for its competitors is 8. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 36. Which of the following would indicate an improvement in a company's financial position, holding other things constant? a. The current and quick ratios both increase. b. The inventory and total assets turnover ratios both decline. c. The debt ratio increases. d. The profit margin declines. e. The EBITDA coverage ratio declines. ANSWER: a POINTS: 1 Cengage Learning Testing, Powered by Cognero

Page 15

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 37. If a bank loan officer were considering a company's request for a loan, which of the following statements would you consider to be CORRECT? a. Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm. b. The lower the company's EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm. c. Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm. d. Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm. e. The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous ratios KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 38. Which of the following statements is CORRECT? a. All else equal, increasing the debt ratio will increase the ROA. b. The use of debt financing will tend to lower the basic earning power ratio, other things held constant. c. A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure. d. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE. e. Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favorable basis than income from stock. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 Cengage Learning Testing, Powered by Cognero

Page 16

Original CA/CL 1.9/1

New Minus .5 CA/CL 0/0.5

Old CR

New CR

1.9/1.5 1.90

1.27

CR falls if initial CR is greater than 1.0

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 Cengage Learning Testing, Powered by Cognero

Page 17

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 41. Which of the following statements is CORRECT? a. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline. b. If a security analyst saw that a firm's days' sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength. c. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding (DSO) will increase. d. There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things. e. A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accounts receivable KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 42. Which of the following statements is CORRECT? a. If two firms differ only in their use of debt⎯ i.e., they have identical assets, sales, operating costs, and tax rates⎯ but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales. b. If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. 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. ANSWER: d a is incorrect. The reverse is true. b is false, because the TIE also depends on the interest RATIONALE: rate and EBIT. c is false, because interest affects the profit margin. d is correct, because the more interest the lower the profits, hence the lower the profit margin. e is simply incorrect. Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage effects Debt management KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 43. Which of the following statements is CORRECT? a. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market-to-book ratios must also be the same. b. If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be the same. c. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same. d. If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price earnings ratio. e. If Firm X's P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and also to be expected to grow at a faster rate. ANSWER: c No reason for a to be true. No reason for b to be true. c must be true, as EPS and P will be RATIONALE: the same. No reason for d to be true. e is wrong, because high risk and low growth lead to low P/Es.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market value ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 44. Which of the following statements is CORRECT? a. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will decrease. b. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS 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. ANSWER: b RATIONALE: × × PM TATO Eq mult. = ROE

Old New

9% 10%

1.0 0.9

1.666667 2.5

15% 23%

We see that b is true, thus c must be false. We can also see that d, e, and a are all false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 45. You observe that a firm's ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. Which of the following statements is CORRECT? a. Its total assets turnover must equal the industry average. b. Its total assets turnover must be above the industry average. c. Its return on assets must equal the industry average. d. Its TIE ratio must be below the industry average. e. Its total assets turnover must be below the industry average. ANSWER: b Thinking through the DuPont equation, we can see that if the firm's PM and Equity multiplier RATIONALE: are below the industry average, the only way its ROE can exceed the industry average is if its equity multiplier exceeds the industry average. The following data illustrate this point:

Firm Industry

ROE 30% 25%

PM 9% 10%

TATO 2.0 1

Eq mult. 1.67 2.50

ROA 18% 10%

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

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

46. Companies Heidee and Leaudy are virtually identical in that they are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company Heidee has the higher debt ratio. Which of the following statements is CORRECT? a. Company Heidee has a lower operating income (EBIT) than Company LD. b. Company Heidee has a lower total assets turnover than Company Leaudy. c. Company Heidee has a lower equity multiplier than Company Leaudy. d. Company Heidee has a higher fixed assets turnover than Company Leaudy. e. Company Heidee has a higher ROE than Company Leaudy. ANSWER: e Rule out all answers except e because they are false. Alternative answer explanation using RATIONALE:

the DuPont equation: ROE = PM × TATO × Eq mult. ROE = NI/S × S/TA × TA/Equity The first two terms are the same, but KB has higher equity multiplier, hence higher ROE.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 47. Cordelion Communications is considering issuing new common stock and using the proceeds to reduce its outstanding debt. The stock issue would have no effect on total assets, the interest rate Cordelion pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue? a. The times interest earned ratio will decrease. b. The ROA will decline. c. Taxable income will decrease. d. The tax bill will increase. e. Net income will decrease. ANSWER: d a The TIE will increase, not decrease. b is false because reducing debt will lower interest, RATIONALE: raise income, and thus raise ROA. c is false for the above reason. d is true for the above reason. e is false.

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

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

a. b. c. d. e.

EBIT. This would lower the profit margin = NI/Sales. Sales fluctuations would have more effects on the DSO and S/Inventory ratios. ROE = ROA × Equity multiplier, so more debt, higher ROE for given ROA. DSO = Receivables/Sales per day. With sales constant, an increase in DSO would mean an increase in receivables, hence a decline, not a rise, in the TATO. An increase in the DSO might increase or decrease ROE, depending on how it affected sales and costs.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statement analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 49. Heidee Corp. and Leaudy Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, Heidee uses more debt than Leaudy. Which of the following statements is CORRECT? a. Heidee would have the higher net income as shown on the income statement. b. Without more information, we cannot tell if Heidee or Leaudy would have a higher or lower net income. c. Heidee would have the lower equity multiplier for use in the DuPont equation. d. Heidee would have to pay more in income taxes. e. Heidee would have the lower net income as shown on the income statement. ANSWER: e More debt would mean more interest, hence a lower NI, given a constant EBIT, so e is RATIONALE: correct. Also, we can rule out b and a, and Heidee would also have the higher multiplier, which rules out c. And with more interest, Heidee would have to pay less taxes, not more.

POINTS:

Cengage Learning Testing, Powered by Cognero

Page 22

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial statement analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 50. Other things held constant, which of the following alternatives would increase a company's cash flow for the current year? a. Increase the number of years over which fixed assets are depreciated for tax purposes. 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. ANSWER: c RATIONALE: Lengthening depreciable lives would lower depreciation, increase taxable

a. b. c. d. e.

income and taxes, and thus lower cash flow. Paying down accounts payable would use cash and thus reduce cash flow. Reducing the DSO would require collecting receivables faster, which would indeed increase cash flow. Decreasing accruals would lower cash flow. Reducing inventory turnover would mean increasing inventories, which would use cash.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flows KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 51. Companies Heidee and Leaudy have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Company Heidee has more net income. b. Company Heidee pays less in taxes. c. Company Heidee has a lower equity multiplier. d. Company Heidee has a higher ROA. Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS e. Company Heidee has a higher times interest earned (TIE) ratio. ANSWER: b Under the stated conditions, Heidee would have more interest charges, thus lower taxable RATIONALE: income and taxes. Thus, b is correct. All of the other statements are incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage, taxes, and ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 52. Companies Heidee and Leaudy have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Company Heidee has a lower times interest earned (TIE) ratio. b. Company Heidee has a lower equity multiplier. c. Company Heidee has more net income. d. Company Heidee pays more in taxes. e. Company Heidee has a lower ROE. ANSWER: a Heidee has higher interest charges. Basic earning power equals EBIT/Assets, and since RATIONALE: assets are equal, EBIT must also be equal. TIE = EBIT/Interest. Therefore, Heidee higher interest charges means that its TIE must be lower. Thus, a is correct. All of the other statements are incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leverage, taxes, and ratios KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 53. Lincoln Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio? a. Use cash to reduce long-term bonds outstanding. b. Borrow using short-term notes payable and use the cash to increase inventories. c. Use cash to reduce accruals. d. Use cash to reduce accounts payable. e. Use cash to reduce short-term notes payable. Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS ANSWER: RATIONALE:

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

Original CA/CL 1/2

New Plus $1 CA/CL 1/1

2/3

Old CR

New CR

0.50

0.67

CR rises if initial CR is less than 1.0

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

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 54. Lofland's has $20 million in current assets and $10 million in current liabilities, while Smaland's current assets are $10 million versus $20 million of current liabilities. Both firms would like to "window dress" their end-of-year financial statements, and to do so each plans to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the results of these transactions? a. The transaction would improve both firms' financial strength as measured by their current ratios. b. The transactions would raise Lofland's financial strength as measured by its current ratio but lower Smaland's current ratio. c. The transactions would lower Lofland's financial strength as measured by its current ratio but raise Smaland's current ratio. d. The transaction would have no effect on the firm' financial strength as measured by their current ratios. e. The transaction would lower both firm' financial strength as measured by their current ratios. ANSWER: c The key here is to recognize that if the CR is less than 1.0, then a given increase to both RATIONALE: current assets and current liabilities will increase the CR, while the reverse will hold if the initial CR is greater than 1.0. Thus, the transaction would make Smaland look stronger but Lofland look weaker. Here's an illustration:

Lofland

Smaland Cengage Learning Testing, Powered by Cognero

Original New CA/CL Plus $10 CA/CL

Old CR

20/10

30/20

2.00

Original New CA/CL Plus $10 CA/CL

Old CR

10/20

0.50

10/10

20/30

New CR CR falls because 1.50 initial CR is greater than 1.0 New CR CR rises because 0.67 initial CR is less than 1.0 Page 25

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS All of the statements except c are incorrect.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 55. Companies Heidee and Leaudy have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company Heidee has a higher debt ratio. Which of the following statements is CORRECT? a. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE. b. Given this information, Leaudy must have the higher ROE. c. Company Leaudy has a higher basic earning power ratio (BEP). d. Company Heidee has a higher basic earning power ratio (BEP). e. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company Heidee will have the higher ROE. ANSWER: a The companies have the same EBIT and assets, hence the same BEP ratio. If the interest RATIONALE: rate is less than the BEP, then using more debt will raise the ROE. Therefore, statement a is correct. The others are all incorrect.

Page 26

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS RATIONALE:

Sales Total assets TATO

$52,000 $22,000 2.36

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total assets turnover KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 57. Hutchinson Corporation has zero debt⎯ it is financed only with common equity. Its total assets are $410,000. The new CFO wants to employ enough debt to bring the debt/assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio? a. $155,800 b. $164,000 c. $172,200 d. $180,810 e. $189,851 ANSWER: b RATIONALE: Total assets $410,000

Target debt ratio Debt to achieve target ratio = amount borrowed

40% $164,000

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt ratio: find the debt, given the D/A ratio KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 58. Orono Corp.'s sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500. What was the firm's times interest earned (TIE) ratio? a. 4.72 b. 4.97 c. 5.23 d. 5.51 e. 5.80 ANSWER: e Cengage Learning Testing, Powered by Cognero

Page 27

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS RATIONALE:

Sales Operating costs Operating income (EBIT) Interest charges TIE ratio

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Times interest earned KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 59. Rappaport Corp.'s sales last year were $320,000, and its net income after taxes was $23,000. What was its profit margin on sales? a. 6.49% b. 6.83% c. 7.19% d. 7.55% e. 7.92% ANSWER: c RATIONALE: Sales $320,000

Net income Profit margin

$23,000 7.19%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Profit margin on sales KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 60. Branch Corp.'s total assets at the end of last year were $315,000 and its net income after taxes was $22,750. What was its return on total assets? a. 7.22% b. 7.58% c. 7.96% d. 8.36% e. 8.78% Cengage Learning Testing, Powered by Cognero

Page 28

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS ANSWER: RATIONALE:

Total assets Net income ROA

$315,000 $22,750 7.22%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on total assets (ROA) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 61. Chambliss Corp.'s total assets at the end of last year were $305,000 and its EBIT was 62,500. What was its basic earning power (BEP)? a. 18.49% b. 19.47% c. 20.49% d. 21.52% e. 22.59% ANSWER: c RATIONALE: Total assets $305,000

EBIT BEP

$62,500 20.49%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Basic earning power (BEP) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 62. Nikko Corp.'s total common equity at the end of last year was $305,000 and its net income after taxes was $60,000. What was its ROE? a. 16.87% b. 17.75% c. 18.69% d. 19.67% e. 20.66% ANSWER: d Cengage Learning Testing, Powered by Cognero

Page 29

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS RATIONALE:

Common equity Net income ROE

$305,000 $60,000 19.67%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on equity (ROE) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 63. An investor is considering starting a new business. The company would require $475,000 of assets, and it would be financed entirely with common stock. The investor will go forward only if she thinks the firm can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net income must be expected to warrant starting the business? a. $52,230 b. $54,979 c. $57,873 d. $60,919 e. $64,125 ANSWER: e RATIONALE: Assets = equity $475,000

Target ROE Required net income

13.5% $64,125

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on equity (ROE): finding net income KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 64. Vang Corp.'s stock price at the end of last year was $33.50 and its earnings per share for the year were $2.30. What was its P/E ratio? a. 13.84 b. 14.57 c. 15.29 d. 16.06 e. 16.86 Cengage Learning Testing, Powered by Cognero

Page 30

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS ANSWER: RATIONALE:

Stock price EPS P/E

$33.50 $2.30 14.57

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Price/Earnings ratio (P/E) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 65. Lindley Corp.'s stock price at the end of last year was $33.50, and its book value per share was $25.00. What was its market/book ratio? a. 1.34 b. 1.41 c. 1.48 d. 1.55 e. 1.63 ANSWER: a RATIONALE: Stock price $33.50

Book value per share M/B ratio

$25.00 1.34

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Price/Earnings ratio (P/E) KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 66. Northwest Lumber had a profit margin of 5.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8. What was the firm's ROE? a. 12.79% b. 13.47% c. 14.18% d. 14.88% e. 15.63% ANSWER: c Cengage Learning Testing, Powered by Cognero

Page 31

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS RATIONALE:

Profit margin TATO Equity multiplier ROE

5.25% 1.50 1.80 14.18%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont equation: basic calculation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 67. Bostian, Inc. has total assets of $625,000. Its total debt outstanding is $185,000. The Board of Directors has directed the CFO to move towards a debt-to-assets ratio of 55%. How much debt must the company add or subtract to achieve the target debt ratio? a. $158,750 b. $166,688 c. $175,022 d. $183,773 e. $192,962 ANSWER: a RATIONALE: Total assets $625,000

Present debt Target debt ratio Target amount of debt Change in amount of debt outstanding

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Debt ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 68. Emerson Inc.'s would like to undertake a policy of paying out 45% of its income. Its latest net income was $1,250,000, and it had 225,000 shares outstanding. What dividend per share should it declare? a. $2.14 b. $2.26 c. $2.38 Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS d. $2.50 e. $2.63 ANSWER: RATIONALE:

Net income Shares outstanding Payout ratio EPS DPS

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EPS, DPS, and payout KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 69. Aziz Industries has sales of $100,000 and accounts receivable of $11,500, and it gives its customers 30 days to pay. The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash freed-up by this change, how would that affect its net income, assuming other things are held constant? a. $267.34 b. $281.41 c. $296.22 d. $311.81 e. $328.22 ANSWER: e RATIONALE: Rate of return on cash generated 8.0%

Sales A/R Days in year Sales/day Company DSO Industry DSO Excess DSO Cash flow from reducing the DSO

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

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

$7,397.26 $4,102.74 $328.22

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 Cengage Learning Testing, Powered by Cognero

Page 33

Sales Sales/Day Receivables DSO Credit period − DSO = Days early (+) or late (−)

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Days sales outstanding (DSO) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 71. Harper Corp.'s sales last year were $395,000, and its year-end receivables were $42,500. Harper sells on terms that call for customers to pay 30 days after the purchase, but many delay payment beyond Day 30. On average, how many days late do customers pay? Base your answer on this equation: DSO − Allowed credit period = Average days late, and use a 365-day year when calculating the DSO. a. 7.95 b. 8.37 c. 8.81 d. 9.27 e. 9.74 ANSWER: d Cengage Learning Testing, Powered by Cognero

Page 34

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS RATIONALE:

Sales Sales/Day Receivables DSO Credit period Credit period − DSO = Days late

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DSO: days of free credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 72. Bonner Corp.'s sales last year were $415,000, and its year-end total assets were $355,000. The average firm in the industry has a total assets turnover ratio (TATO) of 2.4. Bonner's new CFO believes the firm has excess assets that can be sold so as to bring the TATO down to the industry average without affecting sales. By how much must the assets be reduced to bring the TATO to the industry average, holding sales constant? a. $164,330 b. $172,979 c. $182,083 d. $191,188 e. $200,747 ANSWER: c RATIONALE: Sales $415,000

Total assets Target TATO Target assets = Sales/Target TATO Asset reduction

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

Page 35

CHAPTER 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% ANSWER: e RATIONALE: Assets $565,000

Sales Operating costs Operating income (EBIT) TIE Maximum interest expense = EBIT/TIE Interest rate Max. debt = Max interest/Interest rate Maximum debt ratio = Debt/Assets

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Max debt ratio consistent with given TIE ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 74. Ziebart Corp.'s EBITDA last year was $390,000 ( = EBIT + depreciation + amortization), its interest charges were $9,500, it had to repay $26,000 of long-term debt, and it had to make a payment of $17,400 under a long-term lease. The firm had no amortization charges. What was the EBITDA coverage ratio? a. 7.32 b. 7.70 c. 8.09 d. 8.49 e. 8.92 ANSWER: b RATIONALE: EBITDA $390,000

Interest charges Repayment of principal Lease payments Total financial charges Funds avail for fin charges (EBITDA + Lease pmts) EBITDA coverage Cengage Learning Testing, Powered by Cognero

$9,500 $26,000 $17,400 $52,900 $407,400 7.70 Page 36

Sales Net income Target ROE Net income req'd to achieve target ROE Profit margin needed to achieve target ROE

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

Page 37

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS d. 10.88% e. 11.42% ANSWER: RATIONALE:

Assets Debt ratio Debt Equity Sales Old net income New net income New ROE Old ROE Increase in ROE

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

BVPS Shares outstanding Debt ratio Total equity Total assets Total debt

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

Page 38

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA EPS, book value, and debt ratio Bloom’s: Analysis TYPE: Multiple Choice: Problem

78. Last year Vaughn Corp. had sales of $315,000 and a net income of $17,832, and its year-end assets were $210,000. The firm's total-debt-to-total-assets ratio was 42.5%. Based on the DuPont equation, what was Vaughn's ROE? a. 14.77% b. 15.51% c. 16.28% d. 17.10% e. 17.95% ANSWER: a RATIONALE: Sales $315,000

Assets Net income Debt ratio Debt Equity Profit margin TATO Equity multiplier ROE

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont equation: basic calculation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 79. Last year Central Chemicals had sales of $205,000, assets of $127,500, a profit margin of 5.3%, and an equity multiplier of 1.2. The CFO believes that the company could reduce its assets by $21,000 without affecting either sales or costs. Had it reduced its assets in this amount, and had the debt-to-assets ratio, sales, and costs remained constant, by how much would the ROE have changed? a. 1.81% b. 2.02% c. 2.22% d. 2.44% e. 2.68% ANSWER: b RATIONALE: Old New

Sales Cengage Learning Testing, Powered by Cognero

$205,000

$205,000 Page 39

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS Original assets Reduction in assets New assets TATO Profit margin Equity multiplier ROE Change in ROE

$127,500

1.61 5.30% 1.20 10.23%

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont eqn: effect of reducing assets on ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 80. Last year Mason Inc. had a total assets turnover of 1.33 and an equity multiplier of 1.75. Its sales were $195,000 and its net income was $10,549. The CFO believes that the company could have operated more efficiently, lowered its costs, and increased its net income by $5,250 without changing its sales, assets, or capital structure. Had it cut costs and increased its net income in this amount, by how much would the ROE have changed? a. 5.66% b. 5.95% c. 6.27% d. 6.58% e. 6.91% ANSWER: c RATIONALE: Old New

Sales Original net income Increase in net income New net income Profit margin TATO Equity multiplier ROE Change in ROE

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

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

Page 40

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS TOPICS: KEYWORDS: OTHER:

DuPont eqn: effect of reducing costs on ROE Bloom’s: Analysis TYPE: Multiple Choice: Problem

81. Last year Rosenberg Corp. had $195,000 of assets, $18,775 of net income, and a debt-to-total-assets ratio of 32%. Now suppose the new CFO convinces the president to increase the debt ratio to 48%. Sales and total assets will not be affected, but interest expenses would increase. However, the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged. By how much would the change in the capital structure improve the ROE? a. 4.36% b. 4.57% c. 4.80% d. 5.04% e. 5.30% ANSWER: a RATIONALE: Assets $195,000

Old debt ratio Old debt Old equity New debt ratio New debt New Equity Net income New ROE Old ROE Increase in ROE

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

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DuPont equation: changing the debt ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 82. Last year Altman Corp. had $205,000 of assets, $303,500 of sales, $18,250 of net income, and a debt-to-total-assets ratio of 41%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets to $152,500. Sales, costs, and net income would not be affected, and the firm would maintain the 41% debt ratio. By how much would the reduction in assets improve the ROE? a. 4.69% b. 4.93% c. 5.19% d. 5.45% e. 5.73% Cengage Learning Testing, Powered by Cognero

Page 41

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS ANSWER: RATIONALE:

Old $205,000 $303,500 $18,250 41.00% $84,050 $120,950 15.089%

Assets Sales Net income Debt ratio Debt Equity ROE Increase in ROE

New $152,500 $303,500 $18,250 41.00% $62,525 $89,975 20.283% 5.19%

$ 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% ANSWER: b RATIONALE: Sales $280,000

Net income Actual current ratio Target current ratio ORIGINAL BALANCE SHEET Cengage Learning Testing, Powered by Cognero

$21,000 4.20 2.70

Page 42

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS Cash Receivables Inventories Net fixed assets Total assets NI/Equity = ROE: Inv. at target CR Reduction in inv & equity New common equity New ROE ΔROE

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

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

7.50% $105,000 = inventories and common $105,000equity decrease by this amount $175,000 12.00% 4.50%

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DSO and its effect on net income KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 84. Last year Swensen Corp. had sales of $303,225, operating costs of $267,500, and year-end assets of $195,000. The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.2%, and the firm's tax rate was 37%. The new CFO wants to see how the ROE would have been affected if the firm had used a 45% debt ratio. Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant. By how much would the ROE change in response to the change in the capital structure? a. 2.08% b. 2.32% c. 2.57% d. 2.86% e. 3.14% ANSWER: d RATIONALE: Old New

Interest rate Tax rate Assets Debt ratio Debt Equity

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

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

Sales

$303,225

Cengage Learning Testing, Powered by Cognero

Page 43

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS Operating costs EBIT Interest paid Taxable income Taxes Net income ROE Change in ROE

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

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

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ROE changing with debt ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 85. For the coming year, Crane Inc. is considering two financial plans. Management expects sales to be $301,770, operating costs to be $266,545, assets to be $200,000, and its tax rate to be 35%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but the TIE ratio would have to be kept at 4.00 or more. Under Plan B the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure? a. 3.83% b. 4.02% c. 4.22% d. 4.43% e. 4.65% ANSWER: a Work down the Plan A column, find the Max Debt, then use it to complete Plan B and the RATIONALE: ROEs.

Interest rate Tax rate Assets Debt ratio Debt Equity

Plan A 8.80% 35% $200,000 25% $50,000 $150,000

Plan B 8.80% 35% $200,000

Sales Operating costs EBIT Interest Taxable income Taxes

$301,770 $266,545 $ 35,225 $ 4,400 $ 30,825 $ 10,789

$301,770Constant $266,545Constant $ 35,225Constant $ 8,806 $ 26,419 $ 9,247

Cengage Learning Testing, Powered by Cognero

$100,071 $99,929

Page 44

CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS Net income ROE TIE Minimum TIE Interest consistent with minimum TIE = EBIT/Min TIE Max debt = Interest/interest rate Change in ROE

$ 20,036 13.36% 8.01 4.00

$ 17,172 17.18%

$8,806 $100,071 3.83%

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maximum debt constrained by TIE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem Exhibit 7.1 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 debt 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 Cengage Learning Testing, Powered by Cognero

2015 $ 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 2015 $58,800.0 $54,978.0 $ 1,029.0 $ 2,793.0 1,050.0 Page 45

CHAPTER 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

$ 1,743.0 $ 610.1 $ 1,133.0 175.00 $ 509.83 6.25% 35% $77.69

86. Refer to Exhibit 7.1. What is the firm's current ratio? a. 0.97 b. 1.08 c. 1.20 d. 1.33 e. 1.47 ANSWER: d Current ratio = Current assets/Current liabilities = 1.33 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 87. Refer to Exhibit 7.1. What is the firm's quick ratio? a. 0.49 b. 0.61 c. 0.73 d. 0.87 e. 1.05 ANSWER: b Quick ratio = (CA − Inventory)/CL = 0.61 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.46 - LO: 7-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS OTHER:

TYPE: Multiple Choice: Multi-part

88. Refer to Exhibit 7.1. What is the firm's days sales outstanding? Assume a 360-day year for this calculation. a. 48.17 b. 50.71 c. 53.38 d. 56.19 e. 59.14 ANSWER: e DSO = Accounts receivable/(Sales/360) = 59.14 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 89. Refer to Exhibit 7.1. What is the firm's total assets turnover? a. 0.90 b. 1.12 c. 1.40 d. 1.68 e. 2.02 ANSWER: c Total assets turnover ratio = Sales/Total assets = 1.40 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 90. Refer to Exhibit 7.1. What is the firm's inventory turnover ratio? a. 4.17 b. 4.38 c. 4.59 Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS d. 5.82 e. 5.07 ANSWER: RATIONALE:

a Inventory turnover ratio = (Cost of goods sold except depreciation + Depreciation)/Inventory = 4.17

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.47 - LO: 7-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 91. Refer to Exhibit 7.1. What is the firm's TIE? a. 1.94 b. 2.15 c. 2.39 d. 2.66 e. 2.93 ANSWER: d TIE = EBIT/Interest charges = 2.66 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 92. Refer to Exhibit 7.1. What is the firm's EBITDA coverage? a. 3.29 b. 3.46 c. 3.64 d. 3.82 e. 4.01 ANSWER: c EBITDA covg = (EBITDA + lease)/(Int + principal + lease) = 3.64 RATIONALE: POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 93. Refer to Exhibit 7.1. What is the firm's debt-to-assets ratio? a. 45.93% b. 51.03% c. 56.70% d. 63.00% e. 70.00% ANSWER: e Debt ratio = Total debt/Total assets = 70.0% RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.48 - LO: 7-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 94. Refer to Exhibit 7.1. What is the firm's ROA? a. 2.70% b. 2.97% c. 3.26% d. 3.59% e. 3.95% ANSWER: a ROA = Net income/Total assets = 2.70% RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS TOPICS: KEYWORDS: OTHER:

Calculating ratios given financial stmts Bloom’s: Application TYPE: Multiple Choice: Multi-part

95. Refer to Exhibit 7.1. What is the firm's ROE? a. 8.54% b. 8.99% c. 9.44% d. 9.91% e. 10.41% ANSWER: b ROE = Net income/Common equity = 8.99% RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 96. Refer to Exhibit 7.1. What is the firm's BEP? a. 6.00% b. 6.32% c. 6.65% d. 6.98% e. 7.33% ANSWER: c BEP = EBIT/Total assets = 6.65% RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 97. Refer to Exhibit 7.1. What is the firm's profit margin? a. 1.40% Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS b. 1.56% c. 1.73% d. 1.93% e. 2.12% ANSWER: d Profit margin = Net income/Sales = 1.93% RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 98. Refer to Exhibit 7.1. What is the firm's dividends per share? a. $2.62 b. $2.91 c. $3.20 d. $3.53 e. $3.88 ANSWER: b DPS = Common dividends paid/Shares outstanding = $2.91 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 99. Refer to Exhibit 7.1. What is the firm's cash flow per share? a. $10.06 b. $10.59 c. $11.15 d. $11.74 e. $12.35 ANSWER: e CFPS = (Net income + Depreciation)/Shares outstanding = $12.35 RATIONALE: Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.49 - LO: 7-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 100. Refer to Exhibit 7.1. What is the firm's EPS? a. $5.84 b. $6.15 c. $6.47 d. $6.80 e. $7.14 ANSWER: c EPS = Net income/common shares outstanding = $6.47 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 101. Refer to Exhibit 7.1. What is the firm's P/E ratio? a. 12.0 b. 12.6 c. 13.2 d. 13.9 e. 14.6 ANSWER: a P/E ratio = Price per share/Earnings per share = 12.0 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Calculating ratios given financial stmts Bloom’s: Application TYPE: Multiple Choice: Multi-part

102. Refer to Exhibit 7.1. What is the firm's book value per share? a. $61.73 b. $64.98 c. $68.40 d. $72.00 e. $75.60 ANSWER: d BVPS = Common equity/Shares outstanding = $72.00 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 103. Refer to Exhibit 7.1. What is the firm's market-to-book ratio? a. 0.56 b. 0.66 c. 0.78 d. 0.92 e. 1.08 ANSWER: e Market/book ratio (M/B) = Price per share/BVPS = 1.08 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.50 - LO: 7-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 104. Refer to Exhibit 7.1. What is the firm's equity multiplier? Cengage Learning Testing, Powered by Cognero

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CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS a. 3.33 b. 3.50 c. 3.68 d. 3.86 e. 4.05 ANSWER: a Equity multiplier = Total assets/Common equity = 3.33 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.52 - LO: 7-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Calculating ratios given financial stmts KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part

Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION 1. A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.53 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Proxy KEYWORDS: Bloom’s: Knowledge 2. The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.53 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preemptive right KEYWORDS: Bloom’s: Knowledge 3. If a firm's stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.53 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preemptive right KEYWORDS: Bloom’s: Knowledge 4. Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting control. Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.54 - LO: 8-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Classified stock KEYWORDS: Bloom’s: Knowledge 5. Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.54 - LO: 8-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Founders' shares KEYWORDS: Bloom’s: Knowledge 6. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected otal stock returns KEYWORDS: Bloom’s: Knowledge 7. The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.56 - LO: 8-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Common stock cash flows KEYWORDS: Bloom’s: Knowledge 8. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.56 - LO: 8-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Value: investment horizon KEYWORDS: Bloom’s: Knowledge 9. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth dividend model KEYWORDS: Bloom’s: Knowledge 10. According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. a. True b. False ANSWER: True POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant growth model KEYWORDS: Bloom’s: Knowledge 11. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.56 - LO: 8-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flows and valuation KEYWORDS: Bloom’s: Knowledge 12. The free cash flow valuation model cannot be used unless a company doesn't pay dividends. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.56 - LO: 8-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model KEYWORDS: Bloom’s: Knowledge 13. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.58 - LO: 8-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Free cash flows and valuation Bloom’s: Knowledge

14. 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. a. True b. False ANSWER: False Preferred dividends don't normally grow, and they are not guaranteed. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.59 - LO: 8-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Knowledge 15. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.59 - LO: 8-13 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Knowledge 16. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth model KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 17. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth free cash flow model KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 18. If a firm's expected growth rate increased then its required rate of return would a. decrease. b. fluctuate less than before. c. fluctuate more than before. d. possibly increase, possibly decrease, or possibly remain constant. e. increase. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 19. You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that you think a. the stock should be sold. b. the stock is a good buy. c. management is probably not trying to maximize the price per share. d. dividends are not likely to be declared. e. the stock is experiencing supernormal growth. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 20. The preemptive right is important to shareholders because it a. will result in higher dividends per share. b. is included in every corporate charter. c. protects the current shareholders against a dilution of their ownership interests. d. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate. e. allows managers to buy additional shares below the current market price. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.53 - LO: 8-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preemptive right KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION 21. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks, regardless of class, must have the same voting rights. b. All firms have several classes of common stock. c. All common stock, regardless of class, must pay the same dividend. d. Some class or classes of common stock are entitled to more votes per share than other classes. e. All common stocks fall into one of three classes: A, B, and C. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.54 - LO: 8-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Classified stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 22. Which of the following statements is CORRECT? a. Two firms with the same expected dividend and growth rates must also have the same stock price. b. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. c. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. ANSWER: e Statement e is true, because the expected growth rate is also the expected capital gains RATIONALE: yield. All the other statements are false.

Page 8

CHAPTER 8—BASIC STOCK VALUATION 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. ANSWER: e Statement e is true, because the expected growth rate is also the expected capital gains RATIONALE: yield. All the other statements are false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.60 - LO: 8-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant free cash flow growth model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 24. 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. ANSWER: d RATIONALE: Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so P1 must be $10(0.95) = $9.50. Therefore, answer d is correct, while the others are all false.

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CHAPTER 8—BASIC STOCK VALUATION 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. ANSWER: d Statement d is true, because the stock price is expected to grow at the dividend growth rate. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 26. 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. ANSWER: d Statement d is true, because the value of operations is expected to grow at the free cash flow RATIONALE: growth rate.

A 10%

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B 12% Page 10

CHAPTER 8—BASIC STOCK VALUATION 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. ANSWER: a The following calculations show that answer a is correct. The others are all wrong. RATIONALE:

Expected return Expected growth Dividend yield

A 10% 7% 3%

B 12% 9% 3%

Price Expected growth Expected return

A $25 7% 10%

B $40 9% 12%

A = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $0.75 B = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $1.20

POINTS: DIFFICULTY:

1 Difficulty: Moderate

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A $25 10% 15% 5% $1.25

Price g r Div. Yield = r − g = D1 = P(Div Yield) =

B $25 5% 15% 10% $2.50

Y Page 12

CHAPTER 8—BASIC STOCK VALUATION 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. ANSWER: b The correct answer is statement b. Both prices are currently the same, but X's price should RATIONALE: grow at 6% vs. 4% for Y, so X's price should be higher a year from now.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 31. 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%. ANSWER: a The correct answer choice is a. One could quickly calculate the dividend yield and see that it RATIONALE: equals the growth rate, but here are some numbers that provide more information.

D1 P0 g

$3.00D1/P0 $50.00rX 6.0%

6.0% 12.0%

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CHAPTER 8—BASIC STOCK VALUATION TOPICS: KEYWORDS: OTHER: NOTES:

Expected and required returns Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

32. 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. ANSWER: a RATIONALE: Dividend = Yield × Price: X dividend = $1.25

Y dividend = $0.75

Stock X has a dividend yield of 5% versus a yield of 3% for Y. Since they both have the same stock price, X must pay a higher dividend.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 33. 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%. ANSWER: c RATIONALE: P1 = P0(1 + g) = $54. Therefore, c is correct. All the other answers are false. P1 = $54.00. POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

United States - AK - DISC: Stocks and Bonds United States - OH - Default City - TBA Expected and required returns Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

34. 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. ANSWER: e Statement e is true, because if the required return for Stock A is higher than that of Stock B, RATIONALE: and if the dividend yield for Stock A is lower than Stock B's, the growth rate for Stock A must be higher to offset this.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend yield and g KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 35. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION TOPICS: KEYWORDS: OTHER: NOTES:

Dividend yield and g Bloom’s: Analysis TYPE: Multiple Choice: Conceptual Question may require calculations to find the correct answer.

36. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend yield and g KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 37. Which of the following statements is NOT CORRECT? 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.60 - LO: 8-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model KEYWORDS: Bloom’s: Analysis Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION OTHER:

TYPE: Multiple Choice: Conceptual

38. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 39. 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 is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free. d. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer. e. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION NOTES:

Question may require calculations to find the correct answer.

40. 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. ANSWER: b Statement a is simply false. Statement b is true. Statements c and d are false, because the RATIONALE: constant growth model can be used anytime as long as the constant growth rate is less than the required return (even if the growth rate is negative). Statement e is false⎯ a number of companies have different classes of stock with different voting rights.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Common stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 41. 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. ANSWER: b Statement a is simply false. Statement b is true. Statements c and d are false, because the RATIONALE: constant growth model can be used anytime as long as the constant growth rate is less than the required return (even if the growth rate is negative). Statement e is false⎯ a number of companies have different classes of stock with different voting rights.

POINTS: DIFFICULTY:

1 Difficulty: Moderate

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Page 18

CHAPTER 8—BASIC STOCK VALUATION LEARNING OBJECTIVES: INTE.GENE.16.60 - LO: 8-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Common stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 42. The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is CORRECT? a. If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X. b. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price. c. The stocks must sell for the same price. d. Stock Y must have a higher dividend yield than Stock X. e. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate. ANSWER: e Since X has the lower required return, if Y has a lower dividend yield it must have a higher RATIONALE: expected growth rate.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Common stock concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Question may require calculations to find the correct answer. 43. 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. ANSWER: a Statement a is true, because Stock A has a higher required return but the stocks have the RATIONALE: Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION same growth rate, so Stock A must have the higher dividend yield. Here are some calculations to demonstrate the point.

rRF 6.40% 6.40%

A B

+ +

Div. Yld.

beta 1.10 0.90

× ×

RPM 6.00% 6.00%

= =

rStock 13.00% 11.80%

rStock

D1/P0

7.00%

13.00%

D1/P0

7.00%

11.80%

D1/P0 = r − g = 6.00% D1/P0 = r − g = 4.80%

rs g P0 = D1/(rs − g)

10.5% 6.4% $18.29

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CHAPTER 8—BASIC STOCK VALUATION 45. 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 ANSWER: c RATIONALE: $0.75 million FCF1

WACC g Vops = FCF1/(WACC − g) Short-term investments Debt shares outstanding

10.5% 6.4% $18.29 million $2 million $2 million $1 million

Total intrinsic value of equity = Value of operations + short-term investments - all debt preferred stock = $18.29 + 2 - 2 - 0 = $18.29 million. Intrinsic stock price = total intrinsic value of equity / shares outstanding = $18.29 million/1 million = $18.29 per share

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.61 - LO: 8-15 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth free cash flow valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 46. 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 ANSWER: e RATIONALE: $1.50 D0

rs g D1 = D0(1 + g) = P0 = D1/(rs − g) POINTS: DIFFICULTY:

10.1% 4.0% $1.56 $25.57

1 Difficulty: Easy

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WACC g FCF1 = FCF0(1 + g) = Vops = FCF1/(rs − g)

10.1% 4.0% $1.56 $25.57

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.60 - LO: 8-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth free cash flow valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 48. 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 ANSWER: d RATIONALE: $1.00 Last dividend (D0)

Long-run growth rate Required return D1 = D0(1 + g) = Cengage Learning Testing, Powered by Cognero

5.4% 11.4% $1.054 Page 22

CHAPTER 8—BASIC STOCK VALUATION P0 = D1/(rs − g)

$17.57

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth dividend valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 49. 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 ANSWER: d RATIONALE: $1.00 million Last FCF (FCF0)

Long-run growth rate Required return FCF1 = FCF0(1 + g) = Vops = FCF1/(WACC − g) Short-term investments = Debt = Shares outstanding =

5.4% 11.4% $1.054 million $17.57 million $4 million $3 million 1 million

Intrinsic value of equity = Value of operations + short-term investments - all debt - preferred stock = 17.57 + 4 - 3 - 0 = $18.57 million. Intrinsic stock price = intrinsic value of equity/number of shares = 18.57/1 = $18.57.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.60 - LO: 8-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth free cash flow valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 50. 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, Cengage Learning Testing, Powered by Cognero

Page 23

CHAPTER 8—BASIC STOCK VALUATION g, forever. What is the equilibrium expected growth rate? a. 6.01% b. 6.17% c. 6.33% d. 6.49% e. 6.65% ANSWER: e RATIONALE: Expected dividend (D ) 1

Stock price Required return Dividend yield Growth rate = rs − D1/P0 =

$1.25 $32.50 10.5% 3.85% 6.65%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 51. $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 ANSWER: e RATIONALE: Stock price $35.50

Growth rate Years in the future P3 = P0(1 + g)3 =

5.50% 3 $41.69

Page 24

CHAPTER 8—BASIC STOCK VALUATION 52. 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 ANSWER: e RATIONALE: Growth rate 4.75%

Years in the future Stock price P5 = P0(1 + g)5 =

5 $35.25 $44.46

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend growth: future price KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 53. 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% ANSWER: d RATIONALE: $1.25 D1

g P0 Dividend yield = D1/P0 =

4.7% $26.00 4.81%

Page 25

CHAPTER 8—BASIC STOCK VALUATION KEYWORDS: OTHER:

Bloom’s: Application TYPE: Multiple Choice: Problem

54. 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% ANSWER: b RATIONALE: $2.25 D0

g P0 D1 = D0(1 + g) = Dividend yield = D1/P0 =

3.5% $50.00 $2.329 4.66%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected dividend yield KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 55. 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% ANSWER: a RATIONALE: $1.50 D1

g P0 Capital gains yield = g =

6.5% $56.00 6.50%

Page 26

CHAPTER 8—BASIC STOCK VALUATION LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Expected cap. gains yield Bloom’s: Application TYPE: Multiple Choice: Problem

56. 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% ANSWER: e RATIONALE: $1.25 D 1

g P0 Total return = rs = D1/P0 + g

5.5% $44.00 8.34%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected total return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 57. 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% ANSWER: e RATIONALE: $1.75 D0

g P0 D1 = D0(1 + g) = Total return = rs = D1/P0 + g POINTS:

3.6% $32.00 $1.81 9.27%

Cengage Learning Testing, Powered by Cognero

Page 27

CHAPTER 8—BASIC STOCK VALUATION DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected total return KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 58. 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 ANSWER: e RATIONALE: $50 FCF5:

g: 6% WACC: 12% HV5 = FCF6/(WACC − g) = FCF5(1 + g)/(WACC − g) = $50(1 + 0.06)/(0.12 − 0.06) = $53/0.06 = $883 POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, horizon value KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 59. 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 ANSWER: a Cengage Learning Testing, Powered by Cognero

Page 28

CHAPTER 8—BASIC STOCK VALUATION RATIONALE:

$40 FCF3: g: 5% WACC: 10% HV3 = FCF4/(WACC − g) = FCF3(1 + g)/(WACC − g) = $40(1 + 0.05)/(0.10 − 0.05) = $42/0.05 = $840

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, horizon value KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 60. Young & Liu Inc.'s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm's value of operations, in millions? a. $948 b. $998 c. $1,050 d. $1,103 e. $1,158 ANSWER: c RATIONALE: $100 FCF0:

g: WACC: Value Ops

5% 15% = FCF1/(WACC − g) = FCF0(1 + g)/(WACC − g) = $100(1 + 0.05)/(0.15 − 0.05) = $105/0.1 = $1,050

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.60 - LO: 8-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 61. 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 Cengage Learning Testing, Powered by Cognero

Page 29

CHAPTER 8—BASIC STOCK VALUATION b. $1,805,000 c. $1,900,000 d. $2,000,000 e. $2,100,000 ANSWER: RATIONALE:

FCF1: g: WACC: Value Ops

$100,000 6% 11% = FCF1/(WACC − g) = FCF0(1 + g)/(WACC − g) = $100,000/(0.11 − 0.06) = $100,000/0.05 = $2,000,000

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.60 - LO: 8-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 62. 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 ANSWER: e RATIONALE: Preferred dividend $7.50

Required return Preferred price = DP/rP =

6.5% $115.38

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.59 - LO: 8-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock valuation KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 63. 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 Cengage Learning Testing, Powered by Cognero

Page 30

CHAPTER 8—BASIC STOCK VALUATION 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 ANSWER: a RATIONALE: $1.25 D 1

b rRF RPM g rs = rRF + b(RPM) = P0 = D1/(rs − g)

1.15 4.00% 5.50% 6.00% 10.33% $28.90

b rRF RPM g D1 = D0(1 + g) = rs = rRF + b(RPM) = P0 = D1/(rs − g) POINTS:

1.15 4.0% 5.0% 5.5% $0.7913 9.75% $18.62

Cengage Learning Testing, Powered by Cognero

Page 31

CHAPTER 8—BASIC STOCK VALUATION DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant dividend g value: CAPM KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 65. 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 ANSWER: a RATIONALE: $0.75 D0

b rRF rM g D1 = D0(1 + g) = rs = rRF + b(rM − RRF) = P0 = D1/(rs − g)

1.25 4.5% 10.5% 6.5% $0.7988 12.0% $14.52

Page 32

CHAPTER 8—BASIC STOCK VALUATION ANSWER: RATIONALE:

Stock price Required return Growth rate P0 = D1/(rs − g), so D1 = P0(rs − g) = Last dividend = D0 = D1/(1 + g)

$25.00 11.50% 7.00% $1.1250 $1.05

Required return Growth rate Vops = FCF1/(WACC − g), so FCF1 = Vops(WACC − g) = Last FCF = FCF0 = FCF1/(1 + g)

11.50% 7.00% $1.1250 $1.05

Page 33

CHAPTER 8—BASIC STOCK VALUATION b. $2.44 c. $2.69 d. $2.96 e. $3.25 ANSWER: RATIONALE:

Stock price Required return Growth rate P0 = D1/(rs − g), so D1 = P0(rs − g) Expected dividend = D1 = P0(rs − g) =

$57.50 10.25% 6.00% $2.44

WACC Growth rate Vops = FCF1/(WACC − g), so FCF1 = Vops(WACC − g) Expected FCF = FCF1 = Vops(WACC − g) =

10.25% 6.00%

$2.44

Page 34

CHAPTER 8—BASIC STOCK VALUATION KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Problem

70. 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 ANSWER: RATIONALE:

Next expected dividend = D1 = Required return Dividend yield = D1/P0 = Find the growth rate: g = rs − yield = Find P0 = D1/(rs − g) = Years in the future = P0(1 + g)7

$1.60 11.0% 6.0% 5.0% $26.67 7 $37.52

Annual dividend = Qtrly dividend × 4 = Preferred stock price Nom. required return = Annual dividend/Price = POINTS: DIFFICULTY:

$4.00 $45.00 8.89%

1 Difficulty: Moderate

Cengage Learning Testing, Powered by Cognero

Page 35

CHAPTER 8—BASIC STOCK VALUATION LEARNING OBJECTIVES: INTE.GENE.16.59 - LO: 8-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 72. 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% ANSWER: e RATIONALE: Periods per year = 4

Pref. quarterly dividend Preferred stock price Eff % required return = (1+ (Qt Div/P))N − 1 =

$1.00 $55.00 7.47%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.59 - LO: 8-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred required return KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 73. 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 ANSWER: d RATIONALE: rs = 9.0%

Year Growth rates: Dividend Horizon value = D3/(rs − g3) = Cengage Learning Testing, Powered by Cognero

0 $1.32

1 30.0% $1.716 49.550

2 10.0% $1.888

3 5.0% $1.982 Page 36

CHAPTER 8—BASIC STOCK VALUATION Total CFs PV of CFs

$1.716 $1.574

$51.437 $43.294

Stock price = $44.87

Year Growth rates: FCF Horizon value = FCF3/(WACC − g3) = Total CFs PV of CFs

0 $1.32

1 30.0% $1.716

2 10.0% $1.888

3 5.0% $1.982

49.550 $1.716 $1.574

$51.437 $43.294

Short-term investments = $4 million Debt = $14 million Value of operations = $44.87 Intrinsic value of equity = ($44.87 + 4 - 14)/1 = $34.87 million

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant FCF growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 75. 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 Cengage Learning Testing, Powered by Cognero

Page 37

CHAPTER 8—BASIC STOCK VALUATION of capital is 14%, what is the firm's value of operations, in millions? a. $158 b. $167 c. $175 d. $184 e. $193 ANSWER: b RATIONALE: −$10 FCF : 1

$20 4% 14%

FCF2: g: WACC:

First, find the horizon, or terminal, value: HV2 = FCF2(1 + g)/(WACC − g) = $20(1.04)/(0.14 − 0.04) = $20.8/0.10 = $208.00 Then find the PV of the free cash flows and the horizon value: 1 2 Value of operations

= −$10/(1.14) + ($20 + $208)/(1.14) = −$8.772 + $175.439 = $167

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 76. 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 ANSWER: RATIONALE:

1 −$50

2 $100

FCF1: FCF2: g: WACC:

−$50 $100 5% 11%

First, find the horizon, or terminal, value: HV2 = FCF2(1 + g)/(WACC − g) = $100(1.05)/(0.11 − 0.05) = $1,750.00 Then find the PV of the free cash flows and the horizon value: Value of operations = −$50/(1.11) + ($100 + $1,750)/(1.11)2 = $1,456 Cengage Learning Testing, Powered by Cognero

Page 38

CHAPTER 8—BASIC STOCK VALUATION POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 77. 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 ANSWER: RATIONALE:

1 −$15

2 $10

3 $40

Year: FCF: g: WACC:

1 −$15

2 $10

3 $40

5% 13%

First, find the horizon, or terminal, value: HV4 = FCF3(1 + g)/(WACC − g) = $40(1.05)/(0.13 − 0.05) = $525 Then find the PV of the free cash flows and the horizon value: Value of operations = −$15/(1.13) + $10/(1.13)2 + ($40 + $525)/(1.13)3 = $386

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 78. 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 Cengage Learning Testing, Powered by Cognero

Page 39

CHAPTER 8—BASIC STOCK VALUATION b. $451 c. $475 d. $500 e. $525 ANSWER: RATIONALE:

Value of operations: Short-term investments: Notes payable: Long-term debt:

$750 $50 $100 $200

Assuming that the book value of debt is close to its market value, the total market value of the company is:

Total market value = Value of operations + Value of non-operating assets = $750 + $50 = $800. Value of Equity

= Total MV − Long- and Short-term debt = $500.

The book value of equity figures are irrelevant for this problem. Also, the accounts payable are not relevant because they were netted out when the FCF was calculated.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: free cash flow valuation model, value of equity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 79. 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 c. $30.43 d. $33.48 e. $36.82 ANSWER: b RATIONALE: Value of operations: $1,200

Short-term investments: Notes payable: Long-term debt: Preferred stock Shares outstanding:

$100 $120 $300 $50 30

Assuming that the book value of debt is close to its market value, the total market value of Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION the company is:

Total market value = Value of operations + Value of non-operating assets = $1,200 + $100 = $1,300. Value of Equity Stock price

= Total MV − Long- and Short-term debt and preferred = $830 = Value of Equity/Shares outstanding = $27.67

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: free cash flow valuation model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 80. 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 ANSWER: c RATIONALE: Value of operations: $900

Short-term investments: Notes payable: Long-term debt: Preferred stock Shares outstanding:

$30 $110 $90 $20 25

Assuming that the book value of debt is close to its market value, the total market value of the company is:

Total market value = Value of operations + Value of non-operating assets = $900 + $30 = $930. Value of Equity Stock price

= Total MV − Long- and Short-term debt and preferred = $710 = Value of Equity/Shares outstanding = $28.40

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION calculated.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 81. 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 ANSWER: d RATIONALE: Value of operations: $300

Short-term investments: Notes payable: Long-term debt: Preferred stock Shares outstanding:

$20 $90 $30 $40 10

Assuming that the book value of debt is close to its market value, the total market value of the company is:

Total market value = Value of operations + Value of non-operating assets = $300 + $20 = $320. Value of Equity Stock price

= Total MV − Long- and Short-term debt and preferred = $160 = Value of Equity/Shares outstanding = $16.00

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not relevant because they were netted out when the FCF was calculated.

Page 42

CHAPTER 8—BASIC STOCK VALUATION KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Problem

82. 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 ANSWER: c RATIONALE: $1.25 Last dividend (D0)

Short-run growth rate 25% Long-run growth rate 0% Beta 1.20 Market risk premium 5.50% Risk-free rate 3.00% 9.60% Required return = rs = rRF + b(RPM) = Year 0 1 2 3 4 5 25% 25% 25% 25% 0% Dividend $1.2500 $1.5625 $1.9531 $2.4414 $3.0518 $3.0518 Horizon value = 31.7891 D5/(rs − g5) = Total CFs $1.5625 $1.9531 $2.4414 $34.8409 PV of the CFs $1.4256 $1.6260 $1.8544 $24.1461 Price = Sum of PVs = $29.05

Page 43

CHAPTER 8—BASIC STOCK VALUATION ANSWER: RATIONALE:

Last dividend (D0) Short-run growth rate Long-run growth rate Required return Year Dividend Horizon value = D3/(rs − g3) = Total CFs PV of CFs

$1.75 25% 6% 12% 0 $1.7500

1 25.00% $2.1875 48.3073 $2.1875 $1.9531

2 25.00% $2.7344

3 6.00% $2.8984

$51.0417 $40.6901

Price = Sum of PVs = $42.64

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 84. 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 ANSWER: b RATIONALE: $1.75 Last FCF (FCF0)

Short-run growth rate Long-run growth rate WACC Year FCF Horizon value = FCF3/(WACC − g3) = Total CFs PV of CFs

25% 6% 12% 0 $1.7500

1 25.00% $2.1875

2 25.00% $2.7344

3 6.00% $2.8984

48.3073 $2.1875 $1.9531

$51.0417 $40.6901

Debt = $7 million Short-term investments = $5 million Value of operations = Sum of PVs = $42.64 million. Intrinsic value of equity = Value of operations + short term investments - debt = 42.64 + 5 - 7 = $40.64 million. Cengage Learning Testing, Powered by Cognero

Page 44

CHAPTER 8—BASIC STOCK VALUATION POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant free cash flow growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 85. The last dividend paid by Wilden Corporation was $1.55. The dividend growth rate is expected to be constant at 1.5% for 2 years, after which dividends are expected to grow at a rate of 8.0% forever. The firm's required return (rs) is 12.0%. What is the best estimate of the current stock price? a. $37.05 b. $38.16 c. $39.30 d. $40.48 e. $41.70 ANSWER: a RATIONALE: $1.55 Last dividend (D0)

Short-run growth rate Long-run growth rate Required return Year

1.50% 8.00% 12.00% 0

Dividend Horizon value = D3/(rs − g3) = Total CFs PV of CFs

$1.5500

1 1.50% $1.5733 43.1149 $1.5733 $1.4047

2 1.50% $1.5968

3 8.00% $1.7246

$44.7118 $35.6439

Price = Sum of PVs = $37.05

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 86. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION b. $26.16 c. $27.30 d. $28.48 e. $29.70 ANSWER: RATIONALE:

Last FCF (FCF0) Short-run growth rate Long-run growth rate Required return Year

$1.55 1.50% 8.00% 12.00% 0

FCF Horizon value = FCF3/(WACC − g3) = Total CFs PV of CFs

$1.5500

1 1.50% $1.5733

2 1.50% $1.5968

3 8.00% $1.7246

43.1149 $1.5733 $1.4047

$44.7118 $35.6439

Short-term investments = $2 million Debt = $14 million Value of operations = Sum of PVs = $37.05 Intrinsic value of equity = value of operations + short-term investments - debt = $37.05 + 2 - 14 = $25.05 million. Intrinsic stock price = intrinsic value of equity / shares outstanding = $25.05 / 1 = $25.05

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant free cash flow growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 87. The last dividend paid by Coppard Inc. was $1.25. The dividend growth rate is expected to be constant at 15% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If the firm's required return (rs) is 11%, what is its current stock price? a. $30.57 b. $31.52 c. $32.49 d. $33.50 e. $34.50 ANSWER: d RATIONALE: Required return 11.0%

Short-run growth rate Long-run growth rate Last dividend (D0) Year Dividend Cengage Learning Testing, Powered by Cognero

15.0% 6.0% $1.25 0 1 2 3 4 $1.2500 $1.4375 $1.6531 $1.9011 $2.0152 Page 46

CHAPTER 8—BASIC STOCK VALUATION Horizon value = P3 = D4/(rs − g4) = Total CFs PV of CFs

40.3032 $1.4375 $1.6531 $42.2043 $1.2950 $1.3417 $30.8594

Price = Sum of PVs = $33.50

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth valuation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 88. 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 ANSWER: RATIONALE:

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

d Required return = 11%

Year Dividend Horizon value = P5 = D6/(rs − g6) = Total CFs PV of CFs

4 5 6 50.00% 25.00% 8.00% $0.000 $0.000 $0.000 $0.250 $0.375 $0.469 $0.506 16.875 $0.000 $0.000 $0.250 $0.375 $17.344 $0.000 $0.000 $0.183 $0.247 $10.293

Price = $10.72

Page 47

CHAPTER 8—BASIC STOCK VALUATION KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Problem

89. The free cash flows (in millions) shown below are forecast by Simmons Inc. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions? Year: Free cash flow: a. $586 b. $617 c. $648 d. $680 e. $714 ANSWER: RATIONALE:

1 −$20

2 $42

3 $45

Year: Free cash flow:

1 −$20

2 $42

3 $45

WACC: 13% First, find the growth rate: g = $45/$42 − 1.0 = 7.14% Second, find the horizon, or terminal, value, at Year 2: HV2 = FCF3/(WACC − g) = $45/(0.13 − 0.0714) = $768 Now find the PV of the FCFs and the horizon value: Value of operations = −$20/(1.13) + ($42 + $768)/(1.13)2 = $617

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.57 - LO: 8-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Free cash flow valuation model, value of operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 90. 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% ANSWER: e RATIONALE: Stock price $40.00

Paid dividend (D0) Short-run growth rate Required return Cengage Learning Testing, Powered by Cognero

$1.00 30.0% 12.0% Page 48

CHAPTER 8—BASIC STOCK VALUATION Forecasted LR growth rate, X Year 0 Dividend Horizon value = P4 = D5/(rs − g5): Total CFs PV of CFs

6.34%Arbitrarily set at 5% initially. 1 2 3 4 5 30.0% 30.0% 30.0% 30.0% 6.34% $1.0000 $1.3000 $1.6900 $2.1970 $2.8561 $3.0372 53.6777 $1.3000 $1.6900 $2.1970 $56.5338 $1.1607 $1.3473 $1.5638 $35.9282

Stock price = $40.00. Must equal $40. Change the forecasted growth rate till reach $40. We must solve for the long-run growth rate. We can forecast the dividends in Years 1-4, so they are inserted in the time line. We need a growth rate to find D5 and the TV. We begin with a guess of say 5.0%, which we insert in the forecast cell. We then find the PV of the forecasted CFs and sum them. If the sum equals the given price, then our growth rate would be correct. If not, we need to substitute in different g's until we find the one that works. We used Excel's Goal Seek function to simplify the process, but one could use trial and error.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.55 - LO: 8-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant dividend growth rate–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 91. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 8—BASIC STOCK VALUATION 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% ANSWER: d Finding the discount rate when we know the dividends and the actual stock price is RATIONALE: complicated if the growth rate is not constant, and an iterative solution is required.

Estimated rs = Actual Market Price, P0: Year 0 Dividend growth rate Dividends (D0 has $1.00 been paid) TV3 = P3 = D4/(rs − g4). Use Estimated rs. Total CFs PVs of CFs discounted $0.974 at Estimated rs

12.97% $15.00 Rapid Growth 1 10% $1.100

Normal Growth 2 3 10% 10%

4 5%

5 5%

$1.210 $1.331 $1.398

$17.527 $1.100

$1.210 $18.858

$0.948

$13.078

Calculated Price = P0 = Sum of PVs = $15.00

Cengage Learning Testing, Powered by Cognero

Page 50

CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING 1. As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spontaneous liabilities KEYWORDS: Bloom’s: Knowledge 2. Firms pay a low interest rate on spontaneous liabilities so these funds are its cheapest source of capital. Consequently, the firm should make arrangements with its suppliers to use as much of this credit as possible. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spontaneous liabilities KEYWORDS: Bloom’s: Knowledge 3. A firm will use spontaneous funds to the extent possible; however, due to credit terms, contracts with workers, and tax laws there is little flexibility in their usage. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spontaneous liabilities KEYWORDS: Bloom’s: Knowledge Cengage Learning Testing, Powered by Cognero

Page 1

CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING 4. As long as a firm does not pay out 100% of its earnings, the firm's annual profit that is retained in the business (i.e., the addition to retained earnings) is another source of funds for a firm's expansion. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Addition to ret. earnings KEYWORDS: Bloom’s: Knowledge 5. A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally large decrease in some other asset. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Asset increase KEYWORDS: Bloom’s: Knowledge 6. A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Knowledge Cengage Learning Testing, Powered by Cognero

Page 2

CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING 7. If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it will require some amount of external funding. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Knowledge 8. To determine the amount of additional funds needed (AFN), you may subtract the expected increase in liabilities, which represents a source of funds, from the sum of the expected increases in retained earnings and assets, both of which are uses of funds. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Knowledge 9. The capital intensity ratio is the amount of assets required per dollar of sales and it has a major impact on a firm's capital requirements. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio Cengage Learning Testing, Powered by Cognero

Page 3

CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING KEYWORDS:

Bloom’s: Knowledge

10. One of the first steps in arriving at a firm's forecasted financial statements is a review of industry-average operating ratios relative to these same ratios for the firm to determine whether changes to the ratios need to be made. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.63 - LO: 9-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forecasted statements KEYWORDS: Bloom’s: Knowledge 11. Operating plans sketch out broad approaches for realization of the firm's strategic vision. These plans usually are developed for a period no longer than a 1-year time horizon because detail is "lost" by extending out the time horizon by more than 1 year. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.64 - LO: 9-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Operating plans KEYWORDS: Bloom’s: Comprehension 12. One of the necessary steps in the financial planning process is a forecast of financial statements under each alternative version of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.64 - LO: 9-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Financial plans Bloom’s: Comprehension

13. If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100%, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it will require external financing. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Comprehension 14. A firm's profit margin is 5%, its debt/assets ratio is 56%, and its dividend payout ratio is 40%. If the firm is operating at less than full capacity, then sales could increase to some extent without the need for external funds, but if it is operating at full capacity with respect to all assets, including fixed assets, then any positive growth in sales will require some external financing. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Comprehension 15. Companies with relatively high assets-to-sales ratios require a relatively large amount of new assets for any given increase in sales; hence, they have a greater need for external financing. There are currently no alternatives for these types of firms to lower their asset requirements. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Comprehension 16. Firms with high capital intensity ratios have found ways to lower this ratio permitting them to achieve a given level of growth with fewer assets and consequently less external capital. For example, just-in-time inventory systems, multiple shifts for labor, and outsourcing production are all feasible ways for firms to reduce their capital intensity ratios. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Comprehension 17. Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm A is operating at full capacity, while Firm B is operating below capacity. If the two firms expect the same growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Comprehension 18. If a firm's capital intensity ratio (A0*/S0) decreases as sales increase, use of the AFN formula is likely to understate the amount of additional funds required, other things held constant. a. True b. False ANSWER: False POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capital intensity ratio KEYWORDS: Bloom’s: Comprehension 19. The minimum growth rate that a firm can achieve with no access to external capital is called the firm's sustainable growth rate. It can be calculated by using the AFN equation with AFN equal to zero and solving for g. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sustainable growth rate KEYWORDS: Bloom’s: Comprehension 20. The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the need for the firm to forecast those accounts on a continual basis. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.65 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial forecasting KEYWORDS: Bloom’s: Comprehension 21. The AFN equation assumes that the ratios of assets and liabilities to sales remain constant over time. However, this assumption can be relaxed when we use the forecasted financial statement method. Three conditions where constant ratios cannot be assumed are economies of scale, lumpy assets, and excess capacity. a. True b. False ANSWER: True Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.66 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forecasting when ratios chg. KEYWORDS: Bloom’s: Comprehension 22. Which of the following assumptions is embodied in the AFN equation? a. Accounts payable and accruals are tied directly to sales. b. Common stock and long-term debt are tied directly to sales. c. Fixed assets, but not current assets, are tied directly to sales. d. Last year's total assets were not optimal for last year's sales. e. None of the firm's ratios will change. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: AFN equation KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 23. F. Marston, Inc. has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)? a. A switch to a just-in-time inventory system and outsourcing production. b. The company reduces its dividend payout ratio. c. The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier whose terms are 3/15, net 35. d. The company discovers that it has excess capacity in its fixed assets. e. A sharp increase in its forecasted sales. ANSWER: e Answer e is obviously correct. A switch to a just-in-time inventory system and outsourcing RATIONALE: production would lower the firm's capital intensity ratio, which would lower AFN. Note that with purchase terms of 1/5 net 90, the nominal cost of non-free trade credit is only 4.34%, whereas with 3/15, net 35, the nominal cost of trade credit is over 56%. Therefore, the firm should have been taking discounts originally, hence should have had few accounts payable, whereas it would probably not take discounts and thus have more accounts payable with the new supplier. That change would lower its AFN.

POINTS: DIFFICULTY:

1 Difficulty: Moderate

Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 24. The term "additional funds needed (AFN)" is generally defined as follows: a. Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations. b. The amount of assets required per dollar of sales. c. The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth. d. A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant. e. Funds that are obtained automatically from routine business transactions. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 25. The capital intensity ratio is generally defined as follows: a. The percentage of liabilities that increase spontaneously as a percentage of sales. b. The ratio of sales to current assets. c. The ratio of current assets to sales. d. The amount of assets required per dollar of sales, or A0*/S0. e. Sales divided by total assets, i.e., the total assets turnover ratio. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING TOPICS: KEYWORDS: OTHER:

Capital intensity ratio Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

26. Which of the following is NOT one of the steps taken in the financial planning process? a. Monitor operations after implementing the plan to spot any deviations and then take corrective actions. b. Determine the amount of capital that will be needed to support the plan. c. Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. d. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors. e. Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external capital can be raised. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.64 - LO: 9-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial planning KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 27. Spontaneous funds are generally defined as follows: a. A forecasting approach in which the forecasted percentage of sales for each item is held constant. b. Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. c. Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes. d. The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm's growth. e. Assets required per dollar of sales. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spontaneous funds KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING 28. A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to increase? a. The company increases its dividend payout ratio. b. The company begins to pay employees monthly rather than weekly. c. The company's profit margin increases. d. The company decides to stop taking discounts on purchased materials. e. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 29. Which of the following statements is CORRECT? a. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales. b. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management's historical performance is evaluated. c. The capital intensity ratio gives us an idea of the physical condition of the firm's fixed assets. d. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists. e. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.66 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forecasting concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 30. Which of the following statements is CORRECT? a. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets. Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets. Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 31. Which of the following statements is CORRECT? a. The AFN equation for forecasting funds requirements requires only a forecast of the firm's balance sheet. Although a forecasted income statement may help clarify the results, income statement data are not essential because funds needed relate only to the balance sheet. b. Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy does not affect the AFN forecast. c. A negative AFN indicates that retained earnings and spontaneous liabilities are far more than sufficient to finance the additional assets needed. d. If the ratios of assets to sales and spontaneous liabilities to sales do not remain constant, then the AFN equation will provide more accurate forecasts than the forecasted financial statements method. e. Any forecast of financial requirements involves determining how much money the firm will need, and this need is determined by adding together increases in assets and spontaneous liabilities and then subtracting operating income. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Additional funds needed KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 32. Which of the following statements is CORRECT? a. If a firm's assets are growing at a positive rate, but its retained earnings are not increasing, then it would be Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: AFN equation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 33. Which of the following statements is CORRECT? a. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. b. Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the financial forecasting process. c. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. d. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. The Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. e. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.66 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forecasting financial reqs. KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 34. The Besnier Company had $250 million of sales last year, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity? Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING a. $312.5 b. $328.1 c. $344.5 d. $361.8 e. $379.8 ANSWER: RATIONALE:

Sales Fixed assets % of capacity utilized

$250 $75.0 80.0%

Full capacity sales = Actual sales/% of capacity used = $312.5

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.66 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Excess capacity KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 35. Last year Baron Enterprises had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity last year. In millions, by how much could Baron's sales increase before it is required to increase its fixed assets? a. $170.09 b. $179.04 c. $188.46 d. $197.88 e. $207.78 ANSWER: c RATIONALE: Sales $350

Fixed assets (not used in calculations) % of capacity utilized Sales at full capacity = Actual sales/% of capacity used =

$270 65% $538.46

Additional sales without adding FA = Full capacity sales − Actual sales = $188.46

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING 36. North Construction had $850 million of sales last year, and it had $425 million of fixed assets that were used at only 60% of capacity. What is the maximum sales growth rate North could achieve before it had to increase its fixed assets? a. 54.30% b. 57.16% c. 60.17% d. 63.33% e. 66.67% ANSWER: e RATIONALE: Sales $850

Fixed assets (not used in calculations) % of capacity utilized Sales at full capacity = Actual sales/% of capacity used = Additional sales without adding FA = Full capacity sales − Actual sales =

$425 60% $1,416.67 $566.67

Percent growth in sales = Additional sales/Old sales = 66.67%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.66 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Excess capacity KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 37. Last year National Aeronautics had a FA/Sales ratio of 40%, comprised of $250 million of sales and $100 million of fixed assets. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set? a. 28.5% b. 30.0% c. 31.5% d. 33.1% e. 34.7% ANSWER: b RATIONALE: Sales $250

Fixed assets % of capacity utilized Sales at full capacity = Actual sales/% of capacity used =

$100 75% $333.33

Target FA/Sales ratio = Full capacity FA/Sales = FA Capacity sales = 30.0%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.66 - LO: 9-7 Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding target FA/S ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 38. Daniel Sawyer, the CEO of the Sawyer Group, is initiating planning for the company's operations next year, and he wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions. $350Last year's accounts payable Last year's sales = S0 Sales growth rate = g 30%Last year's notes payable $500 Last year's accruals Last year's total assets = A0* Last year's profit margin = PM 5%Target payout ratio a. $102.8 b. $108.2 c. $113.9 d. $119.9 e. $125.9 ANSWER: d RATIONALE: Last year's sales = S0

Sales growth rate = g Forecasted sales = S0 × (1 + g) ΔS = change in sales = S1 − S0 = S0 × g Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, so does not enter AFN calculation Last year's accruals L0* = payables + accruals Profit margin = M Target payout ratio

$40 $50 $30 60%

$350 30% $455 $105 $500 $40 $50 $30 $70 5.0% 60.0%

AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout) AFN = $150.0 − $21.0 − $9.1 = $119.9

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING OTHER:

TYPE: Multiple Choice: Problem

39. In your internship with Lewis, Lee, & Taylor Inc. you have been asked to forecast the firm's additional funds needed (AFN) for next year. The firm is operating at full capacity. Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? $200,000Last year's accounts payable Last year's sales = S0 Sales growth rate = g 40%Last year's notes payable $135,000Last year's accruals Last year's total assets = A0* Last year's profit margin = PM 20.0%Target payout ratio a. −$14,440 b. −$15,200 c. −$16,000 d. −$16,800 e. −$17,640 ANSWER: c RATIONALE: Last year's sales = S0

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

$200,000 40% $280,000 $80,000 $135,000 $50,000 $15,000 $20,000 $70,000 20.0% 25.0%

AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout) AFN = $54,000 − $28,000 − $42,000 = −$16,000

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Negative AFN KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 40. You have been asked to forecast the additional funds needed (AFN) for Houston, Hargrove, & Worthington (HHW), which is planning its operation for the coming year. The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING All dollars are in millions. $300.0Last year's accounts payable Last year's sales = S0 Sales growth rate = g 40%Last year's notes payable $500.0Last year's accruals Last year's total assets = A0* Last year's profit margin = PM 20.0%Initial payout ratio a. $31.9 b. $33.6 c. $35.3 d. $37.0 e. $38.9 ANSWER: b RATIONALE: Last year's sales = S0

$50.0 $15.0 $20.0 10.0%

$300 40% $420 $120 $500 $50 $15 $20 $70 20% 10% 50%

AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout) Old AFN = $200.0 − $28.0 − $75.6 = $96.4 New AFN = $200.0 − $28.0 − $42.0 = $130.0 Change in AFN = $33.6

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.62 - LO: 9-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: AFN–changing div. payout KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 41. Weber Interstate Paving Co. had $450 million of sales and $225 million of fixed assets last year, so its FA/Sales ratio was 50%. However, its fixed assets were used at only 65% of capacity. If the company had been able to sell off enough of its fixed assets at book value so that it was operating at full capacity, with sales held constant at $450 million, how much cash (in millions) would it have generated? a. $74.81 b. $78.75 c. $82.69 Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING d. $86.82 e. $91.16 ANSWER: RATIONALE:

Sales Fixed assets % of capacity utilized Sales at full capacity = Actual sales/% of capacity used = Target FA/Sales ratio = Full capacity FA/Sales = FA/Capacity sales = Optimal FA = Sales × Target FA/Sales ratio = Cash generated = Actual FA − Optimal FA =

$450 $225 65% $692.31 32.50% $146.25 $78.75

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.66 - LO: 9-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Finding target FA/S ratio KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem These are the simplified financial statements for Judd Enterprises. Income statement Current Projected Sales na Costs na Profit before tax na Taxes na Net income na Dividends na

1,000 700 300 90 210 63

Balance sheets Current assets Net fixed assets

115 1,080

Current Projected 100 900

Current liabilities Long-term debt Common stock Retained earnings

Current Projected 70 81 400 300 230

42. 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 ANSWER: b Retained earnings = old retained earnings + new net income - new dividends = 230 + 210 RATIONALE: 63 = 377

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.65 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows United States - OH - Default City - TBA Projecting financial statements Bloom’s: Analysis TYPE: Multiple Choice: Problem

43. 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 ANSWER: c Additional net financing = Projected assets - Projected liabilities and equity = 1,195 - (81 + RATIONALE: 400 + 300 + (230 + 210 - 63)) = 37

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.65 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Projecting financial statements KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 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 Net income Dividends

Current Projected na 1,500 na 1,050 na 450 na 135 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

44. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING ANSWER: RATIONALE:

a Financing deficit = additional net financing = projected assets - projected liabilities and equity If financing deficit < 0 then instead, financing surplus = -financing deficit. Financing deficit = 1,555 - (81 + 360 + 500 + 650) = -36 so financing surplus = 36.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.65 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financing surplus/deficit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 45. 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 ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.65 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financing surplus/deficit KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 46. 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 ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.65 - LO: 9-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financing surplus/deficit KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 9—CORPORATE VALUATION AND FINANCIAL PLANNING OTHER:

TYPE: Multiple Choice: Conceptual

Cengage Learning Testing, Powered by Cognero

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CHAPTER 10—CORPORATE GOVERNANCE 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.67 - LO: 10-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Knowledge 2. A poison pill is also known as a corporate restructuring. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.67 - LO: 10-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Comprehension 3. The CEO of D'Amico Motors has been granted some stock options that have provisions similar to most other executive stock options. If D'Amico's stock underperforms the market, these options will necessarily be worthless. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.67 - LO: 10-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stock options KEYWORDS: Bloom’s: Comprehension 4. ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent Cengage Learning Testing, Powered by Cognero

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CHAPTER 10—CORPORATE GOVERNANCE hostile takeovers. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.68 - LO: 10-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ESOP KEYWORDS: Bloom’s: Comprehension 5. Which of the following is NOT normally regarded as being a barrier to hostile takeovers? a. Targeted share repurchases. b. Shareholder rights provisions. c. Restricted voting rights. d. Poison pills. e. Abnormally high executive compensation. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.67 - LO: 10-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Corporate governance KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 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. ANSWER: b Statement b is the correct answer, because firms can easily grant stock options to employees RATIONALE: without an ESOP.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.68 - LO: 10-3 Cengage Learning Testing, Powered by Cognero

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CHAPTER 10—CORPORATE GOVERNANCE NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ESOP KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual

Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING 1. 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 ANSWER: False False. In a private placement, securities are sold to one or a few investors, generally RATIONALE: institutional investors. Private placements are most common with bonds, but they also occur with stocks.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.114 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Private placements KEYWORDS: Bloom’s: Knowledge 2. 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 ANSWER: False False. Going public does establish the firm's market value, but it does not ensure that a liquid RATIONALE: market will continue to exist, and this is especially true for small firms that are not widely followed.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.115 - LO: 18-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Going public KEYWORDS: Bloom’s: Comprehension 3. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.115 - LO: 18-2 Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Disadvantages of going public KEYWORDS: Bloom’s: Comprehension 4. 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 ANSWER: False False. Leaving money on the table occurs when a security issue is underpriced. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.116 - LO: 18-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: IPOs KEYWORDS: Bloom’s: Comprehension 5. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.116 - LO: 18-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment banking KEYWORDS: Bloom’s: Comprehension 6. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING a. True b. False ANSWER: RATIONALE:

False False. An equity carve-out occurs when there is only a partial public offering. In other words, the public is sold equity in a wholly owned subsidiary but the parent retains full control of the subsidiary by retaining the majority of the subsidiary's common stock.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.117 - LO: 18-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Equity carve-outs KEYWORDS: Bloom’s: Comprehension 7. Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then long-term rates (10 years or longer) have remained constant, but the yield curve has resumed its normal upward slope. Under such conditions, a bond refunding would almost certainly be profitable. a. True b. False ANSWER: False False. Since long-term rates have not fallen, the yield on new bonds would be the same as RATIONALE: the coupon rate on the old bonds, hence there would be no interest savings to offset the call premium and the new flotation costs.

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING LOCAL STANDARDS: TOPICS: KEYWORDS:

financing United States - OH - Default City - TBA Refunding discount rate Bloom’s: Comprehension

9. If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and replaces it with an issue that has a lower coupon rate. a. True b. False ANSWER: False False. If there is a fairly high probability that interest rates are going to decline further, then it RATIONALE: might be better to delay the refunding.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.118 - LO: 18-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding decision KEYWORDS: Bloom’s: Comprehension 10. When a firm refunds a debt issue, the firm's stockholders gain and its bondholders lose. This points out the risk of a call provision to bondholders and explains why a non-callable bond will typically command a higher price than an otherwise similar callable bond. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.118 - LO: 18-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding and callable bonds KEYWORDS: Bloom’s: Comprehension 11. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING e. Facilitates stockholder diversification. ANSWER: d Publicly owned firms are regulated by the SEC, and this limits the sort of deals that the RATIONALE: owner/managers of private companies can make with themselves.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.115 - LO: 18-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Going public KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 12. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.115 - LO: 18-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Listing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 13. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING LEARNING OBJECTIVES: INTE.GENE.16.114 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Private placements KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 14. Which of the following statements is most CORRECT? a. The key benefits associated with refunding debt are the reduction in the firm's debt ratio and the creation of more reserve borrowing capacity. b. The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates. c. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the debt after rates have risen. d. Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done. The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to the firm and thus increase the expected interest savings. e. If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the beforetax cost of new debt. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.118 - LO: 18-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding decision KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 15. Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time? a. A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates. b. The flotation costs associated with issuing new bonds rise. c. The firm's CFO believes that interest rates are likely to decline in the future. d. The firm's CFO believes that corporate tax rates are likely to be increased in the future. e. The yield to maturity on the company's outstanding bonds increases due to a weakening of the firm's financial situation. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING LEARNING OBJECTIVES: INTE.GENE.16.118 - LO: 18-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding decision KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 16. 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 issue. e. The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.114 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment banking process KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 17. 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." ANSWER: a Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.114 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment banking process KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 18. 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 ANSWER: e RATIONALE: Gross funds: $5,000,000 Current price: $5.00

Small fee: Normal fee: Option shares:

6% 10% 200,000

Expected price: Possible price: Required return:

$6.50 $12.00 15%

Fee received now = 6% × $5,000,000 = $300,000 Additional fee: Option profit if the stock price is $12 in 1 year = ($12 − $5) × 200,000 = $1,400,000 PV of total compensation if $12 price = $300,000 + $1,400,000/(1.15)1 = $1,517,391

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.116 - LO: 18-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Investment bankers' compensation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 19. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING 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 ANSWER: c RATIONALE: Flotation%, 3 issues: 3.0% Flotation %, 1 issue: 1.6% Total funds needed = 3 × $5,000,000 = $15,000,000 Total debt needed = 40% × $15,000,000 = $6,000,000 Debt/year if use 3 separate issues = Total debt/3 = $2,000,000 Grossed-up debt if use a single issue = Net debt needed/(1 − F) = $6,000,000/(1 − 0.016) = $6,097,561 Flotation cost for single issue: Gross debt − Proceeds to company = $97,561 Gross debt with 3 issues: Net debt needed/(1 − F) = $6,000,000/(1 − 0.03) = $6,185,567 Flotation cost for yearly issues: Gross debt − Proceeds to company = $185,567 Difference = Additional cost of 3 issues: $185,567 − $97,561 = $88,006

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.114 - LO: 18-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Flotation costs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 20. 10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refunding? Note that cities pay no income taxes, hence taxes are not relevant. a. $453,443 b. $476,115 c. $499,921 d. $524,917 e. $551,163 ANSWER: a RATIONALE: Call premium: 6%Old rate: 8%

Flotation %: 2%New rate: Amount: $3,000,000Years: Cost of refunding: Call premium = 6%($3,000,000) $180,000 Flotation cost = 2%($3,000,000) $ 60,000 Total investment outlay: $240,000 Cengage Learning Testing, Powered by Cognero

6% 20

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING Interest on old bond per 6 months: Interest on new bond per 6 months: Savings per six months:

$120,000 $ 90,000 $ 30,000

PV of savings, 40 periods @ new rate/2 = $693,443 NPV of refunding = PV of savings − Cost of refunding = $453,443

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.118 - LO: 18-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 21. Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year, 5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%. What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant. a. $278,606 b. $292,536 c. $307,163 d. $322,521 e. $338,647 ANSWER: a RATIONALE: Call premium: 5%Old rate: 7%

Flotation %: 2%New rate: Amount: $2,000,000Years: Cost of refunding: Call premium = 5% ($2,000,000) Flotation cost = 2% ($2,000,000) Total investment outlay: Interest on old bond per 6 months: Old rate/2 × Amount = Interest on new bond per 6 months: New rate/2 × Amount = Savings per six months:

5% 15 $100,000 $ 40,000 $140,000 $ 70,000 $ 50,000 $ 20,000

PV of savings, 30 periods @ new rate/2 = $418,606 NPV of refunding = PV of savings − Cost of refunding = $278,606

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.118 - LO: 18-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing United States - OH - Default City - TBA Refunding NPV Bloom’s: Analysis TYPE: Multiple Choice: Problem

22. Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations⎯ assume that the firm's tax rate is zero. The company's decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds? a. 9.57% b. 10.07% c. 10.60% d. 11.16% e. 11.72% ANSWER: d RATIONALE: Call premium: $50 Old rate: 12.0%

Flotation cost per bond: Amount of issue: Par value of bonds:

$10 $5,000,000 $1,000

Years to maturity: Number of bonds:

15 5,000

Cost of refunding:

Call premium per bond × number of bonds = Flotation cost = $10 × Number of bonds issued = Total investment outlay: Interest on old bond per year = Old rate × Amount =

$250,000 $ 50,000 $300,000 $600,000

If the company does not call the bonds, it will have to pay $600,000 per year for 15 years, plus $5,000,000 at Year 15. If it goes ahead and calls the bonds, it will have to pay $300,000 + $5,000,000 = $5,300,000 today. We can find the discount rate that equates these cash flows. Here is the time line:

0 −300000 −5000000 −5300000

1 $600,000

2 $600,000

3 $600,000

600000

∙∙∙

15 $ 600,000 $5,000,000 $5,600,000

If you enter these cash flows in the cash flow register of a calculator and then press the IRR key, you will get the breakeven rate, which is 11.1583%, rounded to 11.16%. You can do the same thing with Excel. Note that the annual savings at this lower rate would be (0.12 − 0.111583) × $5,000,000 = $42,084.78. The PV of that amount, discounted back for 15 years at 11.16%, is $300,000.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.118 - LO: 18-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid Cengage Learning Testing, Powered by Cognero

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

financing United States - OH - Default City - TBA Refunding Breakeven interest rate Bloom’s: Analysis TYPE: Multiple Choice: Problem

23. Stanovich Enterprises has 10-year, 12.0% semiannual coupon bonds outstanding. Each bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company must replace them with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual "breakeven rate"? a. 9.29% b. 9.78% c. 10.29% d. 10.81% e. 11.35% ANSWER: c RATIONALE: Call price of bonds: $1,060Old rate: 12.0%

Flotation cost per bond: Par value of bonds:

$45Years to maturity: $1,000Semiannual periods:

10 20

Cost of refunding:

Call price per bond: Flotation cost per bond: Total investment outlay per bond: Interest on old bond per year = Old rate × Amount = Interest per period:

$1,060 $ 45 $1,105 $ 120 $ 60

If the company does not call the bonds, it will have to pay $60 for 20 periods, plus $1,000 at Period 20. If it goes ahead and calls the bonds now, it will have to pay $1,060 + $45 = $1,105 today. We can find the discount rate that equates these cash flows. Here is the time line:

0 −$1,105

1 $60

2 $60

3 $60

−$1,105

$60

∙∙∙

20 $ 60 $1,000 $1,060

If you enter these cash flows in the cash flow register of a calculator and then press the IRR key, you will get the breakeven rate, which is 5.1469%, rounded to 5.15%. You can do the same thing with Excel. Note that the semiannual savings at this lower rate would be (0.12/2 − 0.051469) × $1,000 = $8.53. The PV of that amount, discounted back for 20 periods at 5.15%, is $105.00, which is the cost of the refunding. The semiannual discount, when doubled, is the breakeven nominal rate. Required nominal annual rate to break even: 10.29%

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Problem

Exhibit 18.1 Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon. NWW is now considering refunding these bonds. It has been amortizing $3 million of flotation costs on these bonds over their 30-year life. The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market. A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million. NWW's marginal tax rate is 40%. The new bonds would be issued when the old bonds are called. 24. Refer to Exhibit 18.1. What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding? a. $5,049,939 b. $5,315,725 c. $5,595,500 d. $5,890,000 e. $6,200,000 ANSWER: e RATIONALE: Amount: $50,000,000Call premium %: 14%

Old rate: Original life: Years ago issued: Orig. flotation cost:

14.00%Tax rate: 30New rate: 5New life: $3,000,000New flotation cost:

40% 11.67% 25 $3,000,000

Years remaining on old bond: 25

Old issue flotation costs: Remaining unexpensed = (25/30)($3) = $2,500,000 Tax saving on unexpensed float cost = $2.5(T) = $2.5(0.4) = After tax cost of call premium: 0.14($50)(0.6) = Flotation costs on new issue: Net after-tax cost to call the bonds:

−1,000,000 4,200,000 3,000,000 6,200,000

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING NOTES:

The problems referring to Exhibit 18.1 MUST be kept together.

25. Refer to Exhibit 18.1. What will the after-tax annual interest savings for NWW be if the refunding takes place? a. $664,050 b. $699,000 c. $768,900 d. $845,790 e. $930,369 ANSWER: b RATIONALE: Old interest: $50,000,000(0.14)(0.6) = $4,200,000

New interest: $50,000,000(0.1167)(0.6) = Net annual interest savings

(3,501,000) $ 699,000

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.118 - LO: 18-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Refunding interest savings KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 18.1 MUST be kept together. 26. Refer to Exhibit 18.1. The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place? a. $6,480 b. $7,200 c. $8,000 d. $8,800 e. $9,680 ANSWER: c RATIONALE: Flotation costs benefit, new: ($3.00/25)(0.4) = $48,000

Flotation costs lost, old: ($3.00/30)(0.4) = Net annual amortization tax effects =

(40,000) $ 8,000

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CHAPTER 18—INITIAL PUBLIC OFFERINGS, INVESTMENT BANKING, AND FINANCIAL RESTRUCTURING KEYWORDS: OTHER: NOTES:

Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to Exhibit 18.1 MUST be kept together.

27. Refer to Exhibit 18.1. What is the NPV if NWW refunds its bonds today? a. $1,746,987 b. $1,838,933 c. $1,935,719 d. $2,037,599 e. $2,241,359 ANSWER: d Appropriate discount rate = New bond cost × (1 − T) = 7.002% Financial calculator solution: RATIONALE: Inputs: N = 25; I/YR = 7.0; PMT = 699,000 + 8,000 = 707,000; FV = 0.

Output: PV = −$8,237,599 = PV of savings = Cost to refund = NPV of the refunding =

$8,237,599 6,200,000 $2,037,599

Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING 1. Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases." a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.120 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Types of leases KEYWORDS: Bloom’s: Knowledge 2. A sale and leaseback arrangement is a type of financial, or capital, lease. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.120 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Types of leases KEYWORDS: Bloom’s: Knowledge 3. Operating leases help to shift the risk of obsolescence from the user to the lessor. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.120 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Operating lease KEYWORDS: Bloom’s: Knowledge 4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor. a. True Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.120 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sale and leaseback KEYWORDS: Bloom’s: Knowledge 5. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.121 - LO: 19-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease payments KEYWORDS: Bloom’s: Knowledge 6. Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm's income statement and, under certain conditions, leased assets and associated liabilities do not appear on the firm's balance sheet. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.122 - LO: 19-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Off-balance sheet leasing KEYWORDS: Bloom’s: Knowledge 7. Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget. Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.123 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease financing KEYWORDS: Bloom’s: Knowledge 8. A leveraged lease is more risky from the lessee's standpoint than an unleveraged lease. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.124 - LO: 19-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leveraged lease KEYWORDS: Bloom’s: Knowledge 9. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.120 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Synthetic leases KEYWORDS: Bloom’s: Comprehension 10. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.120 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Synthetic leases KEYWORDS: Bloom’s: Comprehension 11. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.125 - LO: 19-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual value and lease rates KEYWORDS: Bloom’s: Comprehension 12. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.125 - LO: 19-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Residual value and lease rates KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING 13. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee's a. capital budgeting project cash flows. b. debt cash flows. c. pension fund cash flows. d. sales. e. equity cash flows. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.123 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease cash flows KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 14. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.120 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Operating lease KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 15. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING with an operating lease the lessor depends on the residual value to realize a full return of and on the investment. e. Firms that use "off balance sheet" financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.120 - LO: 19-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Leasing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 16. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report, financial (or capital) leases 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.122 - LO: 19-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Capitalizing leases KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 17. Heavy use of off-balance sheet lease financing will tend to a. make a company appear less risky than it actually is because its stated debt ratio will appear lower. b. affect a company's cash flows but not its degree of risk. c. have no effect on either cash flows or risk because the cash flows are already reflected in the income statement. d. affect the lessee's cash flows but only due to tax effects. e. make a company appear more risky than it actually is because its stated debt ratio will be increased. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING LEARNING OBJECTIVES: INTE.GENE.16.122 - LO: 19-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Off-balance sheet leasing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 18. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.123 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease decision KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 19. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.123 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lease analysis discount rate Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

20. 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 b. $196,854 c. $207,215 d. $217,576 e. $228,455 ANSWER: c RATIONALE: Years: 5

Loan amount: Interest rate: Lease Pmt: Loan:

0 −$6,000,000

$6,000,000 10.0% $1,790,000 1 2 PMT PMT

3 PMT

4 PMT

5 PMT

Find the loan payment: Financial calculator solution: Inputs: N = 5; I/YR = 10; PV = −6,000,000; FV = 0. Output = PMT = $1,582,785. Difference in payments = $1,790,000 − $1,582,785 = $207,215.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.123 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Difference in payments KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 21. 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 40%. 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. $96 b. $106 c. $112 d. $117 e. $123 ANSWER: b Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING RATIONALE:

Years: Loan amount = equipment cost: Interest rate: Lease Pmt:

3Tax rate:

40%

$4,800Maintenance costs:

$240

10.0%Salvage value: $2,100

After tax cost of debt = Rate × (1 − T) = 6.0% Depreciation per year = Cost/3 = $1,600 Tax saving from deprn = Deprn × T = $640

0 Cost of owning: Interest Interest tax saving Maintenance Maintenance tax saving Deprn tax saving Repayment of loan Net cash loan costs PV cost of owning (6%): Cost of leasing: Lease payment Tax savings from lease Net cash lease costs PV cost of leasing (6%): NAL = PV Cost of Owning − PV Cost of Leasing =

−480 192 −240 96 640

208

−480 192 −240 96 640 −4,800 −4,592

−2,100 840 −1,260

−3,474

−3,368 $106.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.123 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net advantage to leasing (NAL) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 22. 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 40%. 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. $849 b. $896 c. $945 Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING d. $999 e. $1,047 ANSWER: RATIONALE:

Life of equipment: Loan amount = equipment cost: Interest rate: Lease Pmt:

4Tax rate: $40,000Maintenance costs: 10.0%Salvage value: $10,000

40% $1,000 $10,000

Loan amortization for cash payment and interest expense: Payment: N = 4, I/YR = 10, PV = 40000, FV = 0. PMT = −$12,618.83

Year Beg. Bal. 1 40,000 2 31,381 3 21,900 4 11,472 Loan Analysis: MACRS factor Depreciation

PMT 12,619 12,619 12,619 12,619 0

Loan Pmt Int tax saving (Int. from table × T) Maintenance Maint. tax saving (Maint. × T) Depr'n tax saving (Deprn × T) Net operating CF Salvage value Tax on residual Net residual val Total Net CF

Interest Principal Ending Bal. 4,000 8,619 31,381 3,138 9,481 21,900 2,190 10,429 11,472 1,147 11,472 0 1 2 3 4 0.3333 0.4445 0.1481 0.0741 13,332 17,780 5,924 2,964 −12,619 −12,619 −12,619 −12,619 1,600

1,255

876

459

−1,000 400 5,333 −6,286

−1,000 400 7,112 −4,852

−1,000 400 2,370 −9,973

−6,286

−4,852

−9,973

−1,000 400 1,186 −11,574 10,000 −4,000 6,000 −5,574

PV cost of buying at I(1 − T) −23,037 = 6.00% Lease Analysis: 0 1 2 3 −10,000 −10,000 −10,000 −10,000 Lease payment Tax saving on pmt 4,000 4,000 4,000 4,000 −6,000 −6,000 −6,000 −6,000 Net cost of lease PV cost of leasing at I (1 − T) −22,038

4 0 0 0

NAL = $999 POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.123 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 19—LEASE FINANCING TOPICS: KEYWORDS: OTHER:

Lessee's analysis Bloom’s: Analysis TYPE: Multiple Choice: Problem

23. 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. The firm is in the 20% tax bracket, and it could obtain a 3year 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 ANSWER: a RATIONALE: Life of equipment: 3Tax rate: 20%

Loan amount = equipment cost: Interest rate, simple: Lease Pmt: Loan Analysis: MACRS factor Depreciation

$100,000Maintenance costs:

$3,000

10.0%Salvage value: $29,000

$30,000

1 0.3333 33,330

2 0.4445 44,550

−10,000 2,000 −3,000 600 6,666 −3,734

−10,000 2,000 −3,000 600 8,890 −1,490

Loan repayment Interest Int tax saving (Interest × T) Maintenance Maint. tax saving (Maint. × T) Depr'n tax saving (Deprn × T) Net operating CF Salvage value before taxes Book value (Cost − Total dep'rn) Taxable salvage value Tax on salvage value Salvage value after taxes Total Net CF PV cost at I(1 − T) = 8.00%

−2,400 −70,306

−3,734

−1,510

Lease Analysis: Lease payment Tax saving on pmt Net cost of lease PV cost of leasing at I(1 − T)

0 −29,000 5,800 −23,200 −64,572

1 −29,000 5,800 −23,200

2 −29,000 5,800 −23,200

Cengage Learning Testing, Powered by Cognero

−3,000 600 −2,400

3 0.1418 14,180

Totals 0.9196 91,960

−100,000 −10,000 2,000

2,836 −105,164 30,000 8,040 21,960 −4,392 25,608 −79,556

3 0 0

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CHAPTER 19—LEASE FINANCING NAL = $5,734

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.123 - LO: 19-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lessee's analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem

Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of preferred stock KEYWORDS: Bloom’s: Knowledge 3. A warrant is an option, and as such it cannot be used as a "sweetener." a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.127 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants KEYWORDS: Bloom’s: Knowledge Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES 4. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.127 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants KEYWORDS: Bloom’s: Knowledge 5. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.127 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants KEYWORDS: Bloom’s: Knowledge 6. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.127 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Detachable warrant KEYWORDS: Bloom’s: Knowledge Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES 7. The owner of a convertible bond owns, in effect, both a bond and a call option. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Knowledge 8. A convertible debenture can never sell for more than its conversion value or less than its bond value. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Knowledge 9. Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Knowledge 10. Firms generally do not call their convertibles unless the conversion value is greater than the call price. Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Knowledge 11. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Comprehension 12. Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES 13. Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Comprehension 14. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Comprehension 15. 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 70% tax exemption on preferred dividends received. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES TOPICS: KEYWORDS:

Floating-rate preferred stock Bloom’s: Comprehension

16. 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 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 17. 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 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. ANSWER: d Response d is correct. From an investor's standpoint, convertibles are normally more risky RATIONALE: than straight debt but less risky than common stock, hence the expected return on the convertible lies between that on the stock and that on the straight bond.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES TOPICS: KEYWORDS: OTHER:

Convertibles Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

18. 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 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.129 - LO: 20-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants and convertibles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 19. 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. ANSWER: b Answer b is correct; convertibles do normally have a relatively low coupon because the RATIONALE: opportunity for capital gains provides part of their expected total return. The other responses are all incorrect. Statement c is incorrect because like other options, the value of the warrant is increased by price volatility in the underlying asset.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.129 - LO: 20-4 Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Warrants and convertibles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 20. 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 ANSWER: d RATIONALE: Stock price: $33.00Coupon rate: 8.00%

Bond price: Conversion ratio:

$850.00Par value: 25.00

$1,000.00

Conversion value = Conversion ratio × Stock price = $825

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertible features: straight-debt value KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 21. 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 ANSWER: a RATIONALE: Par value: $1,000.00

Conversion ratio:

25.00

Conversion price = Par value/Conversion ratio = $40.00 Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Conversion price KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 22. Mariano Manufacturing can issue a 25-year, 8.1% 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 40% 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. 6.66% b. 6.99% c. 7.34% d. 7.71% e. 8.09% ANSWER: a RATIONALE: Maturity: 25Pfd. exclusion: 70%

Coupon rate: Risk premium

8.10%Tax rate: 1.00%

40.00%

Bond yield AT = BT yield(1 − T) = 4.86% Preferred yield AT = AT bond yield + RP = 5.86% AT pfd yield = BT pfd yield − BT pfd yield(1 − Exclusion)(Tax rate) Preferred yield BT = 5.86%/[1 − (0.3)(0.4)] = 6.66%

Check: base case AT pfd yield

= 6.66% − Tax = 6.66% − 6.66%(1 − Exclusion)(Tax rate) = 6.66% − 6.66%(1 − 0.7)(0.4) = 6.66% − 6.66%(1 − 0.7)(0.4) = 5.86%.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.126 - LO: 20-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Preferred stock vs. bond yields KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 23. Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells for $42 per Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES 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% ANSWER: b RATIONALE: Stock price: $42.00Bond par value: $1,000

Exercise price: No. of warrants: Value of warrants:

$47.00Bond maturity: 75Straight-debt yield: $2.00

20 10.0%

Total value = Straight-debt value + Warrant value = $1,000 = Bond value + $150 VB = $1,000 − $150 = $850 Now set N = 20, I/YR = 10, PV = −850, FV = 1000 and solve for PMT: $82.38 To get this payment on a $1,000 bond, the coupon rate must be: 8.24%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.127 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bonds with warrants KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 24. 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% ANSWER: d RATIONALE: Bond par value: $1,000No. of warrants: 20

Bond maturity: Straight-debt yield:

30Value of warrants: 10.0%

$10.00

Total value = Straight-debt value (VB) + Warrant value = $1,000 VB = $1,000 − $200.00 = $800.00 Set N = 30, I/YR = 10, PV = −800, and FV = 1000. Then solve for PMT: $78.78 To get this payment on a $1,000 bond, the coupon rate must be: 7.88%

POINTS:

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.127 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bonds with warrants KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 25. 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 ANSWER: a RATIONALE: Bond par value: $1,000No. of warrants: 50

Bond maturity: Straight-debt yield:

20Convertible coupon: 15.0%

12.0%

Find the straight-debt value: N = 20, I/YR = 15, PMT = −120, and FV = −1000. PV = $812.22 Total value = Straight-debt value + Warrant value. $1,000 = Straight-debt value + 50(Warrant value) Warrant value = ($1,000 − Straight-debt value)/50 = $3.76

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.127 - LO: 20-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bonds with warrants KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 26. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES e. $972.41 ANSWER: RATIONALE:

Bond par value: Bond maturity: Evaluation year: Straight-debt yield: Dividend per share:

Conversion ratio $1,000 (Shares): 10Convertible coupon: 3Stock price: 10.0%Growth rate: $2.00

20 8.0% $40.00 5.0%

Find the straight-debt value at N = 10 − 3 = 7: N = 7, I/YR = 10, PMT = −80, and FV = −1000. PV = VB = $902.63 Conversion value at t = 3: CV = (Shares) × (Stock price) × (1 + g)3 = $926.10 The floor value is the higher of the bond value or the conversion value, so it is $926.10.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertibles KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem Exhibit 20.1 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:

27. Refer to Exhibit 20.1. What is the bond's conversion ratio? a. 27.14 b. 28.57 c. 30.00 d. 31.50 e. 33.08 ANSWER: b RATIONALE: Years to maturity:

Par value: Annual coupon:

$30.00 $35.00 8.00%

10Stock price: $1,000.00Conversion price: 5.00%Straight-debt yield:

$30.00 $35.00 8.00%

Conversion ratio = Par/Conversion price = $1,000/$35 = 28.57

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

financing United States - OH - Default City - TBA Convertible features: conversion ratio Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to Exhibit 20.1 MUST be kept together.

28. Refer to Exhibit 20.1. What is the bond's conversion value? a. $698.15 b. $734.89 c. $773.57 d. $814.29 e. $857.14 ANSWER: e Conversion value = Conversion ratio × Market price of stock = $857.14 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertible features: conversion value KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 20.1 MUST be kept together. 29. Refer to Exhibit 20.1. What is the bond's straight-debt value? a. $684.78 b. $720.82 c. $758.76 d. $798.70 e. $838.63 ANSWER: d Inputs to find the straight-debt value: N = 10; I/YR = 8; PMT = 50; FV = 1,000. $798.70 RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.128 - LO: 20-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Investments and hybrid fin - DISC: Investments and hybrid financing LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Convertible features: straight-debt value Cengage Learning Testing, Powered by Cognero

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CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES KEYWORDS: OTHER: NOTES:

Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to Exhibit 20.1 MUST be kept together.

30. Refer to Exhibit 20.1. 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 ANSWER: e The floor price is the higher of the bond's conversion value or straight debt value. Those RATIONALE: values are as follows:

Conversion value: Straight-debt value:

$857.14 $798.70

Max of the two = minimum price = floor = $857.14

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 1. Net working capital, defined as current assets minus the sum of payables and accruals, is equal to the current ratio minus the quick ratio. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.130 - LO: 21-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net working capital KEYWORDS: Bloom’s: Knowledge 2. Net working capital is defined as current assets divided by current liabilities. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.130 - LO: 21-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net working capital KEYWORDS: Bloom’s: Knowledge 3. Net operating working capital is defined as operating current assets minus operating current liabilities.. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.130 - LO: 21-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Net operating working capital KEYWORDS: Bloom’s: Knowledge 4. Determining a firm's optimal investment in working capital and deciding how that investment should be financed are critical to working capital management. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital management KEYWORDS: Bloom’s: Knowledge 5. An increase in any current asset must be accompanied by an equal increase in some current liability. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital financing KEYWORDS: Bloom’s: Knowledge 6. The concept of permanent current operating assets reflects the fact that some components of current assets do not shrink to zero even when a business is at its seasonal or cyclical low. Thus, permanent current operating assets represent a minimum level of current assets that must be financed. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Permanent curr. oper. assets KEYWORDS: Bloom’s: Knowledge 7. A conservative current operating asset financing approach will result in permanent current assets and some seasonal current assets being financed using long-term securities. a. True b. False ANSWER: True POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Conservative fin. approach KEYWORDS: Bloom’s: Knowledge 8. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive current operating asset financing strategy because of the inherent risks of using shortterm financing. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Aggressive fin. approach KEYWORDS: Bloom’s: Knowledge 9. If a firm takes actions that reduce its days sales outstanding (DSO), then, other things held constant, this will lengthen its cash conversion cycle (CCC). a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Knowledge 10. Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts payable, this will lengthen its cash conversion cycle (CCC). a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Knowledge 11. Shorter-term cash budgets⎯ say a daily cash budget for the next month⎯ are generally used for actual cash control while longer-term cash budgets⎯ say monthly cash budgets for the next year⎯ are generally used for planning purposes. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Knowledge 12. Cash is often referred to as a "non-earning" asset. Thus, one goal of cash management is to minimize the amount of cash necessary for conducting a firm's normal business activities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.134 - LO: 21-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Goal of cash management KEYWORDS: Bloom’s: Knowledge 13. Firms hold cash balances in order to complete transactions (both routine and precautionary) that are necessary in business operations and as compensation to banks for providing loans and services. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.134 - LO: 21-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Motives for holding cash Bloom’s: Knowledge

14. For a firm that makes heavy use of net float, being able to forecast collections and disbursement check clearings is essential. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.135 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Float KEYWORDS: Bloom’s: Knowledge 15. Setting up a lockbox arrangement is one way for a firm to speed up the collection of payments from its customers. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.135 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Knowledge 16. The overriding goal of inventory management is to ensure that the firm never suffers a stock-out, i.e., never runs out of an inventory item. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.136 - LO: 21-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Goal of inventory management KEYWORDS: Bloom’s: Knowledge Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 17. The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.136 - LO: 21-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Goal of inventory management KEYWORDS: Bloom’s: Knowledge 18. The average accounts receivable balance is a function of both the volume of credit sales and the days sales outstanding. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables balance KEYWORDS: Bloom’s: Knowledge 19. If a firm has a large percentage of accounts over 30 days old, this is proof positive that its receivables manager is not doing a good job. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables aging KEYWORDS: Bloom’s: Knowledge 20. The aging schedule is a commonly used method for monitoring receivables. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Monitoring receivables KEYWORDS: Bloom’s: Knowledge 21. The four primary elements in a firm's credit policy are (1) credit standards, (2) discounts offered, (3) credit period, and (4) collection policy. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit policy KEYWORDS: Bloom’s: Knowledge 22. Changes in a firm's collection policy can affect sales, working capital, and profits. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Knowledge 23. Not taking cash discounts is costly, and as a result, firms that do not take them are usually those that are performing poorly and have inadequate cash balances. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Taking discounts KEYWORDS: Bloom’s: Knowledge 24. Suppose a firm changes its credit policy from 2/10 net 30 to 3/10 net 30. The change is meant to meet competition, so no increase in sales is expected. The average accounts receivable balance will probably decline as a result of this change. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Change in credit policy KEYWORDS: Bloom’s: Knowledge 25. If a firm busy on terms of 2/10 net 30, it should pay as early as possible during the discount period. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Knowledge 26. Trade credit can be separated into two components: free trade credit, which is credit received after the discount period ends, and costly trade credit, which is the cost of discounts not taken. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Trade credit Bloom’s: Knowledge

27. As a rule, managers should try to always use the free component of trade credit but should use the costly component only if the cost of this credit is lower than the cost of credit from other sources. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Knowledge 28. If a firm's suppliers stop offering discounts, then its use of trade credit is more likely to increase than to decrease, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Knowledge 29. When deciding whether or not to take a trade discount, the cost of borrowing from a bank or other source should be compared to the cost of trade credit to determine if the cash discount should be taken. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT KEYWORDS:

Bloom’s: Knowledge

30. The calculated cost of trade credit can be reduced by paying late. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of trade credit KEYWORDS: Bloom’s: Knowledge 31. The calculated cost of trade credit for a firm that buys on terms of 2/10 net 30 is lower (other things held constant) if the firm plans to pay in 40 days than in 30 days. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of trade credit KEYWORDS: Bloom’s: Knowledge 32. One of the effects of ceasing to take trade credit discounts is that the firm's accounts payable will rise, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of trade credit KEYWORDS: Bloom’s: Knowledge 33. "Stretching" accounts payable is a widely accepted, entirely ethical, and costless financing technique. a. True Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stretching accounts payable KEYWORDS: Bloom’s: Knowledge 34. Accruals are "free" capital in the sense that no explicit interest must normally be paid on accrued liabilities. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accruals KEYWORDS: Bloom’s: Knowledge 35. Accruals are "spontaneous," but unfortunately, due to law and economic forces, firms have little control over the level of these accounts. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accruals KEYWORDS: Bloom’s: Knowledge 36. The facts (1) that no explicit interest is paid on accruals and (2) that the firm can control the level of these accounts at will makes them an attractive source of funding to meet working capital needs. a. True b. False ANSWER: False POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accruals KEYWORDS: Bloom’s: Knowledge 37. Short-term marketable securities are held for two separate and distinct purposes: (1) to provide liquidity as a substitute for cash and (2) as a non-operating investment. Marketable securities held while awaiting reinvestment are not available for liquidity purposes. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.130 - LO: 21-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term mkt. securities KEYWORDS: Bloom’s: Knowledge 38. Short-term financing is riskier than long-term financing since, during periods of tight credit, the firm may not be able to rollover (renew) its debt. This is especially true if the funds are used to finance long-term assets rather than short-term assets. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.139 - LO: 21-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Knowledge 39. One of the advantages of short-term debt financing is that firms can obtain short-term credit more quickly than longterm credit. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LEARNING OBJECTIVES: INTE.GENE.16.139 - LO: 21-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Knowledge 40. Funds from short-term loans can generally be obtained faster than from long-term loans for two reasons: (1) when lenders consider long-term loans they must make a more thorough evaluation of the borrower's financial health, and (2) long-term loan agreements are more complex. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.139 - LO: 21-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Knowledge 41. An informal line of credit and a revolving credit agreement are similar except that the line of credit creates a legal obligation for the bank and thus is a more reliable source of funds for the borrower. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bank loans KEYWORDS: Bloom’s: Knowledge 42. The maturity of most bank loans is short term. Bank loans to businesses are frequently made as 90-day notes which are often rolled over, or renewed, rather than repaid when they mature. However, if the borrower's financial situation deteriorates, then the bank may refuse to roll over the loan. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bank loans KEYWORDS: Bloom’s: Knowledge 43. Loans from commercial banks generally appear on balance sheets as notes payable. A bank's importance is actually greater than it appears from the dollar amounts shown on balance sheets because banks provide nonspontaneous funds to firms. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bank loans KEYWORDS: Bloom’s: Knowledge 44. A promissory note is the document signed when a bank loan is executed, and it specifies financial aspects of the loan. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Promissory note KEYWORDS: Bloom’s: Knowledge 45. A line of credit can be either a formal or an informal agreement between a borrower and a bank regarding the maximum amount of credit the bank will extend to the borrower during some future period, assuming the borrower maintains its financial strength. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Line of credit Bloom’s: Knowledge

46. If a firm has set up a revolving credit agreement with a bank, the risk to the firm of being unable to obtain funds when needed is lower than if it had an informal line of credit. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Revolving credit KEYWORDS: Bloom’s: Knowledge 47. Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to match maturities on an ex ante (expected) basis. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maturity matching KEYWORDS: Bloom’s: Comprehension 48. The maturity matching, or "self-liquidating," approach to financing involves obtaining the funds for permanent current assets with a combination of long-term capital and short-term capital that varies depending on the level of interest rates. When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maturity matching Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT KEYWORDS:

Bloom’s: Comprehension

49. A firm that follows an aggressive current asset financing approach uses primarily short-term credit and thus is more exposed to an unexpected increase in interest rates than is a firm that uses long-term capital and thus follows a conservative financing policy. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Aggressive financing KEYWORDS: Bloom’s: Comprehension 50. The relative profitability of a firm that employs an aggressive current asset financing policy will improve if the yield curve changes from upward sloping to downward sloping. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Aggressive financing KEYWORDS: Bloom’s: Comprehension 51. The longer its customers normally hold inventory, the longer the credit period supplier firms normally offer. Still, suppliers have some flexibility in the credit terms they offer. If a supplier lengthens the credit period offered, this will shorten the customer's cash conversion cycle but lengthen the supplier firm's own CCC. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 52. The cash conversion cycle (CCC) combines three factors: The inventory conversion period, the average collection period, and the payables deferral period, and its purpose is to show how long a firm must finance its working capital. Other things held constant, the shorter the CCC, the more effective the firm's working capital management. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Comprehension 53. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality payments are concentrated at the beginning of each month. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Comprehension 54. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality receipts are concentrated at the beginning of each month. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 55. The cash budget and the capital budget are handled separately, and although they are both important, they are developed completely independently of one another. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash and capital budgets KEYWORDS: Bloom’s: Comprehension 56. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. Thus, if the depreciation charge for the coming year doubled or halved, this would have no effect on the cash budget. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget and depreciation KEYWORDS: Bloom’s: Comprehension 57. Synchronization of cash flows is an important cash management technique, as proper synchronization can reduce the required cash balance and increase a firm's profitability. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.135 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash flow synchronization KEYWORDS: Bloom’s: Comprehension 58. On average, a firm collects checks totaling $250,000 per day. It takes the firm approximately 4 days from the day the checks were mailed until they result in usable cash for the firm. Assume that (1) a lockbox system could be employed Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 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 ANSWER: False Funds generated = Days saved × Checks per day = $375,000 Return on funds generated = RATIONALE: Funds generated × Rate of return = $22,500 < $25,000

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.135 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Comprehension 59. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables balance KEYWORDS: Bloom’s: Comprehension 60. Dimon Products' sales are expected to be $5 million this year, with 90% on credit and 10% for cash. Sales are expected to grow at a stable, steady rate of 10% annually in the future. Dimon's accounts receivable balance will remain constant at the current level, because the 10% cash sales can be used to support the 10% growth rate, other things held constant. a. True b. False ANSWER: False Accounts receivable will increase by 10%. That percentage increase would occur regardless RATIONALE: of the level of the cash sales. Even if cash sales were 90%, receivables would still increase by 10% under the assumptions in the question.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT TOPICS: KEYWORDS:

Receivables and growth Bloom’s: Comprehension

61. For a zero-growth firm, it is possible to increase the percentage of sales that are made on credit and still keep accounts receivable at their current level, provided the firm can shorten the length of its collection period sufficiently. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables and growth KEYWORDS: Bloom’s: Comprehension 62. A firm's collection policy, i.e., the procedures it follows to collect accounts receivable, plays an important role in keeping its average collection period short, although too strict a collection policy can reduce profits due to lost sales. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Comprehension 63. Because money has time value, a cash sale is always more profitable than a credit sale. a. True b. False ANSWER: False Department stores, auto dealers, and many others sell on credit, using interest bearing notes RATIONALE: payable. The interest rate on this credit can exceed the firm's cost of capital, making credit sales more profitable than cash sales.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash vs. credit sales Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT KEYWORDS:

Bloom’s: Comprehension

64. If a firm sells on terms of 2/10 net 30 days, and its DSO is 28 days, then the fact that the 28-day DSO is less than the 30-day credit period tells us that the credit department is functioning efficiently and there are no past-due accounts. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: DSO and past-due accounts KEYWORDS: Bloom’s: Comprehension 65. If a firm switched from taking trade credit discounts to paying on the net due date, this might cost the firm some money, but such a policy would probably have only a negligible effect on the income statement and no effect whatever on the balance sheet. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit KEYWORDS: Bloom’s: Comprehension 66. If a profitable firm finds that it simply must "stretch" its accounts payable, then this suggests that it is undercapitalized, i.e., that it needs more working capital to support its operations. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stretching accounts payable KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 67. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it does not represent a real financial cost to your firm as long as the customer periodically pays off its entire balance. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stretching accounts payable KEYWORDS: Bloom’s: Comprehension 68. If the yield curve is upward sloping, then short-term debt will be cheaper than long-term debt. Thus, if a firm's CFO expects the yield curve to continue to have an upward slope, this would tend to cause the current ratio to be relatively low, other things held constant. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.139 - LO: 21-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Comprehension 69. The risk to the firm of borrowing using short-term credit is usually greater than if it used long-term debt. Added risk stems from (1) the greater variability of interest costs on short-term than long-term debt and (2) the fact that even if its long-term prospects are good, the firm's lenders may not be willing to renew short-term loans if the firm is temporarily unable to repay those loans. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.139 - LO: 21-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 70. Long-term loan agreements always contain provisions, or covenants, that constrain the firm's future actions. Shortterm credit agreements are just as restrictive in order to protect the interest of the lender. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.139 - LO: 21-11 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Comprehension 71. A firm constructing a new manufacturing plant and financing it with short-term loans, which are scheduled to be converted to first mortgage bonds when the plant is completed, would want to separate the construction loan from its current liabilities associated with working capital when calculating net working capital. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.139 - LO: 21-11 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Comprehension 72. A revolving credit agreement is a formal line of credit. The firm must generally pay a fee on the unused balance of the committed funds to compensate the bank for the commitment to extend those funds. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Revolving credit KEYWORDS: Bloom’s: Comprehension 73. Which of the following will cause an increase in net working capital, other things held constant? a. A cash dividend is declared and paid. Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.141 - LO: 21-0 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 74. Firms generally choose to finance temporary current operating assets with short-term debt because a. short-term interest rates have traditionally been more stable than long-term interest rates. b. a firm that borrows heavily on a long-term basis is more apt to be unable to repay the debt than a firm that borrows short term. c. the yield curve is normally downward sloping. d. short-term debt has a higher cost than equity capital. e. matching the maturities of assets and liabilities reduces risk under some circumstances, and also because shortterm debt is often less expensive than long-term capital. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current asset financing KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 75. Which of the following actions should Reece Windows take if it wants to reduce its cash conversion cycle? a. Take steps to reduce the DSO. b. Start paying its bills sooner, which would reduce the average accounts payable but not affect sales. c. Sell common stock to retire long-term bonds. d. Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock. e. Increase average inventory without increasing sales. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 76. A lockbox plan is a. used to identify inventory safety stocks. b. used to slow down the collection of checks our firm writes. c. used to speed up the collection of checks received. d. used primarily by firms where currency is used frequently in transactions, such as fast food restaurants, and less frequently by firms that receive payments as checks. e. used to protect cash, i.e., to keep it from being stolen. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.135 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 77. A lockbox plan is most beneficial to firms that a. have widely dispersed manufacturing facilities. b. have a large marketable securities portfolio and cash to protect. c. receive payments in the form of currency, such as fast food restaurants, rather than in the form of checks. d. have customers who operate in many different parts of the country. e. have suppliers who operate in many different parts of the country. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.135 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Lockbox KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 78. Which of the following is NOT commonly regarded as being a credit policy variable? a. Collection policy. Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT b. Credit standards. c. Cash discounts. d. Payments deferral period. e. Credit period. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit policy KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 79. Summary balance sheet data for Greener Gardens Co. is shown below (in thousands of dollars). The company is in a highly seasonal business, and the data show its assets and liabilities at peak and off-peak seasons: Cash Marketable securities Accounts receivable Inventories Net fixed assets Total assets

Peak $ 50 0 40 100 500 $690

Off-Peak $ 30 20 20 50 500 $620

Payables and accruals Short-term bank debt Long-term debt Common equity Total claims

$ 30 50 300 310 $690

$ 10 0 300 310 $620

From this data we may conclude that a. Greener Gardens' current asset financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt. b. Greener Gardens follows a relatively conservative approach to current asset financing; that is, some of its short-term needs are met by permanent capital. c. Without income statement data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy. d. Without cash flow data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy. e. Greener Gardens' current asset financing policy calls for exactly matching asset and liability maturities. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Current asset financing Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

80. Which of the following statements is CORRECT? a. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current asset financing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 81. Other things held constant, which of the following would tend to reduce the cash conversion cycle? a. Place larger orders for raw materials to take advantage of price breaks. b. Take all discounts that are offered. c. Continue to take all discounts that are offered and pay on the net date. d. Offer longer payment terms to customers. e. Carry a constant amount of receivables as sales decline. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 82. Which of the following actions would be likely to shorten the cash conversion cycle? a. Change the credit terms offered to customers from 3/10 net 30 to 1/10 net 50. b. Begin to take discounts on inventory purchases; we buy on terms of 2/10 net 30. c. Adopt a new manufacturing process that saves some labor costs but slows down the conversion of raw materials to finished goods from 10 days to 20 days. d. Change the credit terms offered to customers from 2/10 net 30 to 1/10 net 60. e. Adopt a new manufacturing process that speeds up the conversion of raw materials to finished goods from 20 days to 10 days. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 83. Which of the following is NOT directly reflected in the cash budget of a firm that is in the zero tax bracket? a. Depreciation. b. Cumulative cash. c. Repurchases of common stock. d. Payment for plant construction. e. Payments lags. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 84. Which of the following statements concerning the cash budget is CORRECT? a. Cash budgets do not include financial items such as interest and dividend payments. b. Cash budgets do not include cash inflows from long-term sources such as the issuance of 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 85. Which of the following items should a company report directly in its monthly cash budget? a. Cash proceeds from selling one of its divisions. b. Accrued interest on zero coupon bonds that it issued. c. New shares issued in a stock split. d. New shares issued in a stock dividend. e. Its monthly depreciation expense. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 86. Which of the following statements is CORRECT? a. The cash budget and the capital budget are developed separately, and although they are both important to the firm, one does not affect the other. b. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. c. The target cash balance should be set such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it should be changed to reflect long-term changes in the firm's operations. d. The typical cash budget reflects interest paid on loans as well as income from the investment of surplus cash. These numbers, as well as other items on the cash budget, are expected values; hence, actual results might vary from the budgeted amounts. e. Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Working capital management United States - OH - Default City - TBA Cash budget Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

87. Which of the following statements is most consistent with efficient inventory management? The firm has a a. low incidence of production schedule disruptions. b. below average total assets turnover ratio. c. relatively high current ratio. d. relatively low DSO. e. below average inventory turnover ratio. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.136 - LO: 21-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory management KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 88. Which of the following statements is CORRECT? a. In managing a firm's accounts receivable, it is possible to increase credit sales per day yet still keep accounts receivable fairly steady, provided the firm can shorten the length of its collection period (its DSO) sufficiently. b. Because of the costs of granting credit, it is not possible for credit sales to be more profitable than cash sales. c. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio. d. Other things held constant, if a firm can shorten its DSO, this will lead to a higher current ratio. e. A firm that makes 90% of its sales on credit and 10% for cash is growing at a constant rate of 10% annually. Such a firm will be able to keep its accounts receivable at the current level, since the 10% cash sales can be used to finance the 10% growth rate. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Receivables management KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 89. Which of the following statements is CORRECT? Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Days sales outstanding (DSO) KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 90. Which of the following is NOT a situation that might lead a firm to increase its holdings of short-term marketable securities? a. The firm is going from its peak sales season to its slack season, so its receivables and inventories will experience a seasonal decline. b. The firm is going from its slack season to its peak sales season, so its receivables and inventories will experience seasonal increases. c. The firm has just sold long-term securities and has not yet invested the proceeds in operating assets. d. The firm just won a product liability suit one of its customers had brought against it. e. The firm must make a known future payment, such as paying for a new plant that is under construction. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Marketable securities KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 91. Which of the following statement completions is CORRECT? If the yield curve is upward sloping, then the marketable securities held in a firm's portfolio, assumed to be held for emergencies, should a. consist mainly of short-term securities because they pay higher rates. b. consist mainly of U.S. Treasury securities to minimize interest rate risk. Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.142 - LO: 21-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Marketable securities KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 92. Which of the following statements is CORRECT? a. Commercial paper is a form of short-term financing that is primarily used by large, strong, financially stable companies. b. Short-term debt is favored by firms because, while it is generally more expensive than long-term debt, it exposes the borrowing firm to less risk than long-term debt. c. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. d. Commercial paper is typically offered at a long-term maturity of at least five years. e. Trade credit is provided only to relatively large, strong firms. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.143 - LO: 21-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current asset financing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 93. Which of the following statements is NOT CORRECT? a. Accruals are "free" in the sense that no explicit interest is paid on these funds. b. A conservative approach to working capital management will result in most, if not all, permanent current operating assets being financed with long-term capital. c. The risk to a firm that borrows with short-term credit is usually greater than if it borrowed using long-term debt. This added risk stems from the greater variability of interest costs on short-term debt and possible difficulties with rolling over short-term debt. d. Bank loans generally carry a higher interest rate than commercial paper. e. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. ANSWER: e POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.143 - LO: 21-13 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Current asset financing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 94. Which of the following statements is CORRECT? a. Conservative firms generally use no short-term debt and thus have zero current liabilities. b. A short-term loan can usually be obtained more quickly than a long-term loan, but the cost of short-term debt is normally higher than that of long-term debt. c. If a firm that can borrow from its bank at a 6% interest rate buys materials on terms of 2/10 net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet. d. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it will not have an adverse financial impact on your firm if the customer periodically pays off its entire balance. e. Under normal conditions, a firm's expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but using short-term debt would probably increase the firm's risk. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Short-term financing KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 95. Which of the following statements is NOT CORRECT? a. Credit policy has an impact on working capital because it influences both sales and the time before receivables are collected. b. The cash budget is useful to help estimate future financing needs, especially the need for short-term working capital loans. c. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10 net 30 to net 60. d. Managing working capital is important because it influences financing decisions and the firm's profitability. e. A company may hold a relatively large amount of cash and marketable securities if it is uncertain about its volume of sales, profits, and cash flows during the coming year. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.142 - LO: 21-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Working capital management United States - OH - Default City - TBA Working capital policy Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

96. Which of the following statements is CORRECT? a. If cash inflows from collections occur in equal daily amounts but most payments must be made on the 10th of each month, then a regular monthly cash budget will be misleading. The problem can be corrected by using a daily cash budget. b. Sound working capital policy is designed to maximize the time between cash expenditures on materials and the collection of cash on sales. c. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10 net 30 to net 60. d. If a firm sells on terms of net 90, and if its sales are highly seasonal, with 80% of its sales in September, then its DSO as it is typically calculated (with sales per day = Sales for past 12 months/365) would probably be lower in October than in August. e. Depreciation is included in the estimate of cash flows (Cash flow = Net income = Depreciation); hence depreciation is set forth on a separate line in the cash budget. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 97. Which of the following statements is CORRECT? a. A conservative financing policy is one where the firm finances part of its fixed assets with short-term capital and all of its net working capital with short-term funds. b. If a company receives trade credit under terms of 2/10 net 30, this implies that the company has 10 days of free trade credit. c. One cannot tell if a firm has a conservative, aggressive, or moderate current asset financing policy without an examination of its cash budget. d. If a firm has a relatively aggressive current asset financing policy vis-á-vis other firms in its industry, then its current ratio will probably be relatively high. e. Accruals are an expensive but commonly used way to finance working capital. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Working capital concepts Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

98. Albrecht Inc. is a no-growth firm whose sales fluctuate seasonally, causing total assets to vary from $320,000 to $410,000, but fixed assets remain constant at $260,000. If the firm follows a maturity matching (or moderate) working capital financing policy, what is the most likely total of long-term debt plus equity capital? a. $260,642 b. $274,360 c. $288,800 d. $304,000 e. $320,000 ANSWER: e RATIONALE: Lower total asset range $320,000

Upper total asset range

$410,000

Minimum total assets = FA + Min. CA = $320,000 = LT Debt + Equity A maturity matching policy implies that fixed assets and permanent current assets are financed with long-term sources. This is its most likely level of long-term financing.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.131 - LO: 21-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maturity matching KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 99. Brothers Breads has the following data. What is the firm's cash conversion cycle? Inventory conversion period = 50 days Average collection period = 17 days Payables deferral period = 25 days a. 31 days b. 34 days c. 38 days d. 42 days e. 46 days ANSWER: d RATIONALE: Inventory conversion period =

Average collection period = Payables deferral period =

50 days 17 days 25 days

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 42 days

POINTS: DIFFICULTY:

1 Difficulty: Easy

Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 100. Fireside Inc. has the following data. What is the firm's cash conversion cycle? Inventory conversion period = 38 days Average collection period = 19 days Payables deferral period = 20 days a. 33 days b. 37 days c. 41 days d. 45 days e. 49 days ANSWER: b RATIONALE: Inventory conversion period =

Average collection period = Payables deferral period =

38 days 19 days 20 days

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 37 days

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 101. Whaley & Whaley has the following data. What is the firm's cash conversion cycle? Inventory conversion period = 41 days Average collection period = 31 days Payables deferral period = 38 days a. 31 days b. 34 days c. 37 days d. 41 days e. 45 days ANSWER: b RATIONALE: Inventory conversion period =

Average collection period = Cengage Learning Testing, Powered by Cognero

41 days 31 days Page 36

CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT Payables deferral period =

38 days

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 34 days

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 102. Mark's Manufacturing's average age of accounts receivable is 45 days, the average age of accounts payable is 40 days, and the average age of inventory is 69 days. Assuming a 365-day year, what is the length of its cash conversion cycle? a. 63 days b. 67 days c. 70 days d. 74 days e. 78 days ANSWER: d CCC = Inv. conv. period + Avg. coll. period − Pay. deferral period RATIONALE:

Age of receivables = Avg. coll. period = Age of inventory = Inv. conv. period = Age of payables = Pay. def. period =

45 days 69 days 40 days

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 74 days

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 103. Baltimore Baking is preparing its cash budget and expects to have sales of $30,000 in January, $35,000 in February, and $35,000 in March. If 20% of sales are for cash, 40% are credit sales paid in the month after the sale, and another 40% are credit sales paid 2 months after the sale, what are the expected cash receipts for March? a. $24,057 b. $26,730 c. $29,700 d. $33,000 e. $36,300 ANSWER: d Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT Payments: 20% 40% 40%

RATIONALE:

Cash Pay 2nd month Pay 3rd month

Collections

January February March Total collections for month:

Sales for Mos. $30,000 35,000 35,000

January

February

March

$6,000 _____

$12,000 7,000 ______

$12,000 14,000 7,000

$6,000

$19,000

$33,000

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 104. Krackle Korn Inc. had credit sales of $3,500,000 last year and its days sales outstanding was DSO = 35 days. What was its average receivables balance, based on a 365-day year? a. $335,616 b. $352,397 c. $370,017 d. $388,518 e. $407,944 ANSWER: a RATIONALE: Sales $3,500,000

DSO

Receivables = (Sales per day)(DSO) = Sales/365 × DSO = $335,616

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accounts receivable balance KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 105. Buchholz Corporation follows a moderate current asset investment policy, but it is now considering a change, perhaps to a restricted or maybe to a relaxed policy. The firm's annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%; and its Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT tax rate is 40%. With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies? a. 4.25% b. 4.73% c. 5.25% d. 5.78% e. 6.35% ANSWER: c RATIONALE: Sales $400,000Debt ratio 50%Interest rate 10%

Fixed assets CA/Sales, restricted

$100,000EBIT CA/Sales, 15% relaxed Restricted $ 60,000 100,000 $160,000

Relaxed $100,000 100,000 $200,000

Debt Equity Total liab. & capital

$ 80,000 80,000 $160,000

$100,000 100,000 $200,000

EBIT Interest EBT Taxes NI

$ 35,000 8,000 $ 27,000 10,800 $ 16,200

$ 35,000 10,000 $ 25,000 10,000 $ 15,000

ROE

20.25%

15.00%

CA FA Total assets

$35,000Tax rate

40%

25%

Difference in ROE = 5.25%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.130 - LO: 21-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: ROE and WC policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 106. Data on Nathan Enterprises for the most recent year are shown below, along with the days sales outstanding of the firms against which it benchmarks. The firm's new CFO believes that the company could reduce its receivables enough to reduce its DSO to the benchmarks' average. If this were done, by how much would receivables decline? Use a 365-day year. Sales Accounts receivable Days sales outstanding (DSO) Benchmark days sales outstanding (DSO) Cengage Learning Testing, Powered by Cognero

$110,000 $16,000 53.09 20.00 Page 39

CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT a. $8,078 b. $8,975 c. $9,973 d. $10,970 e. $12,067 ANSWER: RATIONALE:

Original Data Sales $110,000 Receivables and DSO $16,000 New receivables = DSO × (Sales/365) = Reduction in receivables = Original receivables − New receivables =

Benchmark Related DSO 53.09

Alternative solution: (Change in DSO/Original DSO) × Orig. receivables =

Receivables at Benchmark DSO Level 20.00

$6,027 $9,973

$9,973

Inventory/COGS = Annual COGS = Avg. inventory =

50.0% $24,000,000 $1,000,000

Inv. conv. period = Inv./COGS per day = Inv./(Annual COGS/365) = 15.2 days

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 Cengage Learning Testing, Powered by Cognero

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$85,000 $20,000 85.88 38.00

Original Data

Cost of goods sold Inventory and ICP New inventory = ICP × (COGS/365) = Reduction in inventories = Original Inv. − New Inv. =

$85,000 $20,000

Benchmark Related ICP 85.88

Alternative solution: (Change in ICP/Original ICP) × Orig. Inv. =

ICP at Benchmark ICP Level 38.00 $8,849

$11,151

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 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 ANSWER: e RATIONALE:

$75,000 $5,000 24.33 30.00

Original Data

Cost of goods sold $75,000 Inventory and PDP $5,000 New payables = PDP × (COGS/365) = Increase in payables = New Payables − Original Payables =

Benchmark Related PDP 24.33

Alternative solution: (Change in PDP/Original PDP) × Orig. Payables =

Payables at Benchmark PDP Level 30.00 $6,164 $1,164

$1,164

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payables deferral period KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 110. Marshall Inc. recently hired your consulting firm to improve the company's performance. It has been highly profitable but has been experiencing cash shortages due to its high growth rate. As one part of your analysis, you want to determine the firm's cash conversion cycle. Using the following information and a 365-day year, what is the firm's present cash conversion cycle? Average inventory = Annual sales = Annual cost of goods sold = Average accounts receivable = Average accounts payable = a. 120.6 days b. 126.9 days c. 133.6 days Cengage Learning Testing, Powered by Cognero

$75,000 $600,000 $360,000 $160,000 $25,000

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT d. 140.6 days e. 148.0 days ANSWER: RATIONALE:

Avg. inventory = $75,000Annual sales = Avg. receivables = $160,000Annual COGS = Avg. payables = $25,000Days in year = Inv. conv. period = Inv./(COGS/365) 76.0 + DSO = Receivables/(Sales/365) 97.3 − Payables deferral = −25.3 Payables/(COGS/365) Cash conversion cycle (CCC) 148.0

$600,000 $360,000 365

$45,000 $31,500 $4,000 $2,000 $2,400

Annual cost of goods sold (COGS) Inventory Accounts receivable Accounts payable Days in year Sales per day = COGS per day = Inv. conv. period = Inv./COGS per day = Avg. coll. period = Receivables/Sales per day = Pay. def. period = Accounts payable/COGS per day =

$45,000 $31,500 $4,000 $2,000 $2,400 365 $123.29 $86.30 46.35 16.22 27.81

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 34.76 days Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 112. Shulman Inc. has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle? Annual sales = Annual cost of goods sold = Inventory = Accounts receivable = Accounts payable = a. 28 days b. 32 days c. 35 days d. 39 days e. 43 days ANSWER: d RATIONALE: Annual sales

$45,000 $30,000 $4,500 $1,800 $2,500

$45,000 $30,000 $4,500 $1,800 $2,500 365 $123.29 $82.19 54.75 14.60 30.42

CCC = Inv. conv. period + Avg. coll. period − Pay. def. period = 38.93 days

Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 113. Kiley Corporation had the following data for the most recent year (in millions). The new CFO believes (1) that an improved inventory management system could lower the average inventory by $4,000, (2) that improvements in the credit department could reduce receivables by $2,000, and (3) that the purchasing department could negotiate better credit terms and thereby increase accounts payable by $2,000. Furthermore, she thinks that these changes would not affect either sales or the costs of goods sold. If these changes were made, by how many days would the cash conversion cycle be lowered? Annual sales: unchanged Cost of goods sold: unchanged Average inventory: lowered by $4,000 Average receivables: lowered by $2,000 Average payables: increased by $2,000 Days in year a. 34.0 b. 37.4 c. 41.2 d. 45.3 e. 49.8 ANSWER: a RATIONALE:

Original $110,000 $80,000 $20,000 $16,000 $10,000 365

Annual sales: unchanged Cost of goods sold: unchanged Average inventory: lowered by $4,000 Average receivables: lowered by $2,000 Average payables: increased by $2,000 Days in year Inv. conv. period = Inv./(COGS/365) = DSO = Receivables/(Sales/365) = Payables deferral = Payables/(COGS/365) = CCC = Inv. conv. + DSO − Pay. def. period =

Revised $110,000 $80,000 $16,000 $14,000 $12,000 365

Original $110,000 $80,000 $20,000 $16,000 $10,000 365 91.25 53.09 45.63 98.72

Revised $110,000 $80,000 $16,000 $14,000 $12,000 365 73.00 46.45 54.75 64.70

Change = 34.01

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 114. Whitson Co. is looking for ways to shorten its cash conversion cycle. It has annual sales of $36,500,000, or $100,000 a day on a 365-day basis. The firm's cost of goods sold is 75% of sales. On average, the company has $9,000,000 in inventory and $8,000,000 in accounts receivable. Its CFO has proposed new policies that would result in a 20% reduction in both average inventories and accounts receivable. She also anticipates that these policies would reduce sales by 10%, while the payables deferral period would remain unchanged at 35 days. What effect would these policies have on the company's cash conversion cycle? Round to the nearest whole day. a. −26 days Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT b. −22 days c. −18 days d. −14 days e. −11 days ANSWER: RATIONALE:

Annual sales Days in year Sales per day COGS/Sales COGS per day Inventory Accounts receivable Pay. deferral period % Reduction in Inv. % Reduction in Rec. % Reduction in Sales

Original $36,500,000 365 $100,000 75% $75,000 $9,000,000 $8,000,000 35

New $32,850,000 365 $90,000 75% $67,500 $7,200,000 $6,400,000 35 20% 20% 10%

Cash conversion cycle = Inv. conversion period + Avg. collection period − Pay. deferral period CCCOrig = 120.00 + 80.00 − 35.00 = 165.00 CCCNew = 106.67 + 71.11 − 35.00 = 142.78 CCCNew − CCCOrig = 142.78 − 165.00 = −22.22 days

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 115. Pascarella Inc. is revising its payables policy. It has annual sales of $50,735,000, an average inventory level of $15,012,000, and average accounts receivable of $10,008,000. The firm's cost of goods sold is 85% of sales. The company makes all purchases on credit and has always paid on the 30th day. However, it now plans to take full advantage of trade credit and to pay its suppliers on the 40th day. The CFO also believes that sales can be maintained at the existing level but inventory can be lowered by $1,946,000 and accounts receivable by $1,946,000. What will be the net change in the cash conversion cycle, assuming a 365-day year? a. −26.6 days b. −29.5 days c. −32.8 days d. −36.4 days e. −40.5 days ANSWER: e RATIONALE: Original New

Annual sales Days in year Sales per day Cengage Learning Testing, Powered by Cognero

$50,735,000 365 $139,000

$50,735,000 365 $139,000 Page 46

CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT COGS/Sales COGS per day Inventory Accounts receivable Pay. deferral period $ Reduction in Inv. $ Reduction in Rec.

85% $118,150 $15,012,000 $10,008,000 30

85% $118,150 $13,062,000 $8,062,000 40 $1,946,000 $1,946,000

Cash conversion cycle = Inv. conversion period + Avg. collection period − Pay. deferral period CCCOrig = 127.06 + 72.00 − 30.00 = 169.06 CCCNew = 110.59 + 58.00 − 40.00 = 128.59 CCCNew − CCCOrig = 128.59 − 169.06 = −40.47 days

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 116. Tierney Enterprises is constructing its cash budget. Its budgeted monthly sales are $5,000, and they are constant from month to month. 40% of its customers pay in the first month and take the 2% discount, while the remaining 60% pay in the month following the sale and do not receive a discount. The firm has no bad debts. Purchases for next month's sales are constant at 50% of projected sales for the next month. "Other payments," which include wages, rent, and taxes, are 25% of sales for the current month. Construct a cash budget for a typical month and calculate the average net cash flow during the month. a. $1,092 b. $1,150 c. $1,210 d. $1,271 e. $1,334 ANSWER: c RATIONALE: Monthly sales $5,000

Monthly purchase % Other payments: Payment pattern: Discount:

Sales Month 40% 2%

Cash budget: Sales Collections, same month's sales (% of Sales)(Sales)(1 − Discount) Collections (last month's sales) Total collections Purchases payments Cengage Learning Testing, Powered by Cognero

50% 25% Next Month 60% Last Month $5,000

Current Month $5,000

Next Month $5,000

$1,960 3,000 $4,960 2,500 Page 47

CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT Other payments Total payments Net cash flow

1,250 $3,750 $1,210

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.133 - LO: 21-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash budget KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 117. Carter & Carter is considering setting up a regional lockbox system to speed up collections. The company sells to customers all over the U.S., and all receipts come in to its headquarters in San Francisco. The firm's average accounts receivable balance is $2.5 million, and they are financed by a bank loan at an 11% annual interest rate. The firm believes this new lockbox system would reduce receivables by 20%. If the annual cost of the system is $15,000, what pre-tax net annual savings would be realized? a. $29,160 b. $32,400 c. $36,000 d. $40,000 e. $44,000 ANSWER: d RATIONALE: Average accounts receivable

$2,500,000 balance Annual interest rate to finance 11.00% A/R % Reduction in A/R 20.00% Annual lockbox cost $15,000 Reduction in A/R = % Reduction in A/R × Avg. A/R balance Reduction in A/R = 20.00% × $2,500,000 Reduction in A/R = $500,000 Annual int. savings Annual int. savings Annual int. savings

= Reduction in A/R × Annual interest rate = $500,000 × 11.00% = $55,000

= Annual interest savings − Annual lockbox cost Pre-tax net annual savings = $55,000 − $15,000 Pre-tax net annual savings = $40,000 Pre-tax net annual savings

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.135 - LO: 21-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

Page 48

CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Working capital management United States - OH - Default City - TBA Lockbox Bloom’s: Analysis TYPE: Multiple Choice: Problem

118. Newsome Inc. buys on terms of 3/15, net 45. It does not take the discount, and it generally pays after 60 days. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year? a. 25.09% b. 27.59% c. 30.35% d. 33.39% e. 36.73% ANSWER: a RATIONALE: Discount % 3%Net days 45

Discount days

15Actual days to payment

Nom. % cost = Disc. %/(100 − Disc. %) × (365/(Actual days − Disc. days) Nom. % cost = 3.09% × 8.11 = 25.09% The effective discount % is earned N times per year; the product is the nominal annual cost rate.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: nom. cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 119. Freeman Builders, Inc. buys on terms of 2/15, net 30. It does not take discounts, and it typically pays 60 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year? a. 10.86% b. 12.07% c. 13.41% d. 14.90% e. 16.55% ANSWER: e RATIONALE: Discount % 2%Net days 30

Discount days

15Actual days to payment

Nom. % cost = Disc. %/(100 − Disc. %) × (365/(Actual days − Disc. days) Nom. % cost = 2.04% × 8.11 = 16.55% The effective discount % is earned N times per year; the product is the nominal annual cost rate.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 Cengage Learning Testing, Powered by Cognero

Page 49

Discount days

30Actual days to payment

120

Nom. % cost = Disc. %/(100 − Disc. %) × (365/(Actual days − Disc. days) = 16.90%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: nom. cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 121. Howes Inc. purchases $4,562,500 in goods per year from its sole supplier on terms of 2/15, net 50. If the firm chooses to pay on time but does not take the discount, what is the effective annual percentage cost of its non-free trade credit? (Assume a 365-day year.) a. 20.11% b. 21.17% c. 22.28% d. 23.45% e. 24.63% ANSWER: d RATIONALE: Discount % 2%Net days 50

Discount days

15Actual days to payment

EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] −1 = 23.45%

Page 50

CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Trade credit: EAR cost Bloom’s: Analysis TYPE: Multiple Choice: Problem

122. Andrews Corporation buys on terms of 2/8, net 45 days, it does not take discounts, and it actually pays after 58 days. What is the effective annual percentage cost of its non-free trade credit? (Use a 365-day year.) a. 14.34% b. 15.10% c. 15.89% d. 16.69% e. 17.52% ANSWER: c RATIONALE: Discount % 2%Net days 45

Discount days

8Actual days to payment

EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] − 1 = 15.89%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: EAR cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 123. Safety Window and Door Co. buys on terms of 2/15, net 60 days. It does not take discounts, and it typically pays on time, 60 days after the invoice date. Net purchases amount to $450,000 per year. On average, how much "free" trade credit does the firm receive during the year? (Assume a 365-day year, and note that purchases are net of discounts.) a. $18,493 b. $19,418 c. $20,389 d. $21,408 e. $22,479 ANSWER: a RATIONALE: Purchases $450,000Net days 60

Discount % Discount days

2%Days to payment 15Days/Year

60 365

Purchases/day = $450,000/365 = $1,233 Free credit = Disc. days × Purchases/day = $18,493

Page 51

CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Free trade credit Bloom’s: Analysis TYPE: Multiple Choice: Problem

124. Taylor Textbooks Inc. buys on terms of 2/15, net 50 days. It does not take discounts, and it typically pays on time, 50 days after the invoice date. Net purchases amount to $450,000 per year. On average, what is the dollar amount of costly trade credit (total credit − free credit) the firm receives during the year? (Assume a 365-day year, and note that purchases are net of discounts.) a. $43,151 b. $45,308 c. $47,574 d. $49,952 e. $52,450 ANSWER: a RATIONALE: Purchases $450,000Net days 50

Discount % Discount days

2%Days to payment 15Days/Year

50 365

Purchases/day = $450,000/365 = $1,233 Avg. trade credit = Average A/P = Days to payment × Net purchases/day = $61,644 Free trade credit = Discount days × Purchases/day = $18,493 Costly trade credit = Total credit − Free credit = $43,151 Alternatively, Costly TC = (Days to pmt. − Disc. days) × (Purchases/day) = $43,151

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Costly trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 125. Fairweather Corporation purchases merchandise on terms of 2/15, net 40, and its gross purchases (i.e., purchases before taking off the discount) are $800,000 per year. What is the maximum dollar amount of costly trade credit the firm could get, assuming it abides by the supplier's credit terms? (Assume a 365-day year.) a. $53,699 b. $56,384 c. $59,203 d. $62,163 e. $65,271 ANSWER: a RATIONALE: Discount 2%Gross purchases $800,000

Discount days Net days

15Days in year 40

365

Net purchases = Gross(1 − Disc. %) = $784,000 Net per day = Net/365 = $2,148 Total trade credit = Net days × Net per day = $85,918 Free credit = Net per day × Discount days = $32,219 Costly credit = Total credit − Free credit = $53,699 Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Costly trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 126. Hinkle Corporation buys on terms of 2/15, net 60 days. It does not take discounts, and it typically pays on time, 60 days after the invoice date. Net purchases amount to $550,000 per year. On average, what is the dollar amount of total trade credit (costly + free) the firm receives during the year, i.e., what are its average accounts payable? (Assume a 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 ANSWER: a RATIONALE: Purchases $550,000Net days 60

Discount % Discount days

2%Days to payment 15Days/Year

60 365

Purchases/day = $550,000/365 = $1,507 Average trade credit = Average A/P = Days to payment × Net purchases/day = $90,411

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 127. Noddings Inc. needs to raise more capital because its business is booming. The company purchases supplies on terms of 1/10 net 20, and it currently takes the discount. One way of getting the needed funds would be to forgo the discount, and the firm's owner believes she could delay payment to 40 days without adverse effects. What would be the effective annual percentage cost of funds raised by this action? (Assume a 365-day year.) a. 10.59% b. 11.15% c. 11.74% d. 12.36% e. 13.01% ANSWER: e Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT RATIONALE:

Discount % Discount days

1%Net days 10Actual days to payment

20 40

EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] − 1 = 13.01%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Stretching accounts payable KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 128. Sanders Enterprises arranged a revolving credit agreement of $9,000,000 with a group of banks. The firm paid an annual commitment fee of 0.5% of the unused balance of the loan commitment. On the used portion of the revolver, it paid 1.5% above prime for the funds actually borrowed on a simple interest basis. The prime rate was 3.25% during the year. If the firm borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of one year, what was the total dollar annual cost of the revolver? a. $285,000 b. $300,000 c. $315,000 d. $330,750 e. $347,288 ANSWER: b RATIONALE: Total commitment $9,000,000

Fee on unused balance 0.50% Prime rate 3.25% Premium over prime 1.50% Amount borrowed $6,000,000 Interest rate on borrowed funds = Prime + Premium = Cost of used portion = Amount borrowed × Rate = Cost of unused portion: Unused balance × Fee = Total annual cost of loan agreement =

4.75% $285,000 $15,000 $300,000

Alternative solution: Rate per day = 4.75%/365 = 0.0130137% Interest per day = (Rate per day)(Amount borrowed) = $781 Interest per year = (Interest per day)(365) = $285,000 Cost of unused portion: Unused balance × Fee = $15,000 Total annual cost of loan agreement = $300,000 POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.140 - LO: 21-12 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT TOPICS: KEYWORDS: OTHER:

Revolving credit agreement Bloom’s: Analysis TYPE: Multiple Choice: Problem

129. Fontana Painting had the following data for the most recent year (in millions). The new CFO believes that the company could improve its working capital management sufficiently to bring its NWC and CCC up to the benchmark companies' level without affecting either sales or the costs of goods sold. Fontana finances its net working capital with a bank loan at an 8% annual interest rate, and it uses a 365-day year. If these changes had been made, by how much would the firm's pre-tax income have increased? Original Data $100,000 $ 80,000 $ 20,000 $ 16,000 $ 5,000

Sales Cost of goods sold Inventory (ICP) Receivables (DSO) Payables (PDP) a. 1,901 b. 2,092 c. 2,301 d. 2,531 e. 2,784 ANSWER: RATIONALE:

Benchmark Related CCC CCC

91.25 58.40 22.81 126.84

38.00 20.00 30.00 28.00

Original Data Sales Cost of goods sold Inventory = ICP(COGS/365) = Receivables = DSO(Sales/365) = Payables = PDP(COGS/365) = New and old NWC

Benchmark Related CCC

Benchmark CCC

Levels

$100,000 $ 80,000 $ 20,000

91.25

38.00

$8,329

$ 16,000

58.40

20.00

$5,479

$ 5,000

22.81

30.00

$6,575

$ 31,000

126.84

28.00

$7,233

Reduction in NWC = Old − New = $23,767 Interest rate = 8% Savings = Interest rate × Reduction in NWC = $1,901

Page 55

CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT 130. Monar Inc.'s CFO would like to decrease its cash conversion cycle by 10 days (based on a 365 day year). The company carries average inventory of $750,000. Its annual sales are $10 million, its cost of goods sold is 75% of annual sales, and its average collection period is twice as long as its inventory conversion period. The firm buys on terms of net 30 days, and it pays on time. The CFO believes he can reduce the average inventory to $647,260 with no effect on sales. By how much must the firm also reduce its accounts receivable to meet its goal in the reduction of the cash conversion cycle? a. $123,630 b. $130,137 c. $136,986 d. $143,836 e. $151,027 ANSWER: c RATIONALE: Original New

Inventory $750,000 $647,260 Annual sales $10,000,000 $10,000,000 Days/year 365 365 COGS/Sales 75.00% 75.00% Payables deferral period (PDP) 30.00 30.00 Avg. collection period (DSO) = 2 × ICP Cost of goods sold $7,500,000 $7,500,000 Inv. conv. period (ICP) 36.50 31.50 DSO (calculated) 73.00 68.00 Receivables (A/R) $2,000,000 $1,863,014 CCC = DSO + ICP − PDP = 79.50 69.50CHECK on CCC Decrease in CCC 10 New CCC 69.50 Reduction in A/R = Orig. A/R − New A/R = $136,986

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.132 - LO: 21-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash conversion cycle KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 131. Suppose the suppliers of your firm offered you credit terms of 2/10 net 30 days. Your firm is not taking discounts, but is paying after 25 days instead of waiting until Day 30. You point out that the nominal cost of not taking the discount and paying on Day 30 is approximately 37%. But since your firm is neither taking discounts nor paying on the due date, what is the effective annual percentage cost (not the nominal cost) of its costly trade credit, using a 365-day year? a. 60.3% b. 63.5% c. 66.7% d. 70.0% e. 73.5% ANSWER: b Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT RATIONALE:

Discount % Discount days

2%Net days 10Actual days to payment

30 25

EAR = [1 + Disc. %/(100 − Disc. %)][365/(Actual days − Disc. Period)] − 1 = 63.49%

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Trade credit: EAR cost KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 132. Arnold Inc. purchases merchandise on terms of 2/10 net 30, and it always pays on the 30th day. The CFO calculates that the average amount of costly trade credit carried is $375,000. What is the firm's average accounts payable balance? (Assume a 365-day year.) a. $458,160 b. $482,273 c. $507,656 d. $534,375 e. $562,500 ANSWER: e RATIONALE: Discount % 2%Net days 30

Discount days Costly trade credit

10Actual days to payment $375,000Years/day = Purchases per day × (Days credit is outstanding − Costly trade credit Discount period) $375,000= Purchases per day × 20 Purchases per day= $18,750

30 365

Free trade credit= Purchases per day × Discount period Free trade credit= $18,750 × 10 Free trade credit= $187,500 Total trade credit= Costly trade credit + Free trade credit Total trade credit= $375,000 + $187,500 Total trade credit= $562,500 POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Accounts payable balance KEYWORDS: Bloom’s: Analysis Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT OTHER:

TYPE: Multiple Choice: Problem

133. Blueroot Inc. is considering a change in its financing policy. Currently, it uses maximum trade credit by not taking discounts on its purchases. The standard industry credit terms offered by all its suppliers are 2/10 net 30 days, and the firm pays on time. The new CFO is considering borrowing from its bank, using short-term notes payable, and then taking discounts. The firm wants to determine the effect of this policy change on its net income. Its net purchases are $11,760 per day, using a 365-day year. The interest rate on the notes payable is 10%, and the tax rate is 40%. If the firm implements the plan, what is the expected change in net income? a. $32,964 b. $34,699 c. $36,526 d. $38,448 e. $40,370 ANSWER: d RATIONALE: Discount % 2%Net days 30

Discount days Net purchases/day Annual interest rate

10Actual days to payment $11,760Days/year 10.00%Tax rate

30 365 40.00%

A/PNo disc. = Net purchases/day × Actual days to payment A/PNo disc. = $11,760 × 30 = $352,800 A/PDisc. = Net purchases/day × Discount days A/PDisc. = $11,760 × 10 = $117,600 Amount needed to be financed = A/PNo disc. − A/PDisc. Amount needed to be financed = $352,800 − $117,600 = $235,200 Additional interest cost = Amount needed to be financed × Annual interest rate Additional interest cost = $235,200 × 10.00% = $23,520 Gross purchases = (Net purchases/day × 365)/(1 − Disc. %) Gross purchases = $11,760 × 365/98.00% = $4,380,000 Discounts lost = Gross purchases × Discount % Discounts lost = $4,380,000 × 2.00% = $87,600 Pre-tax savings = Discounts lost − Additional interest Pre-tax savings = $87,600 − $23,520 = $64,080 After-tax savings = Pre-tax savings × (1 − T) Aftertax savings = $64,080 × 60.00% = $38,448

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Fin. stmts. and trade credit KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 134. Famous Farm's payables deferral period (PDP) is 50 days (on a 365-day basis), accounts payable are $100 million, and its balance sheet shows inventory of $125 million. What is the inventory turnover ratio? a. 4.73 b. 5.26 c. 5.84 d. 6.42 e. 7.07 ANSWER: c RATIONALE: PDP 50Days/year 365 Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT Payables

$100Inventory

$125

Use PDP equation to find sales: PDP = Receivables/(COGS/365) COGS = 365(Payables)/DSO = $730 Inventory turnover = COGS/Inventory = 5.84

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.137 - LO: 21-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory turnover and DSO KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 135. During the coming year, Gold & Gold wants to increase its free cash flow by $180 million, which should result in a higher EVA and stock price. The CFO has made these projections for the upcoming year: ∙ EBIT is projected to equal $850 million. Gross capital expenditures are expected to total to $360 million versus depreciation of $120 ∙ million, so its net capital expenditures should total $240 million. ∙ The tax rate is 40%. There will be no changes in cash or marketable securities, nor will there be any changes in ∙ notes payable or accruals. What increase in net working capital (in millions of dollars) would enable the firm to meet its target increase in FCF? a. $72 b. $90 c. $108 d. $130 e. $156 ANSWER: b RATIONALE: EBIT $850

Gross capital expenditures $360 Depreciation $120 Tax rate 40% Target increase in FCF $180 FCF= EBIT(1 − T) + Deprec. − Capex. −ΔNWC $180= $510 + $120 − $360 − ΔNWC $180= $270 − ΔNWC −$90= − ΔNWC ΔNWC= $90 POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.138 - LO: 21-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Working capital, FCF Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT KEYWORDS: OTHER:

Bloom’s: Analysis TYPE: Multiple Choice: Problem

Exhibit 21.1 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 40%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2. 136. Refer to Exhibit 21.1. If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy? a. $8,418 b. $8,861 c. $9,327 d. $9,818 e. $10,309 ANSWER: d RATIONALE: Annual sales $3,600,000

Fixed assets turnover (FATO) Debt/TA Equity/TA EBIT Interest rate Tax rate Total assets turnover (restricted) Total assets turnover (relaxed) FA turnover= Sales/Net FA 4.0= $3,600,000/Net FA Net FA= $900,000

4.0 50.00% 50.00% $150,000 10.00% 40.00% 2.5 2.2

Restricted:

TATO= Sales/Total assets 2.5= $3,600,000/Total assets Total assets= $1,440,000 Relaxed:

TATO= Sales/Total assets 2.2= $3,600,000/Total assets Total assets= $1,636,364 Balance Sheets: Restricted Current assets $ 540,000 Fixed assets 900,000 Total assets $1,440,000

Relaxed $ 736,364 900,000 $1,636,364

Debt Equity Total liab. & equity

$ 720,000 720,000 $1,440,000

$ 818,182 818,182 $1,636,364

$72,000

$81,818

Interest: Difference in interest = $9,818

POINTS:

Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.130 - LO: 21-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WC investment policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 137. Refer to Exhibit 21.1. What's the difference in the projected ROEs under the restricted and relaxed policies? a. 1.20% b. 1.50% c. 1.80% d. 2.16% e. 2.59% ANSWER: b RATIONALE: Restricted Relaxed

EBIT Interest EBT Taxes Net income

$150,000 72,000 $ 78,000 31,200 $ 46,800

$150,000 81,818 $ 68,182 27,273 $ 40,909

6.50%

5.00%

ROE = Net income/Equity Difference in ROEs = 1.50%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.130 - LO: 21-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Working capital management LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: WC investment, ROE KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 138. Refer to Exhibit 21.1. Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same. In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies? a. 2.24% b. 2.46% c. 2.70% d. 2.98% e. 3.27% ANSWER: a RATIONALE: % Change in sales −15.00% Cengage Learning Testing, Powered by Cognero

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CHAPTER 21—SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT % Change in EBIT New sales New EBIT

−10.00% $3,060,000 $135,000

Restricted:

TATO= Sales/Total assets 2.5= $3,060,000/Total assets Total assets= $1,224,000 Balance Sheet:

Restricted

Total assets

$1,224,000

Debt Equity Total liab. & equity

$ 612,000 612,000 $1,224,000

Income Statement: EBIT Interest EBT Taxes Net income

Restricted $ 135,000 61,200 $ 73,800 29,520 $ 44,280

ROE = Net income/Equity = 7.24% Relaxed ROE from above: 5.00% Difference in ROE = 2.24%

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT 1. The credit period is the amount of time it takes to do a credit search on a potential customer. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.144 - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit period KEYWORDS: Bloom’s: Comprehension 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.144 - LO: 22-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit standards KEYWORDS: Bloom’s: Comprehension 3. The collection process, although sometimes difficult, is a fairly inexpensive component of doing business. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.145 - LO: 22-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Comprehension 4. The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket expenses. a. True Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.145 - LO: 22-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Comprehension 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.146 - LO: 22-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash discounts KEYWORDS: Bloom’s: Comprehension 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.146 - LO: 22-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash discounts KEYWORDS: Bloom’s: Comprehension 7. The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are paying more slowly. a. True Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.147 - LO: 22-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Comprehension 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.147 - LO: 22-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Comprehension 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.148 - LO: 22-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Comprehension 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Comprehension 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Uncollected balances schedule KEYWORDS: Bloom’s: Comprehension 12. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT 13. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.145 - LO: 22-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Collection policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 14. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.147 - LO: 22-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments pattern approach KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Credit policy and seasonal dating KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 16. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.150 - LO: 22-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Choosing a bank KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual Exhibit 22.1 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. 17. Refer to Exhibit 22.1. How large are your brother's monthly payments? a. $6,250 b. $7,000 c. $7,500 Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT d. $5,250 e. $6,875 ANSWER: RATIONALE:

e The monthly payments would be:

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Loan payments KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 18. Refer to Exhibit 22.1. What is the nominal annual add-on interest rate on this loan? a. 10.00% b. 16.47% c. 18.83% d. 20.00% e. 24.00% ANSWER: d RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Add-on installment loan KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Multi-part 19. 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% Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT ANSWER: RATIONALE:

d Will receive $2,000. Face amount of loan = $2,000/(1 − 0.14 − 0.20) = $3,030.30. Discount interest = 0.14($3,030.30) = $424.24. Compensating balance = 0.20($3,030.30) = $606.06.

With a

financial calculator, enter N = 1, PV = 2,000, PMT = 0, FV = and solve for I/YR = 21.21%.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EAR discount/compensating balance loan KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 20. 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% ANSWER: b Assume firm needs $10,000. Face amount of loan = $10,000/(1 − 0.11 − 0.20) = $14,492.75. RATIONALE: Discount interest = 0.11($14,492.75) = $1,594.20. Compensating balance = 0.20($14,492.75) = $2,898.55.

With

a financial calculator, enter N = 1, PV = 10,000, PMT = 0, FV = −11,594.20, and solve for I/YR = 15.94%.

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

capital United States - OH - Default City - TBA EAR discount/compensating balance loan Bloom’s: Application TYPE: Multiple Choice: Problem

21. 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% ANSWER: d First, calculate the amount of "add-on" interest. Interest = 0.1019($12,000) = $1,222.80. The RATIONALE: total amount to be repaid is $1,222.80 + $12,000 = $13,222.80. The quarterly payments are $13,222.80/4 = $3,305.70. Find the periodic rate, where N = 4, PV = 12,000, PMT = −3,305.70, FV = 0, so the quarterly rate = 3.9977%. Finally, enter the nominal rate into your calculator, 4 × 3.9977% = 15.99% = NOM%. Enter P/YR = 4. Now, solve for EFF% = 16.98%.

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 22. 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% ANSWER: c Interest is 9%($200,000) = $18,000. Thus, the face value of the loan is $200,000 + $18,000 = RATIONALE: $218,000. Monthly payments are $218,000/12 = $18,166.67. Calculate the periodic rate as follows: N = 12, PV = 200,000, FV = 0, PMT = −18,166.67, I/YR = ? = 1.3514%. Convert this to an annual rate: 1.3514% × 12 = 16.2168%. Applying the EAR formula, solve for EAR = (1 + 0.162168/12)12 − 1 = 17.48%.

POINTS: DIFFICULTY:

1 Difficulty: Easy

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 23. 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.

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% ANSWER: e Alternative 1: Face amount of loan = $75,000/(1 − 0.07 − 0.10) = $90,361.45 ≈ $90,361. RATIONALE:

To solve

for the loan's effective rate enter N = 1, PV = 75,000, PMT = 0, FV = −81,325, and solve for I/YR = 8.43%. Alternative 2: EAR = (1 + 0.08/12)12 − 1 = 8.30%.

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT c. 12.5% d. 13.6% e. 14.1% ANSWER: RATIONALE:

d Will receive $12,000. Face amount of loan = $12,000/(1 − 0.12) = $13,636.36. Discount interest = 0.12($13,636.36) = $1,636.36.

With

a financial calculator, enter N = 1, PV = 12,000, PMT = 0, FV = −13,636.36, and solve for I/YR = 13.64% ≈ 13.6%.

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT KEYWORDS: OTHER:

Bloom’s: Application TYPE: Multiple Choice: Problem

26. 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 ANSWER: a Convert the annual rate to a periodic rate (quarterly) in the denominator of the face value RATIONALE:

formula:

Interest= $13,222.80 − $12,000 = $1,222.80.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Add-on interest loan KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 28. Refer to Exhibit 27.2. 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) ANSWER: d RATIONALE: Bad debt losses

old: Bad debt losses new:

(.05)($15,000,000) = $750,000. (.03)($14,500,000) = $435,000.

Change in bad debt losses = $435,000 − $750,000 = −$315,000.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bad debt losses KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 29. Refer to Exhibit 27.2. 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 ANSWER: b RATIONALE: DSO0 = 60 days; DSON = 30 days. No discounts. Calculate cost of carrying receivables at current and new sales levels: Cost of carrying receivables = DSO(Sales/Day)(Variable cost ratio)(Cost of funds)

Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000. Sales at $14,500,000: 30($14,500,000/360)(0.6)(0.15) = $108,750. Change = $108,750 − $225,000 = −$116,250.

POINTS:

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of carrying receivables KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 30. Refer to Exhibit 27.2. 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 ANSWER: e Analysis of policy change: RATIONALE:

Net sales Production costs Profit before credit costs Cost of carrying receivables Bad debt losses Pre-tax profits

Current Effect of Credit Projections Policy Change $15,000,000 −$500,000 9,000,000 + 300,000 $ 6,000,000 −$200,000

New Projections $14,500,000 8,700,000 $ 5,800,000

225,000

+ 116,250

108,750

750,000 $ 5,025,000

+ 315,000 +$231,250

435,000 $ 5,256,250

Change in incremental pre-tax profits = $231,250.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Incremental profits KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 31. Refer to Exhibit 272.3. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT ANSWER: RATIONALE:

c No discounts with old policy; 2% discount with new policy (2/10, net 30). Discount = $15,500,000(0.5)(0.02) = $155,000.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash discounts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 32. Refer to Exhibit 27.3. 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 ANSWER: d RATIONALE: Bad debt losses

old: Bad debt losses new:

(0.05)($15,000,000) = $750,000. (0.04)($15,500,000) = $620,000.

Changes in bad debt losses = $620,000 − $750,000 = −$130,000.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bad debt losses KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 33. Refer to Exhibit 27.3. 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 ANSWER: a RATIONALE: DSO0 = 60 days; DSON = 30 days. Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT Cost of carrying = DSO(Sales/Day)(Variable cost ratio)(Cost of receivables funds) Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000. Sales at $15,500,000: 30($15,500,000/360)(0.6)(0.15) = $116,250. Change = $116,250 − $225,000 = −$108,750.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of carrying receivables KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 34. Refer to Exhibit 27.3. 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 ANSWER: a Analysis of policy change: RATIONALE:

Sales Discounts Net sales Production costs Profit before credit costs Cost of carrying receivables Bad debt losses Pre-tax profits

Current Effect of Credit Projections Policy Change $15,000,000 +$500,000 0 − 155,000 $15,000,000 +$345,000 − 300,000 9,000,000 $ 6,000,000 +$ 45,000

New Projections $15,500,000 155,000 $15,345,000 9,300,000 $ 6,045,000

225,000

+ 108,750

116,250

750,000 $ 5,025,000

+ 130,000 +$283,750

620,000 $ 5,308,750

Change in incremental pre-tax profits = +$283,750.

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT 35. Darren's Hair Products, Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Darren takes 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. ANSWER: d Bank loan: RATIONALE:

With account: Without account:

12%/(1 − 0.12 − 0.10) = 15.38%. 12%/(1 − 0.12 − 0.20) = 17.65%.

Trade credit:

Approximately: Effective rate:

(1%/99%)[360/(40 − 10)] = 12.12%. (1.0101)12 − 1.0 = 12.82%.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of short-term financing–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 36. 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% ANSWER: c Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT RATIONALE:

Simple interest: EAR = 15%. Nominal interest, daily compounding: 9% add-on, 12 mos. payments:

Total amount to be repaid is $25,000 principal, plus 0.09($25,000) = $2,250 of interest, or $27,250. b. The monthly payment = $27,250/12 = $2,270.83. a.

c. With a financial calculator, enter N = 12; PV = 25,000; PMT = −2,270.83; and FV = 0 to solve for I = 1.3514%. However, this is a monthly rate. d. EARAdd-on = (1.013514)12 − 1 = 17.48%. The difference between the highest and lowest EAR is 17.48% − 13.88% = 3.60%.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cost of short-term financing–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 37. 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 ANSWER: e RATIONALE: DSO0 = 30 days; DSON = 50 days; no discounts. Calculate cost of carrying receivables at current and new sales levels: Cost of carrying receivables = DSO(Sales/Day)(Variable cost ratio)(Cost of funds)

Sales at $1,000,000: Sales at $1,200,000:

30($1,000,000/360)(0.8)(0.15) = $10,000. 50($1,200,000/360)(0.8)(0.15) = $20,000.

Analysis of policy changes:

Net sales Cengage Learning Testing, Powered by Cognero

Current Effect of Credit Projections Policy Change $1,000,000 +$200,000

New Projections $1,200,000 Page 18

CHAPTER 22—PROVIDING AND OBTAINING CREDIT Production costs 800,000 − 160,000 960,000 Profit before credit costs $ 200,000 +$ 40,000 $ 240,000 Cost of carrying − 10,000 10,000 20,000 receivables Bad debt losses* 20,000 − 10,000 30,000 Pre-tax profits $ 710,000 +$ 20,000 $ 190,000 Bad debt losses * $1,000,000(0.02) = $20,000. old: Bad debt losses $1,000,000(0.02) + $200,000(0.05) = $30,000. new: The annual incremental pre-tax profit with the change in policy is $20,000.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.149 - LO: 22-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Change in credit policy KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: d Calculate total to be repaid and quarterly payments RATIONALE:

Total to be repaid = $12,000(1.1019) = $13,222.80. Quarterly payment = $13,222.80/4 = $3,305.70. Tabular solution:

PV= $12,000 = $3,305.70(PVIFAi,4) (PVIFAi,4)= 3.6301 I≈ 4.0%. EAR = 1.0(FVIF4%,4) −1.0 = 1.1699 − 1.0 = 0.1699 = 16.99%. Financial calculator solution: Calculate the nominal interest rate per period Inputs: N = 4; PV = −12,000; PMT = 3,305.71; FV = 0. Output: I = 4.0%. Calculate EAR using periodic rate and interest rate conversion feature Nominal annual rate = NOM% = 4 × 4.0% = 16.0%. Inputs: NOM% = 16; P/YR = 4. Output: EFF% = 16.99%.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.151 - LO: 22-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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CHAPTER 22—PROVIDING AND OBTAINING CREDIT STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - AK - DISC: Capital budgeting and cost - DISC: Capital budgeting and cost of capital United States - OH - Default City - TBA Effective interest rate Bloom’s: Analysis TYPE: Multiple Choice: Problem

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Target cash balance–nonalgorithmic KEYWORDS: Bloom’s: Comprehension 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Precautionary balance–nonalgorithmic KEYWORDS: Bloom’s: Comprehension 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cash balances–nonalgorithmic KEYWORDS: Bloom’s: Comprehension Cengage Learning Testing, Powered by Cognero

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL 4. A just-in-time system is designed to stretch accounts payable as long as possible. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory systems–nonalgorithmic KEYWORDS: Bloom’s: Comprehension 5. If a company increases its safety stock, then its EOQ will go up. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EOQ Extension–nonalgorithmic KEYWORDS: Bloom’s: Comprehension 6. If a company increases its safety stock, then its average inventory will go up. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EOQ Extension–nonalgorithmic KEYWORDS: Bloom’s: Comprehension 7. 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). Cengage Learning Testing, Powered by Cognero

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL c. The sales forecast is revised downward by 10 percent. d. Interest rates fall. e. Fixed order costs double. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Average inventory–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 8. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.154 - LO: 23-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Inventory accounting–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 9. 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%. ANSWER: b POINTS: 1 Cengage Learning Testing, Powered by Cognero

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Baumol model–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 10. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ. 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%. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: EOQ model–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 11. 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 ANSWER: d RATIONALE:

TC= (r)(C*/2) + (T/C*)(F) = 0.05($3,741.50) + ($700,000/$7,483)($2.00) = $374.17 ≈ $374. POINTS:

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$1,000= 2FT= 0.04($1,000)2 = 0.04($1,000,000) 2FT= $40,000. C*New=

= $666.67.

C*/2= $333.33 ≈ $333. POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Baumol model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 13. 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% Cengage Learning Testing, Powered by Cognero

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL c. 6.3% d. 12.1% e. 9.6% ANSWER: RATIONALE:

e Use the Baumol model and solve for r, the opportunity cost of holding cash.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Opportunity cost: Baumol model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 14. 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% ANSWER: e Method 1: Use the total cost formula to solve for the opportunity cost, r. Note that RATIONALE: transactions costs and holding costs are equal when C*/2 is the optimal average cash

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL

balance.

Method 2: Divide the total cost (TC) into the optimal

cash transfer, C*, to yield the opportunity cost. Note that the holding costs equal transactions at C*. Thus, total costs are twice holding or transactions costs, and C* is twice the average cash balance held. r = TC/C* = $5,760/$60,000 = 0.096 = 9.6%. or r = Holding costs/(C*/2) = $2,880/$30,000 = 0.096 = 9.6%.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Opportunity cost: Baumol model–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 15. 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.) ANSWER: d RATIONALE: Total cost of ordering and carrying EOQ (5,000)

Total cost of ordering and carrying

10,000

Cost of increase = $500. Savings from discount = $0.02(50,000) = $1,000. Net benefit = $1,000 − $500 = $500.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 Cengage Learning Testing, Powered by Cognero

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quantity discounts–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 16. 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. ANSWER: e RATIONALE:

TC= (50,000/5,000)($100) + (10,000/2)($0.50)(0.80) = $1,000 + $1,000 = $2,000. If the firm orders 10,000 gallons at a time,

TC= (50,000/10,000)($100) + (10,000/2)($0.47)(0.80) = $500 + $1,880 = $2,380. Therefore, costs increase by $2,380 − $2,000 = $380. The benefit is ($0.03)(50,000) = $1,500. Thus, the benefit exceeds the cost by $1,120.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quantity discounts–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 17. 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 Carrying cost Purchase price

= $10 per order = 20% of purchase price = $10 per unit

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL 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. ANSWER: c RATIONALE: Units per order under current policy: Thus, Total costCurrent policy − Total costEOQ = $203 − $200 = $3. Total costs of current policy exceed total costs of EOQ by $3.00.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total inventory costs–nonalgorithmic KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem Exhibit 23.1 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. 18. Refer to Exhibit 23.1. 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 ANSWER: c RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 Cengage Learning Testing, Powered by Cognero

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POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Average cash balance KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 20. Refer to Exhibit 23.1. 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 ANSWER: b

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL RATIONALE:

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.152 - LO: 23-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Baumol model KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part Exhibit 23.2 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.) 21. Refer to Exhibit 23.2. What is the economic ordering quantity for chips? a. 12,088 b. 3,175 c. 6,243 d. 13,675 e. 8,124 ANSWER: b RATIONALE:

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL inventory level? a. 12,088 b. 3,175 c. 15,750 d. 13,675 e. 8,124 ANSWER: RATIONALE:

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Average inventory KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 23. Refer to Exhibit 23.2. 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 ANSWER: d Maximum inventory level = EOQ + Safety stock = 3,175 + 10,500 = 13,675. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maximum inventory KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 24. Refer to Exhibit 23.2. How many orders should Cartwright place during the year? a. 12 Cengage Learning Testing, Powered by Cognero

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL b. 25 c. 30 d. 40 e. 60 ANSWER: RATIONALE:

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Orders per year KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 25. Refer to Exhibit 23.2. If the lead time for placing an order is 5 days, and Cartwright holds a safety stock equal to a 30day 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 e. 8,124 ANSWER: c RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Ordering inventory KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 26. Refer to Exhibit 23.2. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL d. $34,220 e. $47,693 ANSWER: RATIONALE:

c Average inventory is rounded to 12,088 = EOQ/2 + (126,000/360)(30). Number of orders is rounded to 40 = 126,000/3,175. Total cost = 40($200) + ($12,088)($25)(0.20) = $68,440.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total inventory costs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part Exhibit 23.3 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. 27. Refer to Exhibit 23.3. What is the firm's EOQ? a. 26,833 b. 30,040 c. 43,987 d. 13,563 e. 21,456 ANSWER: a RATIONALE:

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL d. $13,563 e. $19,825 ANSWER: RATIONALE:

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.153 - LO: 23-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Total inventory costs KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part 29. Refer to Exhibit 23.3. 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. 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. ANSWER: d RATIONALE: Total inventory cost with discount Incremental costs = $11,560 − $10,733 = $827. Savings from discount = ($2)(0.005)(1,440,000) = $14,400. Net savings = $14,400 − $827 = $13,573.

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CHAPTER 23—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL

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CHAPTER 24—ENTERPRISE RISK MANAGEMENT 1. One objective of risk management can be to reduce the volatility of a firm's cash flows. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.155 - LO: 24-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk management KEYWORDS: Bloom’s: Knowledge 2. Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.156 - LO: 24-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Swaps KEYWORDS: Bloom’s: Knowledge 3. Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.157 - LO: 24-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Speculative versus pure risk KEYWORDS: Bloom’s: Knowledge 4. In theory, reducing the volatility of its cash flows will always increase a company's value. a. True b. False Cengage Learning Testing, Powered by Cognero

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CHAPTER 24—ENTERPRISE RISK MANAGEMENT ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.156 - LO: 24-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk management KEYWORDS: Bloom’s: Knowledge 5. The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long" and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.156 - LO: 24-7 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Futures market hedging KEYWORDS: Bloom’s: Comprehension 6. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.155 - LO: 24-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk management KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 7. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 24—ENTERPRISE RISK MANAGEMENT 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.155 - LO: 24-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate and reinvestment rate risk KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 8. 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, 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.156 - LO: 24-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Swaps KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 9. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 24—ENTERPRISE RISK MANAGEMENT ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.158 - LO: 24-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Forwards vs. futures KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 10. 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. ANSWER: c Given its interest rate exposure, the bank needs a strategy which is profitable whenever RATIONALE: interest rates rise. If designed correctly, the profits from this strategy can partially, or in some cases, completely offset the losses the bank realizes from its basic operations whenever rates rise. Of the 5 strategies, only the short hedge is profitable when rates rise⎯ all the other strategies would make sense if the bank were looking for extra profits when rates dropped.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.156 - LO: 24-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Hedging KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 11. 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. ANSWER: b A pays LIBOR + 1% to its lenders, receives LIBOR from B, and pays B 7.95%, for a net fixed RATIONALE: Cengage Learning Testing, Powered by Cognero

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CHAPTER 24—ENTERPRISE RISK MANAGEMENT payment of 8.95%. B pays 9.4% to its lenders, pays LIBOR to A, and receives 7.95% from A, for a net payment of LIBOR + 1.45%.

POINTS:

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CHAPTER 24—ENTERPRISE RISK MANAGEMENT DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.156 - LO: 24-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Derivatives LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Treasury bond futures contracts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 14. 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 nearest whole dollar.) a. −$78.00 b. −$82.00 c. −$86.00 d. −$90.00 e. −$95.00 ANSWER: a RATIONALE: Quote: 80'07 0.80 0.07 Increase in annual rate: 0.01000 Par value: $1,000 N: 40 PMT: $30 Price = PV = (0.80 + 0.07/32) × $1,000 = −$802.1875 Enter data to get rate = I/YR 2 = 7.9986% New rate = (Old rate + 1.0%)/2 = 4.4993% New price = −$724.08 Change in price = loss = −$78

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CHAPTER 25—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.159 - LO: 25-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy issues KEYWORDS: Bloom’s: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.160 - LO: 25-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy claimants KEYWORDS: Bloom’s: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.161 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Doctrine of fairness Cengage Learning Testing, Powered by Cognero

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CHAPTER 25—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION KEYWORDS:

Bloom’s: Knowledge

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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.161 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Standard of feasibility KEYWORDS: Bloom’s: Knowledge 5. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.162 - LO: 25-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Social issues and bankruptcy KEYWORDS: Bloom’s: Knowledge 6. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.162 - LO: 25-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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CHAPTER 25—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION TOPICS: KEYWORDS:

Social issues and bankruptcy Bloom’s: Knowledge

7. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.161 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy proceedings KEYWORDS: Bloom’s: Comprehension 8. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.161 - LO: 25-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Replacing management KEYWORDS: Bloom’s: Comprehension 9. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.163 - LO: 25-6 Cengage Learning Testing, Powered by Cognero

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CHAPTER 25—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Liquidation procedures KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 10. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.163 - LO: 25-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy law KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 11. 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 assets if they are sold off individually. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate Cengage Learning Testing, Powered by Cognero

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CHAPTER 25—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION LEARNING OBJECTIVES: INTE.GENE.16.163 - LO: 25-6 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bankruptcy issues KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 12. 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)

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 (4) 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 ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.162 - LO: 25-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Financial statements, anal - DISC: Financial statements, analysis, forecasting, and cash flows LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Priority of claims KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual

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CHAPTER 26—MERGERS AND CORPORATE CONTROL 1. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies' pre-merger values. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.164 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Synergistic merger KEYWORDS: Bloom’s: Knowledge 2. Synergistic benefits can arise from a number of different sources, including operating economies of scale, financial economies, and increased managerial efficiency. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.164 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Sources of synergy KEYWORDS: Bloom’s: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.164 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Spin-off KEYWORDS: Bloom’s: Knowledge 4. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine. a. True Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.165 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Conglomerate merger KEYWORDS: Bloom’s: Knowledge 5. Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.166 - LO: 26-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Mergers and interest rates KEYWORDS: Bloom’s: Knowledge 6. Most defensive mergers occur as a result of managers' actions to maximize shareholders' wealth. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.167 - LO: 26-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Defensive mergers KEYWORDS: Bloom’s: Knowledge 7. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.167 - LO: 26-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger terms KEYWORDS: Bloom’s: Knowledge 8. A company seeking to fight off a hostile takeover might employ the services of an investment banking firm to develop a defensive strategy. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.167 - LO: 26-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Defensive tactics KEYWORDS: Bloom’s: Knowledge 9. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.168 - LO: 26-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Knowledge 10. Currently (2012), mergers can be accounted for using either the purchase method or the pooling method. a. True b. False ANSWER: False Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.169 - LO: 26-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger accounting KEYWORDS: Bloom’s: Knowledge 11. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.170 - LO: 26-14 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Poison pills KEYWORDS: Bloom’s: Knowledge 12. 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 b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.171 - LO: 26-16 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Joint ventures KEYWORDS: Bloom’s: Knowledge 13. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.172 - LO: 26-18 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Holding companies KEYWORDS: Bloom’s: Knowledge 14. The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.164 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger motivation KEYWORDS: Bloom’s: Comprehension 15. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.164 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger motivation KEYWORDS: Bloom’s: Comprehension 16. 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 ANSWER: False Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.164 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Managerial control KEYWORDS: Bloom’s: Comprehension 17. One of the main reasons why foreign firms are interested in buying U.S. companies is to gain entrance to the U.S. market. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.165 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: International mergers KEYWORDS: Bloom’s: Comprehension 18. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.165 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Vertical merger KEYWORDS: Bloom’s: Comprehension 19. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.165 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Congeneric merger KEYWORDS: Bloom’s: Comprehension 20. Since a manager's central goal is to maximize the firm's stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.167 - LO: 26-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Managerial opposition KEYWORDS: Bloom’s: Comprehension 21. Only if a target firm's value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.168 - LO: 26-6 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Comprehension 22. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger cash flows KEYWORDS: Bloom’s: Comprehension 23. In a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the two companies, measured as if they were operated independently. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Relevant merger cash flows KEYWORDS: Bloom’s: Comprehension 24. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Financial merger KEYWORDS: Bloom’s: Comprehension 25. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.174 - LO: 26-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Two-tier offer KEYWORDS: Bloom’s: Comprehension 26. The distribution of synergistic gains between the stockholders of two merged firms is almost always based strictly on their respective market values before the announcement of the merger. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.174 - LO: 26-9 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Synergistic gain KEYWORDS: Bloom’s: Comprehension 27. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.175 - LO: 26-10 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discount rate in a merger analysis KEYWORDS: Bloom’s: Comprehension 28. Any goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes. a. True Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.169 - LO: 26-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger accounting KEYWORDS: Bloom’s: Comprehension 29. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.169 - LO: 26-12 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger accounting KEYWORDS: Bloom’s: Comprehension 30. 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.172 - LO: 26-18 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Holding company advantages KEYWORDS: Bloom’s: Comprehension 31. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Comprehension 32. 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Comprehension 33. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.164 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Mergers Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL KEYWORDS: OTHER:

Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual

34. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.167 - LO: 26-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Hostile mergers KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 35. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.170 - LO: 26-14 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous merger concepts KEYWORDS: Bloom’s: Comprehension OTHER: TYPE: Multiple Choice: Conceptual 36. 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL 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 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.164 - LO: 26-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger motivation KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 37. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 38. Which of the following statements about valuing a firm using the APV 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 39. Which of the following statements about valuing a firm using the APV 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 APV 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger analysis KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 40. 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. Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.167 - LO: 26-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Miscellaneous merger concepts KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 41. 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 34% and if the exclusion on intercompany dividends is 70%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received? a. 10.2%; $2,245,000 b. 10.2%; $2,135,000 c. 23.8%; $1,905,000 d. 10.2%; $1,750,000 e. 34.0%; $1,650,000 ANSWER: a RATIONALE: Effective tax rate = (1 − Exclusion)(Tax rate)

= (1 − 0.70)(0.34) = 10.2%. Net dividends

= Gross dividends − Tax = $2,500,000 − $2,500,000(1 − 0.70)(0.34) = $2,500,000 − $255,000 = $2,245,000.

Alternate method: Effective tax rate = Tax amount/Gross dividends. = $255,000/$2,500,000 = 10.2%. POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.165 - LO: 26-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Intercompany dividends KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 42. A regional restaurant chain, Club Café, is considering purchasing a smaller chain, Sally's Sandwiches, which is currently financed using 20% debt at a cost of 8%. Club Café's analysts project that the merger will result in incremental 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 Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL million in Year 4. (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Sally's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The riskfree rate is 8%, and the market risk premium is 4%. 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% ANSWER: c RATIONALE: rsL = 8% + 2.0(4%) = 16%; rsU = 0.20(8%) + 0.80(16%) = 14.4%. POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discount rate KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem 43. The owners of Arthouse Inc., a national artist supplies chain, are contemplating purchasing Craftworks Inc, a smaller 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 ANSWER: d RATIONALE: Price per share =

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.174 - LO: 26-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Maximum price per share KEYWORDS: Bloom’s: Application OTHER: TYPE: Multiple Choice: Problem Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL 44. 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%. 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% ANSWER: e RATIONALE: Calculate the current required return to Workman's equity: rK = rRF + b(RPM) = 6% + (0.9)4% = 9.6%. Calculate Workman's unlevered cost of equity: rsU = wdrd + wsrs = 0.20(8%) + 0.80(9.6%) = 9.28%. Calculate Workman's levered cost of equity at the new capital structure with the new cost of debt: rsL = rsU + (rsU − rd)(D/S) = 9.28% + (9.28% − 9%)/(0.6/0.4) = 9.7%.

1 $1

2 $3

3 $3

4 $7 75 3 32

Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% 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 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value of SGP to Raymond? a. $53.40 million b. $61.96 million c. $64.64 million d. $76.96 million e. $79.64 million Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL ANSWER: RATIONALE:

b rsL = rRF + b(RPM) = 8% + 2.0(4%) = 16%. rsU = wdrd + wsrs = 0.30(10%) + 0.70(16%) = 14.2%. Since all of the cash flows are to be discounted at the same rate, we don't need to separately calculate the values of the tax shield and unlevered value of operations. We can simply add the tax shields and free cash flows together each year to input in the financial calculator: Time line: (In millions)

Financial

calculator solution: (In millions) Inputs: CF0 = 0; CF1 = 2; CF2 = 4; CF3 = 5; CF4 = 117; I/YR = 14.2. Output: NPV = $76.96 million = Value of operations. Value of equity = Value of operations − Value of debt = $76.96 − 15 = $61.96 million. Some students will calculate separately the value of the tax shield and the unlevered value of operations and add them together. In that case, the separate calculations are: Unlevered value of operations: Inputs: CF0 = 0; CF1 = 1; CF2 = 3; CF3 = 3; CF4 = 75 + 7 = 82; I/YR = 14.2. Output: NPV = $53.40 million = Unlevered value of operations. Value of tax shields: Inputs: CF0 = 0; CF1 = 1; CF2 = 1; CF3 = 2; CF4 = 3 + 32 = 35; I/YR = 14.2. Output: NPV = $23.56 million = Value of tax shields. Value of operations = Value of tax shields + Unlevered value of operations = $53.40 + $23.56 = $76.96 million.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.175 - LO: 26-10 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Value of an acquisition KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 46. Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers expects Fast Fruit's NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Fast Fruit is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year only, Fast Fruit will need $10 million of net new investment in operating capital. Fast Fruit's marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Fast Fruit to Juicers will both grow at a constant rate of 4%. Juicers has determined that Fast Fruit's cost of equity is 17.5%, and Fast Fruit currently has no debt outstanding. Assume that all cash flows occur at the end of the year, Juicers must pay $45 million to acquire Fast Fruit. What it the NPV of the proposed acquisition? Note that you must first calculate the value to Juicers of Fast Fruit's equity. a. $45.0 million b. $68.2 million c. $86.5 million d. $113.2 million e. $133.0 million ANSWER: c The unlevered cost of equity is 17.5%. All cash flows are discounted at this rate: Time line: RATIONALE:

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CHAPTER 26—MERGERS AND CORPORATE CONTROL

(In millions)

Vops =

$9/(1.175) + $171/(1.175)2 = $131.5 = V equity since there is no debt. The NPV is $131.5 − $45 = $86.5 million.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Merger NPV KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem Exhibit 26.1 Best Window & Door Corporation is considering the acquisition of Glassmakers Inc. Glassmakers has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Glassmakers' premerger beta is 1.36. Best's beta is 1.02, and both it and Glassmakers face a 40% tax rate. Best's capital structure is 40% debt and 60% equity. The free cash flows from Glassmakers are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%. 47. Refer to Exhibit 26.1. What is Glassmakers' pre-merger WACC? a. 9.02% b. 9.50% c. 9.83% d. 10.01% e. 11.29% ANSWER: c The pre-merger weight of debt is $5/($5 + $10) = 0.333 The pre-merger required rate of RATIONALE: return on equity is 6% + 1.36(4%) = 11.44%. WACC = wdrd(1 − T) + wSrS = 0.333(11%)(1 − 0.40) + 0.667(11.44%) = 9.83%.

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CHAPTER 26—MERGERS AND CORPORATE CONTROL TOPICS: KEYWORDS: OTHER: NOTES:

WACC of target Bloom’s: Analysis TYPE: Multiple Choice: Multi-part The problems referring to Exhibit 26.1 MUST be kept together.

48. Refer to Exhibit 26.1. What discount rate should you use to discount Glassmakers' free cash flows and interest tax savings? a. 10.01% b. 10.06% c. 11.29% d. 11.44% e. 13.49% ANSWER: c The correct discount rate is the unlevered cost of equity. The levered cost of equity is 6% + RATIONALE: 1.36(4%) = 11.44%, the percent of debt is $5/($5 + $10) = 0.333. The rate on the debt is 11%. The unlevered cost of equity is wdrd + wsrsL = 0.333(11%) + 0.667(11.44%) = 11.29%.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.173 - LO: 26-8 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Mergers and acquisitions a - DISC: Mergers and acquisitions analysis LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discount rate for value of operations KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Multi-part NOTES: The problems referring to Exhibit 26.1 MUST be kept together. 49. Refer to Exhibit 26.1. What is the value of Glassmakers' equity to Best? (Round your answer to the closest thousand dollars.) a. $16,019,000 b. $17,111,000 c. $18,916,000 d. $22,111,000 e. $22,916,000 ANSWER: b Because the cash flows are all discounted at the same rate, we don't need to separately RATIONALE: calculate the unlevered value of operations and the value of the tax shield. We can simply enter the sum of the tax shields and free cash flows and their horizon values for each year into the financial calculator: Time line: (In millions) Financial calculator solution: Inputs: CF0 = 0; CF1 = 4,000,000; Nj = 3; CF2 = 19,000,000; I/YR = 11.29. Output: PVInflows = $22,111,708 = Vops. Value of equity = Vops − Debt = $22.111 − $5 = $17.111 million. Alternately, some students will calculate separately the unlevered value of operations and the value of the tax shield: Inputs: CF0 = 0; CF1 = 3,000,000; Nj = 3; CF2 = Cengage Learning Testing, Powered by Cognero

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CHAPTER 26—MERGERS AND CORPORATE CONTROL 13,000,000; I/YR = 11.29. Output: PVInflows = $15,768,917 = Value of unlevered operations. Inputs: CF0 = 0; CF1 = 1,000,000; Nj = 3; CF2 = 6,000,000; I/YR = 11.29. Output: PVInflows = $6,342,792 = Value of tax shield. Adding these together gives the value of operations above, and subtracting the debt gives the value of equity above.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 1. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV versus FV KEYWORDS: Bloom's: Comprehension 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV versus FV KEYWORDS: Bloom's: Comprehension 5. If a bank compounds savings accounts quarterly, the effective annual rate will exceed the nominal rate. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom's: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growing annuity KEYWORDS: Bloom's: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Zero coupon bond KEYWORDS: Bloom's: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Discounted cash flows KEYWORDS: Bloom's: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond prices and interest rates KEYWORDS: Bloom's: Comprehension 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 b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Interest rate risk Bloom's: Comprehension

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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom's: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Standard deviation KEYWORDS: Bloom's: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Coefficient of variation Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS KEYWORDS:

Bloom's: Knowledge

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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom's: Comprehension 15. Diversification will normally reduce the riskiness of a portfolio of stocks. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom's: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk KEYWORDS: Bloom's: Knowledge 17. Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS how much those actions would increase the firm's expected rate of return. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and expected returns KEYWORDS: Bloom's: Comprehension 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and risk KEYWORDS: Bloom's: Comprehension 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 b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and risk KEYWORDS: Bloom's: Knowledge 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS flows during the subsequent constant growth period. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant growth model KEYWORDS: Bloom's: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Compounding KEYWORDS: Bloom's: Knowledge 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 ANSWER: False Work out the numbers with a calculator: RATIONALE:

PV Rate on A Rate on B Years

1000FVA = 5%2 × FVA = 12%FVB =

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

11FVB > 2 × FVA, so FALSE

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Comparative compounding Bloom's: Analysis

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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a dollar KEYWORDS: Bloom's: Comprehension 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 ANSWER: True One could make up an example and see that the statement is true. Alternatively, one could RATIONALE: simply recognize that the PV of an annuity declines as the discount rate increases and recognize that more frequent compounding increases the effective rate.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Periodic and nominal rates Bloom's: Knowledge

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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective and nominal rates KEYWORDS: Bloom's: Comprehension 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Knowledge 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. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS KEYWORDS:

Bloom's: Knowledge

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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond premiums and discounts KEYWORDS: Bloom's: Knowledge 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 ANSWER: True The bonds expected return (YTM) is 13.81%, which exceeds the 12% required return, so buy RATIONALE: the bond.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond value–annual payment KEYWORDS: Bloom's: Application 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 ANSWER: True The reason for this is that more of the cash flows of a low-coupon bond comes late in the RATIONALE: bond's life (as the maturity payment), and later cash flows are impacted most heavily by changing market rates.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Prices and interest rates KEYWORDS: Bloom's: Comprehension 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Variance KEYWORDS: Bloom's: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Coefficient of variation KEYWORDS: Bloom's: Comprehension 34. A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Beta coefficients Bloom's: Knowledge

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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom's: Comprehension 36. If the returns of two firms are negatively correlated, then one of them must have a negative beta. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom's: Comprehension 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. a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom's: Comprehension Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom's: Comprehension 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom's: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom's: Knowledge 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Cor. coefficient and risk KEYWORDS: Bloom's: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Diversification effects KEYWORDS: Bloom's: Comprehension 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom's: Knowledge 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Required return KEYWORDS: Bloom's: Comprehension 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Changes in beta KEYWORDS: Bloom's: Comprehension 46. The slope of the SML is determined by the value of beta. a. True b. False ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Knowledge 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 ANSWER: True POINTS: 1 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Application 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Application 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Knowledge 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk premium KEYWORDS: Bloom's: Comprehension 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 ANSWER: False There is no reason to think that this statement would always be true. The portion of the RATIONALE: payment representing interest declines, while the portion representing principal repayment increases. Therefore, the statement is false. We could also work out some numbers to prove this point. Here's an example for a 3-year loan at a 10% and a 41.45% annual interest rate. The interest component is not equal to the principal repayment component except at the high interest rate.

Original loan Rate Life Payment 1 2 3

Beg. Balance $1,000.00 $697.89 $365.56

$1,000Original loan 10%Rate 3Life $402.11Payment Interest Principal $100.00 $302.11 $69.79 $332.33 $36.56 $365.56

End. Bal. $697.89 1 $365.56 2 $0.00 3

Beg. Balance Interest Principal $1,000.00 $414.50 $226.48 $773.52 $320.62 $320.36 $453.15 $187.83 $453.15

$1,000 41.45% 3 $640.98 End. Bal. $773.52 $453.15 $0.00

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LOCAL STANDARDS: TOPICS: KEYWORDS:

United States - OH - Default City - TBA Amortization Bloom's: Comprehension

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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 54. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS TOPICS: KEYWORDS: OTHER: NOTES:

Constant growth model Bloom's: Comprehension TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

55. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 56. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS NOTES:

Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

57. Which of the following 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 58. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rate risk KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time lines KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 60. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effects of factors on PVs KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annuities KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 62. 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%. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Quarterly compounding KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 63. A $250,000 loan is to be amortized over 8 years, with annual end-of-year payments. Which of these statements is Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: d a, b, and e can be ruled out as incorrect by simple reasoning. c is also incorrect because RATIONALE:

interest in the first year would be Loan amount × interest rate regardless of the life of the loan, so the interest payment would be identical for the first payment. Think about the situation where r = 0%, statement d is the "most logical guess." One could also set up an amortization schedule and change the numbers to confirm that only d is correct.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 64. Which of the following statements 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. ANSWER: c c is the correct answer. Thinking through the question, the other answers can all be RATIONALE: eliminated. One could also set up an amortization schedule to prove that only statement c is correct.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

United States - OH - Default City - TBA Amortization Bloom's: Comprehension TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

65. Which of the following 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%. ANSWER: c c is correct. b is clearly wrong, as are d and e. It is not obvious whether a is correct or not, RATIONALE: but we could set up an example to see:

Loan Rate Periodic rate Payment Interest as % of total #360 payment: Principal as % of total #360 payment

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

30 12 360 $666.67

1%Interest, Month 360

$7.25

99%Principal, Month 360

$726.51

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization KEYWORDS: Bloom's: Comprehansion OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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). Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS d. Investment D pays $2,500 at the end of 10 years (just one payment). e. Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments). ANSWER: a A dominates B because it provides the same total amount, but it comes faster, hence it can RATIONALE: earn more interest over the 10 years. A also dominates C and E for the same reason, and it dominates D because with D no interest whatever is earned. We could also do these calculations to answer the question:

A B C D E

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

Largest

EFF% NOM%

10.00% 9.76%

250 125 125 2500 250

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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). ANSWER: d A is smaller than E and B is smaller than C because the money comes in later. A is smaller RATIONALE: than B because a larger annuity is received later. So, now the choice comes down to either A or D. Since all of D is received at the end, this is the logical choice. We could also do these calculations to answer the question:

A B C D E

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

EFF% NOM% Smallest

10.00% 9.76%

250 125 125 2500 250

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

United States - TN - DISC: Time value of money United States - OH - Default City - TBA Time value concepts Bloom's: Analysis TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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. e. The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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%. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER: NOTES:

United States - OH - Default City - TBA Time value concepts Bloom's: Comprehension TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Time value concepts KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: e POINTS: 1 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Annuities KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. e. Bond A's current yield will increase each year. ANSWER: c Note that Bond B sells at par, so the required return on all these bonds is 10%. B's price will RATIONALE: remain constant; A will sell initially at a discount and will rise, and C will sell initially at a premium and will decline. Note too that since it has larger cash flows from its higher coupons, Bond C would be less sensitive to interest rate changes; i.e., it has less interest rate risk. Perhaps it has less default risk.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates and bond prices KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: a We can tell by inspection that b, c, d, and e are all incorrect. That leaves answer a as the RATIONALE: only possibly correct statement. Recognize that longer-term bonds, and ones where payments come late (like low coupon bonds) are most sensitive to changes in interest rates. Thus, the 10-year, 8% coupon bond should be more sensitive to a decline in rates. You could also do some calculations to confirm that a is correct.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Interest rates and bond prices KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond yields and prices KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond concepts KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 77. You are considering investing in one of these three stocks: Stock A

Standard Deviation 20%

Cengage Learning Testing, Powered by Cognero

Beta 0.59 Page 30

WEB CHAPTER 29—BASIC FINANCIAL TOOLS B C

10% 12%

0.61 1.29

If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; B. b. B; A. c. C; A. d. C; B. e. A; A. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk aversion KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk measures KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 79. Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. She is highly Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: b With only 4 stocks in the portfolio, unsystematic risk matters, and B has less. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Standard deviation KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Beta coefficients KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk and port. divers. KEYWORDS: Bloom's: Conceptual Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS OTHER: NOTES:

TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk, return, and beta KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk concepts KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. return, CAPM, and beta KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. 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. ANSWER: c POINTS: 1 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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%. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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%. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS d. Portfolio P has a beta that is less than 1.2. e. Portfolio P has a beta that is greater than 1.2. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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%. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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%. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio risk and return KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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, 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. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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%. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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). 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%. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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%. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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? Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM and required return KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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%. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM, beta, and req. return KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 104. Which of the following statements is CORRECT? a. If the risk-free rate rises, then the market risk premium must also rise. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 108. Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines, with the net effect Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: SML, CAPM, and beta KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: c POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Risk concepts KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: e Statement e is true, because the expected growth rate is also the expected capital gains RATIONALE: yield. All the other statements are false.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS OTHER: NOTES:

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. ANSWER: d RATIONALE: Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so P1 must be $10(0.95) = $9.50. Therefore, answer d is correct, while the others are all false.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Declining constant growth KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 113. 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. ANSWER: d Statement d is true, because the stock price is expected to grow at the dividend growth rate. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth stock Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS KEYWORDS: OTHER: NOTES:

Bloom's: Knowledge TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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. ANSWER: a The following calculations show that answer a is correct. The others are all wrong. RATIONALE:

Expected return Expected growth Dividend yield

A 10% 7% 3%

B 12% 9% 3%

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS e. The two stocks should have the same expected dividend. ANSWER: d The following calculations show that answer d is correct. The others are all wrong. RATIONALE:

Price Expected growth Expected return

A $25 7% 10%

B $40 9% 12%

A = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $0.75 B = P0 = D1/(r − g) = D1 = P0(r) − P0(g) = $1.20

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: e Statement e is correct, because if both stocks have the same price and the same required RATIONALE: return, and A's growth rate is twice that of B, then A's dividend and dividend yield must be half that of B. This point is illustrated with the following example.

Price g r Div. Yield = r − g = D1 = P(Div Yield) = POINTS: DIFFICULTY:

A $25 10% 15% 5% $1.25

B $25 5% 15% 10% $2.50

1 Difficulty: Moderate

Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 117. 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. ANSWER: b The correct answer is statement b. Both prices are currently the same, but X's price should RATIONALE: grow at 6% vs. 4% for Y, so X's price should be higher a year from now.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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%. ANSWER: a The correct answer choice is a. One could quickly calculate the dividend yield and see that it RATIONALE: equals the growth rate, but here are some numbers that provide more information.

D1 P0 g

$3.00D1/P0 $50.00rX 6.0%

6.0% 12.0%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: a RATIONALE: Dividend = Yield × Price: X dividend = $1.25

Y dividend = $0.75

Stock X has a dividend yield of 5% versus a yield of 3% for Y. Since they both have the same stock price, X must pay a higher dividend.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS OTHER: NOTES:

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%. ANSWER: c RATIONALE: P1 = P0(1 + g) = $54. Therefore, c is correct. All the other answers are false. P1 = $54.00 POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected and required returns KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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? 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. ANSWER: e Statement e is true, because if the required return for Stock A is higher than that of Stock B, RATIONALE: and if the dividend yield for Stock A is lower than Stock B's, the growth rate for Stock A must be higher to offset this.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS TOPICS: KEYWORDS: OTHER: NOTES:

Dividend yield and g Bloom's: Comprehension TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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. ANSWER: a POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend yield and g KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: e POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Dividend yield and g Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS KEYWORDS: OTHER: NOTES:

Bloom's: Comprehension TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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. ANSWER: a Statement a is true, because Stock A has a higher required return but the stocks have the RATIONALE: same growth rate, so Stock A must have the higher dividend yield. Here are some calculations to demonstrate the point.

A B

rRF 6.40% 6.40%

+ +

Div. Yld.

beta 1.10 0.90

× ×

RPM 6.00% 6.00%

= =

rStock 13.00% 11.80%

rStock

D1/P0

7.00%

13.00%

D1/P0

7.00%

11.80%

D1/P0 = r − g = 6.00% D1/P0 = r − g = 4.80%

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: d POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Solving for I: uneven CFs KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: a By inspection, we can see that a dominates b and c, and that d dominates e because, with RATIONALE: the same interest rate, the account with the most frequent compounding has the highest EFF%. Thus, the correct answer must be either a or d. Moreover, we can see by inspection that since a and d have the same compounding frequency yet a has the higher nominal rate, a must have the higher EFF%. You could also prove that a is the correct choice by calculating the EFF%s:

a. b. c. d. e.

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

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS TOPICS: KEYWORDS: OTHER: NOTES:

Effective annual rate Bloom's: Knowledge TYPE: Multiple Choice: Conceptual Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question.

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

a. = (1 + 0.061/12) 12−1 = 6.100% e. = (1 + 0.06/365) 365−1 = 6.183% POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Effective annual rate KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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%. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS ANSWER: RATIONALE:

c c is correct. The portfolio's beta is 1.08. Therefore, if the market risk premium increases by 2.0% the portfolio's required return will increase by 2.16%.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. ANSWER: e e is correct. Stock A's required return is 10% = 5% + b(6%), so b = 5%/6% = 0.83333. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Port. risk & ret. relationships KEYWORDS: Bloom's: Comprehension OTHER: TYPE: Multiple Choice: Conceptual NOTES: Students may be able to correctly determine the answer to this question without [many] calculations. Please see the "Answers & Solutions" section to see calculation requirements for this question. 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. b. Portfolio AB has more money invested in Stock A than in Stock B. Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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. ANSWER: b b is correct. Beta P = %A(1.2) + %B(1.4) = 1.25. If 50% is in each stock, then we would have RATIONALE: Beta P = 0.5(1.2) + 0.5(1.4) = 1.3. But beta P < 1.3, so more money must be invested in the low beta stock, A.

I/YR PV PMT FV

8.5% $125 $0 $240.08

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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? Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS a. $1,781.53 b. $1,870.61 c. $1,964.14 d. $2,062.34 e. $2,165.46 ANSWER: RATIONALE:

N I/YR PV PMT FV

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: c RATIONALE: N 5

I/YR PV PMT FV

6.0% $225.00 $0.00 $301.10

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS a. $12.54 b. $13.20 c. $13.86 d. $14.55 e. $15.28 ANSWER: RATIONALE:

N I/YR PV PMT FV

75 3.5% $1.00 $0.00 $13.20

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of a lump sum KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: b RATIONALE: N 25

I/YR PV PMT FV

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

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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 ANSWER: a RATIONALE: N

I/YR PMT FV PV

8 5.5% $0 $1,000.00 $651.60

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a lump sum KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: e RATIONALE: N 25

I/YR PMT FV PV

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

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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 ANSWER: b RATIONALE: N

I/YR PMT FV PV

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a lump sum KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: d RATIONALE: N 10

PV PMT FV I/YR

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

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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% ANSWER: b RATIONALE: N 5

PV PMT FV I/YR

$1.50 $0 $3.20 16.36%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growth rate KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem 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 e. $14,626 ANSWER: c RATIONALE: N 3

I/YR PV PMT FV

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

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS OTHER:

TYPE: Multiple Choice: Problem

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 ANSWER: a RATIONALE: N 5

I/YR PV PMT FV

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of ordinary annuity KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: c BEGIN Mode RATIONALE:

N I/YR PV PMT FV

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

Alternative setup:

0 $7,000 POINTS:

1 $7,000

2 $7,000

3 $7,000 FV = $23,261

Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV of annuity due KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: e RATIONALE: N 5

I/YR PMT FV PV

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of ordinary annuity KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: e RATIONALE: N 20

I/YR PMT FV PV Cengage Learning Testing, Powered by Cognero

5.0% $5,000 $0.00 $62,311 Page 67

WEB CHAPTER 29—BASIC FINANCIAL TOOLS POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of ordinary annuity KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: a BEGIN Mode RATIONALE:

N I/YR PMT FV PV

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

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of annuity due KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 147. What's the present value of a perpetuity that pays $250 per year if the appropriate interest rate is 5%? a. $4,750 b. $5,000 c. $5,250 d. $5,513 e. $5,788 ANSWER: b RATIONALE: I/YR 5.0%

PMT PV POINTS:

$250 $5,000

Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: PV of a perpetuity KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: a RATIONALE: Cost (PV) $950

PMT I/YR

$85 8.95%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on a perpetuity KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: a RATIONALE: N 7

I/YR PMT FV PV POINTS: DIFFICULTY:

8.5% $70 $1,000 $923.22

1 Difficulty: Easy

Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: d RATIONALE: Coupon rate 5.5%

PMT N I/YR FV PV

$55 10 7.0% $1,000 $894.65

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: e RATIONALE: N 15

PV PMT FV I/YR Cengage Learning Testing, Powered by Cognero

$1,165 $95 $1,000 7.62% Page 70

WEB CHAPTER 29—BASIC FINANCIAL TOOLS POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: b RATIONALE: N 15

PV PMT FV I/YR

$1,080 $10 $1,000 9.01%= YTM

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 153. 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% ANSWER: b RATIONALE: Coupon rate 7.25%

N PV = Price PMT Cengage Learning Testing, Powered by Cognero

13 $1,125 $72.50 Page 71

WEB CHAPTER 29—BASIC FINANCIAL TOOLS FV = Par I/YR

$1,000 5.85%= YTM

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Yield to maturity KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: a RATIONALE: Par value $1,000

Coupon rate Periods/year Yrs to maturity N = periods Annual rate Periodic rate PMT/period FV PV

9.5% 2 15 30 11.0% 5.50% $47.50 $1,000 $891.00

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: semiannual coupons KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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% Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS c. 9.90% d. 10.15% e. 10.40% ANSWER: RATIONALE:

Conditions Good Average Poor

Prob. 0.50 0.30 0.20 1.00

Return 25.0% 10.0% −28.0%

Prob. × Return 12.50% 3.00% −5.60% 9.90%

= Expected return

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected return KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: a RATIONALE: Expected return 25.0%

Standard deviation Coefficient of variation = Std dev/Expected return =

30.0% 1.20

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Coefficient of variation KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS c. 0.80 d. 0.89 e. 0.98 ANSWER: RATIONALE:

Company X Y

Investment $ 35,000 $ 65,000 $100,000

Weight 0.35 0.65 1.00

Beta 1.50 0.70

Weight × beta 0.53 0.46 0.98

= Portfolio beta

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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% d. 12.25% e. 12.55% ANSWER: c RATIONALE: Beta 1.40

Risk-free rate Market risk premium Required return

4.25% 5.50% 11.95%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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% Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS c. 6.09% d. 6.25% e. 6.40% ANSWER: RATIONALE:

a Use the SML to determine the market risk premium with the given data.

rs= rRF + bStock × RPM 12.25%= 5.00% + 1.25 × RP M 7.25%= RP M × 1.25 5.80%= RP M POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Market risk premium KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: c RATIONALE: $0.75 D1

rs g P0 = D 1/(rs − g)

10.5% 6.4% $18.29

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth valuation KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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? Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS a. $23.11 b. $23.70 c. $24.31 d. $24.93 e. $25.57 ANSWER: RATIONALE:

D0 rs g D1 = D0(1 + g) = P0 = D 1/(rs − g)

$1.50 10.1% 4.0% $1.56 $25.57

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth valuation KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: d RATIONALE: $1.00 Last dividend (D 0)

Long-run growth rate Required return D1 = D0(1 + g) = P0 = D 1/(rs − g)

5.4% 11.4% $1.054 $17.57

Page 76

WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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% ANSWER: e RATIONALE: $1.25 Expected dividend (D1)

Stock price Required return Dividend yield Growth rate = rs − D1/P0 =

$32.50 10.5% 3.85% 6.65%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth rate KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: e RATIONALE: Stock price $35.50

Growth rate Years in the future P3 = P0(1 + g) 3 =

5.50% 3 $41.69

Page 77

WEB CHAPTER 29—BASIC FINANCIAL TOOLS TOPICS: KEYWORDS: OTHER:

Constant growth: future price Bloom's: Analysis TYPE: Multiple Choice: Problem

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 ANSWER: e RATIONALE: Growth rate 4.75%

Years in the future Stock price P5 = P0(1 + g) 5 =

5 $35.25 $44.46

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Constant growth: future price KEYWORDS: Bloom's: Analysis OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: d RATIONALE: $1.25 D1

g P0 Dividend yield = D1/P0 =

4.7% $26.00 4.81%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - TN - DISC: Stocks and bonds United States - OH - Default City - TBA Expected dividend yield Bloom's: Knowledge TYPE: Multiple Choice: Problem

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% ANSWER: b RATIONALE: $2.25 D0

g P0 D1 = D0(1 + g) = Dividend yield = D1/P0 =

3.5% $50.00 $2.329 4.66%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected dividend yield KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: a RATIONALE: $1.50 D1

g P0 Capital gains yield = g = POINTS: DIFFICULTY:

6.5% $56.00 6.50%

1 Difficulty: Easy

Cengage Learning Testing, Powered by Cognero

Page 79

g P0 Total return = r s = D1/P0 + g

5.5% $44.00 8.34%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected total return KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: e RATIONALE: $1.75 D0

g P0 D1 = D0(1 + g) = Cengage Learning Testing, Powered by Cognero

3.6% $32.00 $1.81 Page 80

WEB CHAPTER 29—BASIC FINANCIAL TOOLS Total return = r s = D1/P0 + g

9.27%

POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Expected total return KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: c BEGIN Mode RATIONALE:

N I/YR PMT FV PV

3 5.5% $550 $0.00 $1,565.48

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS RATIONALE:

BEGIN Mode

N I/YR PMT FV PV

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

N I/YR PMT FV PV

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

Page 82

WEB CHAPTER 29—BASIC FINANCIAL TOOLS c. $249,090 d. $261,545 e. $274,622 ANSWER: RATIONALE:

b BEGIN Mode

N I/YR PMT FV PV

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

I/YR PMT FV PV

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

Alternative setup:

1 $2,250

2 $2,250

3 $2,250

$2,250

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

PV = $10,446.50 POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA Cengage Learning Testing, Powered by Cognero

Page 83

WEB CHAPTER 29—BASIC FINANCIAL TOOLS TOPICS: KEYWORDS: OTHER:

PV of ord. ann. & end. pmt. Bloom's: Knowledge TYPE: Multiple Choice: Problem

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 ANSWER: d RATIONALE: N 25

I/YR PV FV PMT

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

N I/YR PV FV PMT POINTS: DIFFICULTY:

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

1 Difficulty: Moderate

Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Payments on annuity due KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: b RATIONALE: N 20

PV PMT FV I/YR

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

N PV PMT Cengage Learning Testing, Powered by Cognero

12 $120,000 $15,000 Page 85

WEB CHAPTER 29—BASIC FINANCIAL TOOLS FV I/YR

$0.00 8.41%

I/YR PMT

6.5% $81.25Multiply Cost by I/YR.

a. $411.57 b. $433.23 c. $456.03 d. $480.03 e. $505.30 ANSWER: RATIONALE:

e I/YR = 6.25%

Cengage Learning Testing, Powered by Cognero

Page 86

WEB CHAPTER 29—BASIC FINANCIAL TOOLS CFs: PV of CFs:

0 $0 $0

1 $75 $71

2 $225 $199

3 $0 $0

4 $300 $235

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

a. $5,987 b. $6,286 c. $6,600 d. $6,930 e. $7,277 ANSWER: RATIONALE:

a I/YR = 6.0%

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

0 1 2 3 $0 $1,000 $2,000 $2,000 $0 $ 943 $1,780 $1,679 Found using the Excel NPV function. Found by summing individual PVs. Found using the calculator NPV key.

4 $2,000 $1,584

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS

a. $526.01 b. $553.69 c. $582.83 d. $613.51 e. $645.80 ANSWER: RATIONALE:

e I/YR = 6.5%

CFs: FV of CFs: FV = $645.80 FV = $645.80 FV = $645.80

0 1 2 3 4 $0 $75 $225 $0 $300 $0 $91 $255 $0 $300 Found by summing individual FVs. Found with the NFV key in some calculators. Found with a calculator by first finding the PV of the stream, then finding the FV of that PV.

PV of the stream: FV of the PV:

$501.99 $645.80

CFs:

−$10,000 −$10,000

I/YR

7.50%

Cengage Learning Testing, Powered by Cognero

$750

$750 $10,000 $750 $750 $750 $750 $10,750 I is the discount rate that causes the PV of the inflows to equal the initial negative CF, and is found with Page 88

WEB CHAPTER 29—BASIC FINANCIAL TOOLS Excel's IRR function or by inputting the CFs into a calculator and pressing the IRR key. POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Rate in uneven cash flows KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: c RATIONALE: Years 5

Periods/Yr Nom. I/YR

2 6.0%

N = Periods PMT I = I/Period

10 $0 3.0%

PV FV =

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

Page 89

WEB CHAPTER 29—BASIC FINANCIAL TOOLS e. $1,873.76 ANSWER: RATIONALE:

Years Periods/Yr Nom. I/YR

5 12 6.0%

N = Periods PMT I/Period

60 $0 0.5%

PV FV

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

Periods/Yr Nom. I/YR

12 6.0%

N = Periods 60 PMT $0 I/Period 0.5% FV $1,525 PV = $1,131 = FV/(1 + r Per)N PV = $1,131 Found using a calculator or Excel POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

Page 90

WEB CHAPTER 29—BASIC FINANCIAL TOOLS STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - TN - DISC: Time value of money United States - OH - Default City - TBA PV, monthly compounding Bloom's: Knowledge TYPE: Multiple Choice: Problem

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% ANSWER: b RATIONALE: APR = Nominal rate 18.00%

Periods/yr EFF% = (1 + (rNOM/N)) N − 1 =

12 19.56%

Nominal rate, Southwestern Nominal rate, Woodburn Periods/yr, Southwestern Periods/yr, Woodburn EFF% Southwestern = (1 + (rNOM/N))N − 1 = EFF% Woodburn Cengage Learning Testing, Powered by Cognero

6.5% 7.0% 12 1 6.70% 7.00% Page 91

WEB CHAPTER 29—BASIC FINANCIAL TOOLS Difference

0.30%

Periods/yr EFF% = (1 + (rNOM/N)) N − 1 =

4 8.24%

You could also find the EFF% as follows: Interest paid each quarter = Loan × rate/4 = Qtrly PMT = $200.00 Then find the IRR as a quarterly rate and convert to an annual rate. This procedure is obviously longer.

CFs:

0 10,000.00

1 −200.00

2 −200.00

3 −200.00

10,000.00

−200.00

4 −200.00 −10,000.00 −10,200.00

IRR (quarterly) = 2.00% Annual effective rate = 8.24% vs. nominal rate = 8.00%

Page 92

WEB CHAPTER 29—BASIC FINANCIAL TOOLS c. $133.22 d. $139.88 e. $146.87 ANSWER: RATIONALE:

Nominal I/YR Days/yr Amount borrowed Interest per month = Interest/day × 30 =

7.25%Days in month 360Daily rate $20,000Interest per day

30 0.020139% $4.02778

$120.83

Number of months Days in year Days in month Amount deposited Ending amount

8Days = Months × 30 = 360 30 $5,000 $5,178.09

240

Page 93

WEB CHAPTER 29—BASIC FINANCIAL TOOLS a. $3,704.02 b. $3,889.23 c. $4,083.69 d. $4,287.87 e. $4,502.26 ANSWER: RATIONALE:

Years = N I/YR FV Amount borrowed = PV Payments = PMT

4 9.0% $0 $12,000 $3,704.02Found with a calculator, as the PMT.

Payments/year Nominal rate Purchase price Down payment

12 Periodic rate 6.50% PV $145,000 FV $15,000 PMT

0.54% $130,000 $0.00 $821.69

Page 94

WEB CHAPTER 29—BASIC FINANCIAL TOOLS 195. 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 ANSWER: e Monthly annuity, so interest must be calculated on a monthly basis. RATIONALE:

Years N PV FV

4Payments/year 48Nominal rate $250,000I/period $50,000PMT

12 6.0% 0.5% $4,947.01

Years Amount borrowed

5 $14,000

Interest in Year 1

$1,400.00

Simply multiply the rate times the amount borrowed.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS OTHER:

TYPE: Multiple Choice: Problem

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 ANSWER: d Find the required payment: RATIONALE:

N I PV FV PMT

7 7.5% $35,000 $0 $6,608.01Found with a calculator or Excel.

Amortization schedule (first 2 years)

Year 1 2

Beg. Balance 35,000.00 31,016.99

Payment 6,608.01 6,608.01

Interest 2,625.00 2,326.27

Principal 3,983.01 4,281.74

End. Balance 31,016.99 26,735.25

I/YR

18.0%

I/MO

1.5%

PV PMT FV

$0 $5,000 $250,000

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Monthly annuity due, so interest must be calculated on monthly basis. rNOM/12.

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS N

37.16Rounded up: 38

PV PMT FV

$4,000 $137.41 $0

I/MO

1.20%

I/YR = I/MO × 12 =

14.36%

Monthly annuity, so interest must be calculated on monthly basis

Page 97

WEB CHAPTER 29—BASIC FINANCIAL TOOLS ANSWER: RATIONALE:

Par value Coupon rate N I/YR PMT FV PV

$1,000 7.5% 14 5.5% $75 $1,000 $1,191.79

Coupon rate Periods/year Yrs to maturity N = periods Annual rate Periodic rate PMT/period FV PV

6.25% 2 10 20 4.75% 2.38% $31.25 $1,000 $1,118.31

Page 98

WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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

Coupon rate Par value Maturity (Yrs) Periods/Yr. YTM

4.0% $1,000 10 2 12.0%

N I/YR PMT FV PV

20 6.0% $20.00 $1,000 $541.20

Determine the number of bonds:

Book value on balance sheet Par value Number of bonds = Book value/Par value

$10,000,000 $1,000 10,000

Calculate the market value of bonds:

Mkt value = PV × Number of bonds =

$5,412,032

Page 99

WEB CHAPTER 29—BASIC FINANCIAL TOOLS State of the Economy Boom Normal Recession a. 0.2839 b. 0.3069 c. 0.3299 d. 0.3547 e. 0.3813 ANSWER: RATIONALE:

Probability of State Occurring 0.45 0.50 0.05

Stock's Expected Return 25% 15% 5%

b This is a relatively technical problem. It should be used only if calculations are emphasized in class, or on a take-home exam where students have time to look up formulas.

Probability of

Return

This state

0.45 0.50 0.05 Expected return =

25.00% 15.00% 5.00%

State Prob. × Sq. from Deviation Mean Dev. 6.00% 0.36% 0.1620% −4.00% 0.16% 0.0800% −14.00% 1.96% 0.0980%

19.00%

0.34%

Deviation Squared

0.3400%

= Expected variance

σ =5.83% Coefficient of variation = 0.3069 σ/Expected return = POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Coefficient of variation KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 204. 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS c. 1.037 d. 1.089 e. 1.143 ANSWER: RATIONALE:

Stock A B C D Total

Investment Percentage $ 50,000 25.00% $ 50,000 25.00% $ 50,000 25.00% $ 50,000 25.00% $200,000 100.00%

Beta 0.95 0.80 1.00 1.20

Product 0.238 0.200 0.250 0.300 0.988

= Portfolio beta

Product 0.56 0.11 0.27 0.24 1.17

= Portfolio beta

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 ANSWER: b RATIONALE:

Beta 1.40 0.80 1.00 1.20

Stock A B C D Total

Investment Percentage $150,000 40.00% $ 50,000 13.33% $100,000 26.67% $ 75,000 20.00% $375,000 100.00%

Beta 1.40 0.80 1.00 1.20

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - TN - DISC: Risk and return United States - OH - Default City - TBA Portfolio beta Bloom's: Knowledge TYPE: Multiple Choice: Problem

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

Stock A B C D Total

Investment Percentage $150,000 40.00% $ 50,000 13.33% $100,000 26.67% $ 75,000 20.00% $375,000 100.00%

Beta Product 1.400 0.560 0.800 0.107 1.000 0.267 1.200 0.240 Old b = 1.173

Beta Product 0.750 0.300 0.800 0.107 1.000 0.267 1.200 0.240 New b = 0.913

Change in beta = New − Old = −0.260 Alternative solution: (bE − bA) × %A = −0.260

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom's: Knowledge OTHER: TYPE: Multiple Choice: Problem 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? a. 1.286 b. 1.255 c. 1.224 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS d. 1.194 e. 1.165 ANSWER: RATIONALE:

% in each stock: Old stock's beta: New stock's beta: Old port. beta:

5% 0.90 1.80 1.12

New beta = (bNew − bOld) × %A + bOld = 1.165

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: e RATIONALE: Beta: A 0.70

Beta: B Market return Risk-free rate Market risk premium Required return A = rRF + bA(RP M) = Required return B = rRF + bB(RP M) = Difference

1.20 11.00% 4.25% 6.75% 8.98% 12.35% 3.38%

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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% ANSWER: e RATIONALE: Use SML to determine the market risk premium. Note that rRF is based on T-bonds, not short-term T-bills.

rs= rRF + RP M 13.00%= 6.50% + RPM 6.50%= RPM Use the SML to determine the firm's required return using the RPM calculated above.

rs= rRF + RP M × b = 6.50% + 6.50% × 1.30 = 14.95% POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: RATIONALE:

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

Beta 1.50 −0.50 1.25 0.75

rM rRF

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13.25% 7.00% Page 104

WEB CHAPTER 29—BASIC FINANCIAL TOOLS Find portfolio beta:

$ 200,000 $ 300,000 $ 500,000 $1,000,000 $2,000,000

Weight 0.100 0.150 0.250 0.500 1.000

Beta 1.50 −0.50 1.25 0.75

Product 0.1500 −0.0750 0.3125 0.3750 0.7625

= portfolio beta

Find RPM = rM − rRF = 6.25% rs = rRF + b(RPM) = 11.77%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 a. 14.00% b. 14.70% c. 15.44% d. 16.21% e. 17.02% ANSWER: a RATIONALE: Old beta

1.00 10.20% 6.00% 30.00% 2.00%

Old rs = r RF + b(RP M) RPM Percentage increase in beta Increase in IP Find new beta after increase = Find old rRF: Old rs = rRF + b(RP M): 10.2% = rRF + 1.0(6.0%): rRF = 10.2% − 6.0% = Find new rRF: Old rRF + increase in IP = Find new rs = new rRF + new beta(RP M) POINTS: DIFFICULTY:

1.00 10.20% 6.00% 30.00% 2.00% 1.30

4.20% 6.20% 14.00%

1 Difficulty: Moderate

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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% ANSWER: a RATIONALE: Beta 1.23

Risk-free rate Required return on stock RPM = (r Stock − rRF)/beta Required return on market = rRF + RPM =

4.30% 11.75% 6.06% 10.36%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Return on the market KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: a RATIONALE: $1.25 D1

b rRF Cengage Learning Testing, Powered by Cognero

1.15 4.00% Page 106

WEB CHAPTER 29—BASIC FINANCIAL TOOLS RPM g rs = rRF + b(RP M) = P0 = D 1/(rs − g)

5.50% 6.00% 10.33% $28.90

b rRF RPM g D1 = D0(1 + g) = rs = rRF + b(RP M) = P0 = D 1/(rs − g)

1.15 4.0% 5.0% 5.5% $0.7913 9.75% $18.62

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS free rate is 4.50%. What is the company's current stock price? a. $14.52 b. $14.89 c. $15.26 d. $15.64 e. $16.03 ANSWER: a RATIONALE: D0

b rRF rM g D1 = D0(1 + g) = rs = rRF + b(r M − RRF) = P0 = D 1/(rs − g)

$0.75 1.25 4.5% 10.5% 6.5% $0.7988 12.0% $14.52

Required return Growth rate P0 = D 1/(rs − g), so D 1 = P 0(rs − g) = Last dividend = D 0 = D 1/(1 + g)

11.50% 7.00% $1.1250 $1.05

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - OH - Default City - TBA Constant growth dividend Bloom's: Application TYPE: Multiple Choice: Problem

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 ANSWER: b RATIONALE: Stock price $57.50

Required return Growth rate P0 = D 1/(rs − g), so D 1 = P 0(rs − g) Expected dividend = D 1 = P0(rs − g) =

10.25% 6.00% $2.44

Next expected dividend = D1 = Required return Dividend yield = D1/P0 = Find the growth rate: g = rs − yield = Find P0 = D 1/(rs − g) = Years in the future

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$1.60 11.0% 6.0% 5.0% $26.67 7 Page 109

WEB CHAPTER 29—BASIC FINANCIAL TOOLS = P0(1 + g) 7

$37.52

Annual dividend = Qtrly dividend × 4 = Preferred stock price Nom. required return = Annual dividend/Price =

$4.00 $45.00 8.89%

Pref. quarterly dividend Preferred stock price Cengage Learning Testing, Powered by Cognero

$1.00 $55.00 Page 110

WEB CHAPTER 29—BASIC FINANCIAL TOOLS Eff % required return = (1 + (Qt Div/P)) N − 1 =

7.47%

Interest rate (I/YR) Annual cost (PMT) Lifetime subscription cost (PV) Number of payments made (N)

6.0% $85 $850 14.33

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS ANSWER: RATIONALE:

Interest rate Periods/year Quarterly rate 1st deposit 2nd deposit 3rd deposit

4.0% 4 1.0% $2,500 $5,000 $7,500

Years on Deposit 3 2 1

Quarters on Deposit 12 8 4

Ending Amount $2,817.06 $5,414.28 $7,804.53

Nominal rate, Partners Periods/yr, Partners Nominal rate, Community Periods/yr, Community EFF% Partners EFF% Community Difference

5.0% 4 6.0% 1 5.09% 6.00% 0.91%

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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 ANSWER: b RATIONALE: Interest rate 8.5%

Years 5 Amount borrowed $15,000 Step 1: Find the PMT Step 2: Find the 1st year's interest Subtract the interest from the payment; this is Step 3: repayment of principal

3,806.49 1,275.00 2,531.49

Years 5 Amount borrowed $15,000 Step 1: Find the PMT Step 2: Find the 1st year's interest Subtract the interest from the payment; this is Step 3: repayment of principal Subtract the repayment of principal from the beginning Step 4: amount owed POINTS: DIFFICULTY:

$3,806.49 $1,275.00 $2,531.49 $12,468.51

1 Difficulty: Moderate

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Amortization: ending bal. KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 c. $64,932 d. $68,179 e. $71,588 ANSWER: c RATIONALE: Interest rate 7.5%

Years to retirement 30 Years in retirement 25 Amount saved per year $7,000 Step 1: Find the amount at age 65; use the FV function Find the PMT for a 25-year ordinary annuity using the Step 2: FV you just found as the PV.

723,796 64,932

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS RATIONALE:

First, use the data provided to find the dollar coupon payment per 6 months, then multiply by 2 to get the annual coupon, and then divide by the par value to find the coupon rate. One could use the indicated data and solve for the price. It would be $850, which confirms the rate.

Par value Maturity Periods/year N YTM Periodic rate PV PMT Coupon rate =

$1,000 25 2 50 9.25% 4.63% $850.00 $38.50 7.70%

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Determining the coupon rate KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: c First find the YTM at this time, then use the YTM with the other data to find the bond's price 5 RATIONALE: years hence.

Par value Coupon rate N PV PMT FV I/YR

$1,000 8.50% Value in 5 years 25 N $875 I/YR $85 PMT $1,000 FV 9.86% PV

20 9.86% $85 $1,000 $882.90

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS TOPICS: KEYWORDS: OTHER:

Bond value in future time periods Bloom's: Application TYPE: Multiple Choice: Problem

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 ANSWER: c These two bonds should provide the same EFF%. Therefore, we can find the EFF% for the RATIONALE: semiannual bond and then use it as the YTM for the annual payment bond. At the calculated price, the two bonds will have YTMs with the same EFF%. Note too that the semiannual payment bond must have a higher price than the annual bond because then it receives the same cash flow, but faster. Therefore Bond A must sell at a price below the $1,000 par value at which S sells.

Semiannual bond Par value Coupon rate = Nominal rate Payment per period Years to maturity Periods/year Total periods EFF% Price

Annual bond $1,000 Par value

$1,000

5.75% Coupon rate

5.75%

$28.75 Pmt/Period 12 Yrs to maturity 2 Periods/year 24 Total periods 5.833% EFF% = YTM $1,000.00 Price

$57.50 12 1 12 5.833% $993.01

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.205 - LO: 29-2 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Bond valuation: effective rates KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS e. $45.99 ANSWER: RATIONALE:

d rs = 9.0%

Year Growth rates: Dividend Terminal value = D3/(rs − g3) = Total CFs PV of CFs

0 $1.32

1 30.0% $1.716 49.550 $1.716 $1.574

2 10.0% $1.888

3 5.0% $1.982

$51.437 $43.294

Stock price = $44.87

N PV PMT FV I/MO I/YR

24 $0 $500 $13,000 0.63% 7.62%

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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% ANSWER: e RATIONALE: N 12

11.0% 0.9167% $72,500 $6,407.67 $0% prin. = Prin2/PMT = 90.45%

rNOM Per. r PV PMT FV

Amortization schedule(first 4 months)

Month 1 2 3 4

Beg. Balance 72,500.00 66,756.91 60,961.18 55,112.32

Payment 6,407.67 6,407.67 6,407.67 6,407.67

Interest 664.58 611.94 558.81 505.20

Principal 5,743.09 5,795.73 5,848.86 5,902.47

Ending Balance 66,756.91 60,961.18 55,112.32 49,209.85

Periods/yr N (12 mo.) PV = Loan FV

12I/period 360PMT $250,000Interest, 2016 $0

0.5833% $1,663.26 $17,419.55

Amortization schedule(first 3 months) Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS Year 1 2 3 4 5 6 7 8 9 10 11 12

Beg. Balance 250,000.00 249,795.08 249,588.96 249,381.64 249,173.11 248,963.36 248,752.39 248,540.19 248,326.75 248,112.07 247,896.13 247,678.94

Payment 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 1,663.26 19,959.07

Interest 1,458.33 1,457.14 1,455.94 1,454.73 1,453.51 1,452.29 1,451.06 1,449.82 1,448.57 1,447.32 1,446.06 1,444.79 17,419.55

Principal 204.92 206.12 207.32 208.53 209.75 210.97 212.20 213.44 214.68 215.94 217.20 218.46 2,539.52

End. Balance 249,795.08 249,588.96 249,381.64 249,173.11 248,963.36 248,752.39 248,540.19 248,326.75 248,112.07 247,896.13 247,678.94 247,460.48

then compounded at the nominal rate for (N − t) years. The sum of the compounded amounts should total to $50,000. With an arbitrary initial amount the ending amount is not likely to be $50,000, so we use goal seek as shown in the completed dialog box to find the correct initial deposit.

Inputs: Years 10 Amount Needed (FV) $50,000 Nominal rate earned on account 5.00% Inflation 3.00% 1. Goal Seek approach: Use Goal Seek in the following table to determine the initial deposit. Start with $5,000 as the initial payment, but this will Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS change to $3,341.94.

Period (t) 0 1 2 3 4 5 6 7 8 9 N = 10 2.

BOY Payment Initial(1 + I)t $3,341.94 $3,442.20 $3,545.47 $3,651.83 $3,761.39 $3,874.23 $3,990.45 $4,110.17 $4,233.47 $4,360.48 $0.00

Computed Value $5,443.67 $5,339.98 $5,238.27 $5,138.49 $5,040.62 $4,944.61 $4,850.42 $4,758.03 $4,667.40 $4,578.50 $50,000.00

= Sum of the 10 compounded values

Formula approach: Find the real rate 1.941748% = (1 + I1572)/(1 + I1573) − 1 Find the PV of the required future amount, discounted at the inflation rate. This is our constant dollar future target. $37,204.70 = I1571/(1 + I1573)(I1570) Use a calculator or Excel to find the initial payment. N = 10, I/YR = 1.941748, PV = 0, FV = −37204.70, and set to BEGIN mode. This is consistent with the Goal Seek solution. $3,341.94 = PMT(H1593, I1570,0, −H1595,1)

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS c. $81,027 d. $89,130 e. $98,043 ANSWER: RATIONALE:

c Inputs:

Number of years = 15 5% Nominal interest rate, rNOM = Available to invest = Portfolio = $1,000,000 Inflation rate = 2% Set up an "Amortization Table" to show exactly what's happening. We begin with $1 million. But we immediately make the first withdrawal, hence have less than $1 million to invest. We don't know how much we can withdraw initially, so we make a "guess" of Step 1. $50,000. We subtract the $50,000 from the initial portfolio and get $950,000, which is invested at 5% and thus earns $47,500. The earnings are added to the beginning balance, less the withdrawal, to produce the ending balance, which is carried forward to create the next beginning balance. This process is continued for 15 years. We want to end up with a $0.00 ending balance. With the $50,000 initial withdrawal, we see that we end with more than zero. Therefore, we should make a larger initial withdrawal. We could just Step 2. go through a series of trials and errors until we found an initial withdrawal that produced the zero ending balance. The amount that does the trick is $81,027.42. Replace the $50,000 with 81027.42 to prove that this value "works" to within one penny. BOY Beginning Amount Investable Ending Balance Withdrawn Funds Earnings Balance 1 $1,000,000.00 $81,027.42 $918,972.58 $45,948.63 $964,921.21 2 $964,921.21 $82,647.97 $882,273.24 $44,113.66 $926,386.90 3 $926,386.90 $84,300.93 $842,085.97 $42,104.30 $884,190.27 4 $884,190.27 $85,986.95 $798,203.33 $39,910.17 $838,113.49 5 $838,113.49 $87,706.69 $750,406.81 $37,520.34 $787,927.15 6 $787,927.15 $89,460.82 $698,466.33 $34,923.32 $733,389.64 7 $733,389.64 $91,250.04 $642,139.61 $32,106.98 $674,246.59 8 $674,246.59 $93,075.04 $581,171.55 $29,058.58 $610,230.13 9 $610,230.13 $94,936.54 $515,293.59 $25,764.68 $541,058.27 10 $541,058.27 $96,835.27 $444,223.00 $22,211.15 $466,434.15 11 $466,434.15 $98,771.97 $367,662.18 $18,383.11 $386,045.29 12 $386,045.29 $100,747.41 $285,297.87 $14,264.89 $299,562.77 13 $299,562.77 $102,762.36 $196,800.41 $9,840.02 $206,640.43 14 $206,640.43 $104,817.61 $101,822.82 $5,091.14 $106,913.96 15 $106,913.96 $106,913.96 $0.00 $0.00 $0.00 Using Goal Seek: Put the pointer on the cell for the Ending Balance after the 15th 1. withdrawal. 2. Click Tools>Goal Seek to get a dialog box, which you then fill out as Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS shown to the right. 3. You will be at the "Set cell" because you put the pointer there initially. Go down to the "To value to" cell. You want to get 0 as the ending 4. balance, so enter 0 here. Now move down to the "By changing cell" box, then click on the cell with 5. the Year 1 withdrawal and select it. Now click OK, and the initial withdrawal will change to $81,027, and the 6. final balance will go to $0.00. You could increase the decimals shown to see the extra digits Excel calculated. Calculator solution:

Step 1:

Step 2: BEGIN N= I = rr = PV = PMT =

Find the real rate of return, rr. rr = (1 + rNOM)/(1 + inflation) −1 rr = (1.05)/(1.02) −1 rr = 2.9412% Use the PMT function in Excel or a calculator to find the initial amount to be withdrawn. Be sure to set the calculator to BEGIN mode, and make a similar adjustment to the Excel function. 15 2.9411765% −1,000,000 $81,027.42 This is consistent with the value found using Goal Seek.

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Growing annuity KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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. 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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 ANSWER: a RATIONALE: Julian's retirement

account No. of payments thus far, including today's payment Number of remaining payments N = total payments I/YR PV PMT FV Julian's FV =

Jonathan's retirement account Payment today

6 40

46 N 41 8.0% I/YR 8.0% $0 PV $0 $2,500 FV = Jonathan's FV = $1,046,065 $1,046,065 PMT $3,726

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retirement planning KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: d There are 3 cash flow streams: the gift and the two annuities. The gift will grow for 12 years. RATIONALE: Then there is a 6-year annuity whose FV at the end of Year 6 will compound for an additional 6 years. Finally, there is a second 6-year annuity. The sum of the compounded values of those three sets of cash flows is the final amount.

Amount at end of Year 6 Cengage Learning Testing, Powered by Cognero

Amount at end of Year 12 Page 123

WEB CHAPTER 29—BASIC FINANCIAL TOOLS Interest rate

9.0% $56,425 Compound @ $ 7,500 9% $15,000NA $25,000NA 12 6Final amt:

1st annuity 2nd annuity Gift Total years Annuity years

$ 94,630 $112,850 $ 70,317 $277,797

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Time value of money LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: FV comb. CF lump sum & ann. KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: c This is a relatively difficult problem for an efficient calculator solution or classroom exam, but RATIONALE: it is appropriate for a challenging take-home or online exam.

I/YR =

0 −$25,000

1 $2,500

2 $5,000

3 $7,500

4 X

5 X

6 X

7 X

Calculator solution:

Use the CF register to find the NPV of the 4 known cash flows, CF0 to CF3: Step 2. Find the FV of this NPV at the end of period 3, i.e., compound the NPV you found for 3 years. Step 3. Now find the PMT for a 4-year annuity with this PV. Step 1.

−$12,444.75 −$15,676.80 $4,733.15

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS TOPICS: KEYWORDS: OTHER:

CF for given return Bloom's: Application TYPE: Multiple Choice: Problem

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 c. $2,177.51 d. $2,292.12 e. $2,412.76 ANSWER: e This is a very difficult problem. It should only be used as a take-home assignment. RATIONALE:

Current college cost/year $14,500 College cost inflation 3.5% Return on investment account 9.0% Payments at t = 1, 2, 3, and 4 $5,000 Account balance at t = 0 $15,000 Determine the cost of each year during college and its PV at t = 8, 1. discounted at the return on investment. Cost PV at t = 8 8 −19,093.73 −19,093.73 Year 1 (t = 8) = Current cost × (1 + infl) = −19,762.01 −18,130.29 Year 2 (t = 9) = Prior year × (1 + infl) = Prior year × (1 + infl) = −20,453.68 −17,215.45 Year 3 (t = 10) = −21,169.56 −16,346.79 Year 4 (t = 11) = Prior year × (1 + infl) = Find PV (at t = 8) −70,786.26 = amount needed at t = 8: of all college costs Create a time line with those cash flows, plus the known initial CFs, as shown below. Put X in for the unknown values for t = 5−7. We show the 2. time line on two sets of rows. Ours now has the solution value, but it didn't originally. 0 1 2 3 4 5 Known values; X for $15,000.0 $5,000.0 $5,000.00 $5,000.00 $5,000.00 X unknown: 0 0 Solution value for $2,412.76 X: Cengage Learning Testing, Powered by Cognero

Page 125

WEB CHAPTER 29—BASIC FINANCIAL TOOLS Cash flows:

$15,000.0 $5,000.0 $5,000.00 $5,000.00 $5,000.00 $2,412.76 0 0 6

$2,412.76

$2,412.7 6

8 9 10 11 −$19,093.7 −$19,762.0 −$20,453.6 −$21,169.5 3 1 8 6

Cash flows, continued $2,412.7 −$19,093.7 −$19,762.0 −$20,453.6 −$21,169.5 $2,412.76 : 6 3 1 8 6 We found the PV of the college costs (t = 3. 8−11) at t = 8 above. −70,786.26 Their sum is shown to the right. 4. Find the FV of t = 0 & 4 positive CFs at t = 8

0 1 2 3 4

$15,000.00 $29,888.44 $ 5,000.00 $ 9,140.20 $ 5,000.00 $ 8,385.50 $ 5,000.00 $ 7,693.12 $ 5,000.00 $ 7,057.91 $62,165.16

Find the difference between the positive and negative t = 8 values:

−$8,621.09

Find PMT for a 3-year annuity due whose FV is equal to this difference:

$2,412.76

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES:INTE.GENE.16.204 - LO: 29-1 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: LOCAL STANDARDS: TOPICS: KEYWORDS: OTHER:

United States - TN - DISC: Time value of money United States - OH - Default City - TBA Saving for college Bloom's: Application TYPE: Multiple Choice: Problem

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

Prob. 30%

Return 32.0%

Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS Normal Weak a. 17.69% b. 18.62% c. 19.55% d. 20.52% e. 21.55% ANSWER: RATIONALE:

40% 30%

10.0% −16.0%

Economic Conditions Strong Normal Weak σ = Sqrt of variance

Prob. 30% 40% 30% 100%

Return This state 32.0% 10.0% −16.0% 8.8%

Dev. from Squared Sqd. dev. × Prob Mean Dev. 23.20% 10.24% 3.07% 1.20% 0.01% 0.01% −24.80% 6.15% 1.85% Variance 4.92%

18.62% 18.62% by Excel

Old funds (millions) New funds (millions) Total portfolio Req'd return, old stocks Risk-free rate Market risk premium: Cengage Learning Testing, Powered by Cognero

$10.00 $5.00 $15.00 9.50% 4.20% rP = rRF + b(RP M) >> 9.5%

66.67% 33.33% 100.00%

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS = 4.2% + 1.05(RP M) RPM = (9.5% − 4.2%)/1.05 = 5.05%

5.30%

New portfolio:

Old portfolio's beta New stocks' beta New portfolio beta New portfolio required return = rRF + New beta(RP M) =

1.05 0.65 0.9167 8.8270%

New funds (millions) Total new funds Beta on existing portfolio Risk-free rate Market risk premium Desired required return Required new bp Required beta, new stocks

$ 60.00 60.00% $100.00 100.00% 1.00 4.25% 6.00% 13% = rRF + b(RP M); b = (13% − 13.00% rRF)/RP M 1.4583beta = (Return − Risk-free)/RP M 1.76Req. b = (Old$/Total$) × Old b + (New$/Total$) × New b

Beta on new stocks = (Req. b − (Old$/Total$) × Old b)/(New$/Total$)

POINTS: DIFFICULTY:

1 Difficulty: Challenging

Cengage Learning Testing, Powered by Cognero

Page 128

WEB CHAPTER 29—BASIC FINANCIAL TOOLS LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Portfolio beta KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 a. 10.56% b. 10.83% c. 11.11% d. 11.38% e. 11.67% ANSWER: RATIONALE:

Amount $1,075,000 675,000 750,000 500,000 $3,000,000

Beta 1.20 0.50 1.40 0.75

Company Stock A Stock B Stock C Stock D

Amount $1,075,000 675,000 750,000 500,000

Weight 0.358 0.225 0.250 0.167

$3,000,000

1.000

Required market return Risk free rate Market risk premium = r Market − rRF = Portfolio's required return = rRF + b(RP M) =

Wt × beta Beta 1.20 0.43 0.50 0.11 1.40 0.35 0.75 0.13 bPortfolio 1.02 Intermediate step = 11.00% 5.00% 6.00% 11.11%

Page 129

WEB CHAPTER 29—BASIC FINANCIAL TOOLS 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% ANSWER: c This problem requires some algebra: RATIONALE:

CCC's beta CCC's initial required return Percentage increase in required market return Initial required return on the market New required return on the market

1.50 12.00% 30.0% 10.00% 13.00%

Now subtract the second equation from the first. rRF and one of the RPMs cancel, leaving: 2% = 0.5(RP M) 4.00% Now solve for RPM: RPM = 2%/0.5 Now find the risk-free rate: rRF = Initial r Market − RP M = 10% − 6.00% 4% = 7.00% New RPM = New required return on the market − rRF 16.50% Now find the new return on CCC = rRF + b(new RP M) = POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.206 - LO: 29-3 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Risk and return LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: CAPM: required rate of return KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS ANSWER: RATIONALE:

Last dividend (D 0) Short-run growth rate Long-run growth rate Beta Market risk premium Risk-free rate Required return = rs = rRF + b(RP M) = Year 0 1 25% Dividend $1.2500 $1.5625 Terminal value = D5/(rs − g5) = Total CFs $1.5625 PV of the CFs $1.4256

$1.25 25% 0% 1.20 5.50% 3.00% 9.60% 2 3 4 5 25% 25% 25% 0% $1.9531 $2.4414 $3.0518 $3.0518 31.7891 $1.9531 $2.4414 $34.8409 $1.6260 $1.8544 $24.1461

Price = Sum of PVs = $29.05

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant growth valuation KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 (rs) is 12%. What is the best estimate of the current stock price? a. $41.58 b. $42.64 c. $43.71 d. $44.80 e. $45.92 ANSWER: b RATIONALE: $1.75 Last dividend (D 0)

Short-run growth rate Long-run growth rate Required return Year Dividend Terminal value = D3/(rs − g3) = Total CFs Cengage Learning Testing, Powered by Cognero

25% 6% 12% 0 $1.7500

1 25.00% $2.1875

2 25.00% $2.7344

3 6.00% $2.8984

48.3073 $2.1875

$51.0417 Page 131

WEB CHAPTER 29—BASIC FINANCIAL TOOLS PV of CFs

$1.9531

$40.6901

Price = Sum of PVs = $42.64

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant growth valuation KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 (rs) is 12.0%. What is the best estimate of the current stock price? a. $37.05 b. $38.16 c. $39.30 d. $40.48 e. $41.70 ANSWER: a RATIONALE: $1.55 Last dividend (D 0)

Short-run growth rate Long-run growth rate Required return Year

1.50% 8.00% 12.00% 0

Dividend Terminal value = D3/(rs − g3) = Total CFs PV of CFs

$1.5500

1 1.50% $1.5733

2 1.50% $1.5968

3 8.00% $1.7246

43.1149 $1.5733 $1.4047

$44.7118 $35.6439

Price = Sum of PVs = $37.05

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WEB CHAPTER 29—BASIC FINANCIAL TOOLS its current stock price? a. $30.57 b. $31.52 c. $32.49 d. $33.50 e. $34.50 ANSWER: RATIONALE:

Required return Short-run growth rate Long-run growth rate Last dividend (D 0) Year Dividend Terminal value = P3 = D4/(rs − g4) = Total CFs PV of CFs

11.0% 15.0% 6.0% $1.25 0 1 2 $1.2500 $1.4375 $1.6531

3 4 $1.9011 $2.0152

40.3032 $1.4375 $1.6531 $42.2043 $1.2950 $1.3417 $30.8594

Price = Sum of PVs = $33.50

POINTS: 1 DIFFICULTY: Difficulty: Challenging LEARNING OBJECTIVES: INTE.GENE.16.207 - LO: 29-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - TN - DISC: Stocks and bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Nonconstant growth valuation KEYWORDS: Bloom's: Application OTHER: TYPE: Multiple Choice: Problem 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 ANSWER: RATIONALE:

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

d Required return = 11%

Year Cengage Learning Testing, Powered by Cognero

4 5 6 50.00% 25.00% 8.00% Page 133

WEB CHAPTER 29—BASIC FINANCIAL TOOLS Dividend $0.000 $0.000 $0.000 $0.250 $0.375 $0.469 $0.506 Terminal value = P5 16.875 = D6/(rs − g6) = Total CFs $0.000 $0.000 $0.250 $0.375 $17.344 PV of CFs $0.000 $0.000 $0.183 $0.247 $10.293 Price = $10.72

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WEB CHAPTER 30—PENSION PLAN MANAGEMENT 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 ANSWER: False POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.208 - LO: 30-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Defined contribution plan KEYWORDS: Bloom’s: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Easy LEARNING OBJECTIVES: INTE.GENE.16.208 - LO: 30-2 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Vesting KEYWORDS: Bloom’s: Knowledge 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 ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.209 - LO: 30-4 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Contribution plans KEYWORDS: Bloom’s: Comprehension 4. 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. Cengage Learning Testing, Powered by Cognero

Page 1

WEB CHAPTER 30—PENSION PLAN MANAGEMENT a. True b. False ANSWER: True POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.210 - LO: 30-5 NATIONAL STANDARDS: United States - BUSPROG: Reflective Thinking STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Performance measurement KEYWORDS: Bloom’s: Comprehension 5. 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. ANSWER: d If assets exceed the present value of benefits, the plan is overfunded. RATIONALE: POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.211 - LO: 30-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Pension plan terminology KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 6. 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. ANSWER: b POINTS: 1 DIFFICULTY: Difficulty: Moderate Cengage Learning Testing, Powered by Cognero

Page 2

WEB CHAPTER 30—PENSION PLAN MANAGEMENT LEARNING OBJECTIVES: INTE.GENE.16.211 - LO: 30-7 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Defined contribution plan KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 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. ANSWER: d Duration is the immunization technique used to either eliminate, or at least significantly RATIONALE: reduce, the risk associated with changing interest rates.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.210 - LO: 30-5 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Performance measurement KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Conceptual 8. 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 ANSWER: d RATIONALE: Final year's salary = $30,000(1.05)35 = $165,480.46. Salary multiplier = 35(2%) = 70%. Pension benefit = 0.70($165,480.46) = $115,836.32.

POINTS: DIFFICULTY:

1 Difficulty: Moderate

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Page 3

WEB CHAPTER 30—PENSION PLAN MANAGEMENT LEARNING OBJECTIVES: INTE.GENE.16.209 - LO: 30-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Retirement benefits KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 9. 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% ANSWER: b RATIONALE: Portfolio's required rate of

return

= rRF + (rM − rRF)b

= 7% + (12% − 7%)1.15 = 7% + (5%)1.15 = 12.75%. Alpha = 12.6% − 12.75% = −0.15%.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.212 - LO: 30-9 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Performance measurement KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem 10. 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 ANSWER: c RATIONALE: Find the PV (at retirement) of the 15-year pension payment: $20,000(PVIFA7%, 15 years) = $182,158.28. Find the annual payment needed to accumulate the above amount over 20 Cengage Learning Testing, Powered by Cognero

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WEB CHAPTER 30—PENSION PLAN MANAGEMENT years: Annual payment = $182,158.28/FVIFA7%, 20 years = $4,443.37.

POINTS: 1 DIFFICULTY: Difficulty: Moderate LEARNING OBJECTIVES: INTE.GENE.16.209 - LO: 30-4 NATIONAL STANDARDS: United States - BUSPROG: Analytic STATE STANDARDS: United States - AK - DISC: Stocks and Bonds LOCAL STANDARDS: United States - OH - Default City - TBA TOPICS: Pension fund mathematics KEYWORDS: Bloom’s: Analysis OTHER: TYPE: Multiple Choice: Problem

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