TEST BANK for Fundamentals of Corporate Finance 10th Edition Richard Brealey, Stewart Myer & Alan Ma by StudyGuide

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 1 Goals and Governance of the Corporation 1) The liability of sole proprietors is limited to the amount of their investment in the company. Answer: FALSE Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation 2) General partners have limited personal liability for business debts in a limited partnership. Answer: FALSE Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation 3) The separation of ownership and management is one distinctive feature of corporations. Answer: TRUE Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

4) A major disadvantage of partnerships is that they have double taxation of profits. Answer: FALSE Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation 5) Financial assets have value because they are claims on the firm's real assets and the cash that those assets will produce. Answer: TRUE Difficulty: 1 Easy Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) Capital budgeting decisions are used to determine how to raise the cash necessary for investments. Answer: FALSE Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) A successful investment is one that increases the value of the firm. Answer: TRUE Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

8) Facebook's decision to spend $700 million to acquire Instagram is an investment decision. Answer: TRUE Difficulty: 1 Easy Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) Boards of directors are generally appointed by the firm's senior officers. Answer: FALSE Difficulty: 1 Easy Topic: Management organization and roles Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) Financial analysts are involved in monitoring the risk associated with investment projects and financing decisions. Answer: TRUE Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 11) The primary goal of any company should be to maximize current period profits. Answer: FALSE Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

12) Maximizing profits is the same as maximizing the value of the firm. Answer: FALSE Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Bloom's: Analyze AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) The Dodd-Frank financial reform law in 2010 granted shareholders a binding vote on executive compensation. Answer: FALSE Difficulty: 1 Easy Topic: Ethics, governance, and regulation Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 14) Sole proprietorships face the same agency problems as those associated with corporations. Answer: FALSE Difficulty: 1 Easy Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 15) Real assets can be intangible assets. Answer: TRUE Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

16) Making good investment and financing decisions is the chief task of the financial manager. Answer: TRUE Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) If a project's value is less than its required investment, then the project is financially attractive. Answer: FALSE Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Analytical Thinking Accessibility: Keyboard Navigation 18) GlaxoSmithKline's spending of $3.6 billion on research and development of new drugs is a capital budgeting decision but not a financing decision. Answer: TRUE Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) Deltas's issuance of a $1.0 billion bond is a financing decision. Answer: TRUE Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

20) An IOU ("I owe you") from your brother-in-law is a financial asset. Answer: TRUE Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) The separation of ownership and management is one distinctive feature of both corporations and sole proprietors. Answer: FALSE Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) Shareholders welcome higher short-term profits even when they damage long-term profits. Answer: FALSE Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) A well-designed compensation package can help a firm achieve its goal of maximizing market value. Answer: TRUE Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Apply AACSB: Ethics Accessibility: Keyboard Navigation

24) While control of large public companies in the United States is exercised through the board of directors and pressure from the stock market, in many other countries the stock market is less important and control shifts to major stockholders, typically banks and other companies. Answer: TRUE Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Remember AACSB: Diversity Accessibility: Keyboard Navigation 25) Investors are responsible for deciding whether to reinvest in the firm's operations or take the profits as a distribution. Answer: FALSE Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) Established firms can create value by developing long-term relationships and maintaining a good reputation. Answer: TRUE Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation

27) Which one of these is a disadvantage of the corporate form of business? A) Access to capital B) Unlimited personal liability for owners C) Limited firm life D) Legal requirements Answer: D Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) Which one of the following gives a corporation its permanence? A) Multiple owners B) Limited liability C) Corporation taxation D) Separation of ownership and control Answer: D Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) In a partnership form of organization, income tax liability, if any, is incurred by: A) the partnership itself. B) the partners individually. C) both the partnership and the partners. D) neither the partnership nor the partners. Answer: B Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

30) Which one of the following would correctly differentiate general partners from limited partners in a limited partnership? A) General partners have more job experience. B) General partners have an ownership interest. C) General partners are subject to double taxation. D) General partners have unlimited personal liability. Answer: D Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 31) Which form of organization provides limited liability for the firm but yet allows the professionals working within that firm to be sued personally? A) Limited liability partnership B) Limited liability company C) Sole proprietorship D) Professional corporation Answer: D Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

32) Which of the following organizations is least likely to use a professional corporation (PC) structure? A) Accountants B) Doctors C) Lawyers D) Manufacturers Answer: D Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33) Which of the following is least likely to be discussed in the articles of incorporation? A) How the firm is to be financed B) The purpose of the business C) The price range of the shares of stock D) How the board of directors is to be structured Answer: C Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) When a corporation fails, the maximum that can be lost by an individual shareholder is: A) the amount of their initial investment. B) the amount of their share of the profits. C) their proportionate share required to pay the corporation's debts. D) the amount of their personal wealth. Answer: A Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

35) Which of the following is a disadvantage to incorporating a business? A) Easier access to financial markets B) Limited liability C) Becoming a permanent legal entity D) Profits taxed at the corporate level and the shareholder level Answer: D Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) Unlimited liability is faced by the owners of: A) corporations. B) partnerships and corporations. C) sole proprietorships and general partnerships. D) all forms of business organization. Answer: C Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) Which one of these statements correctly applies to a limited partnership? A) All partners share the daily management duties. B) All partners enjoy limited personal liability. C) General partners have unlimited personal liability. D) Taxes are imposed at both the firm and the personal level on profits earned. Answer: C Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

38) In the case of a limited liability partnership, A) only some of partners B) only the managing partner C) all of the partners D) none of the partners

has/have limited liability.

Answer: C Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) A board of directors is elected as a representative of the corporation's: A) top management. B) stakeholders. C) shareholders. D) customers. Answer: C Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) The legal "life" of a corporation is: A) coincidental with that of its CEO. B) equal to the life of its board of directors. C) permanent, as long as shareholders don't change. D) permanent, regardless of current ownership. Answer: D Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

41) In which type of organizational structure is the agency problem least likely to exist? A) Limited Liability Corporation B) Partnership C) Professional Corporation D) Sole Proprietorship Answer: D Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 42) When the management of a business is conducted by individuals other than the owners, the business is most likely to be a: A) corporation. B) sole proprietorship. C) partnership. D) general partner. Answer: A Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 43) "Double taxation" refers to: A) all partners paying equal taxes on profits. B) corporations paying taxes on both dividends and retained earnings. C) paying taxes on profits at the corporate level and dividends at the personal level. D) the fact that marginal tax rates are doubled for corporations. Answer: C Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

44) A corporation is considered to be closely held when: A) only a few shareholders exist. B) the market value of the shares is stable. C) it operates in a small geographic area. D) management also serves as the board of directors. Answer: A Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 45) Which of the following is NOT a requirement of the Sarbanes-Oxley Act of 2002? A) The compensation committee must be appointed by an outside director B) The CEO and CFO must sign off personally on corporate accounting results C) The board of directors must meet in executive session D) More board of directors members are independent Answer: A Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 46) Corporations are referred to as public companies when their: A) shareholders have no tax liability. B) shares are held by the federal or state government. C) stock is publicly traded. D) products or services are available to the public. Answer: C Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

47) A common problem for closely held corporations is: A) the lack of access to substantial amounts of capital. B) the restriction that shareholders receive only one vote each. C) the separation of ownership and management. D) an abundance of agency problems. Answer: A Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) Corporate managers are expected to make corporate decisions that are in the best interest of: A) top corporate management. B) the corporation's board of directors. C) the corporation's shareholders. D) all corporate employees. Answer: C Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 49) Which one of the following is a financial asset? A) A corporate bond B) A machine C) A patent D) A factory Answer: A Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

50) Which of the following statements best distinguishes the difference between real and financial assets? A) Real assets have less value than financial assets. B) Real assets are tangible; financial assets are not. C) Financial assets represent claims to income that is generated by real assets. D) Financial assets appreciate in value; real assets depreciate in value. Answer: C Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) Which one of the following is a real asset? A) A patent B) A personal IOU C) A checking account balance D) A share of stock Answer: A Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) Which one of these is not considered to be a security? A) Shares of GE stock B) A bond traded in the financial market C) A mortgage loan issued and held by a bank D) A convertible bond issued to the public Answer: C Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) Corporations that issue financial securities such as stock or debt obligations to the public do so primarily to: A) increase sales. B) become profitable. C) increase their access to funds. D) avoid double taxation of their profits. Answer: C Difficulty: 2 Medium Topic: Forms of business organization Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) Which one of the following would be considered a capital budgeting decision? A) Planning to issue common stock rather than issuing preferred stock B) Deciding to expand into a new line of products, at a cost of $5 million C) Repurchasing shares of common stock D) Issuing debt in the form of long-term bonds Answer: B Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) Which one of these is a capital budgeting decision? A) Deciding between issuing stock or debt securities B) Deciding whether or not the firm should go public C) Deciding if the firm should repurchase some of its outstanding shares D) Deciding whether to buy a new machine or repair the old machine Answer: D Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

56) The best criterion for success in a capital budgeting decision would be to: A) minimize the cost of the investment. B) maximize the number of capital budgeting projects. C) maximize the value added to the firm. D) finance all capital budgeting projects with debt. Answer: C Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) The overall goal of capital budgeting projects should be to: A) decrease the firm's reliance on debt. B) increase the firm's sales. C) increase the firm's outstanding shares of stock. D) increase the wealth of the firm's shareholders. Answer: D Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) An example of a firm's financing decision would be: A) acquiring a competitive firm. B) determining how much to pay for a specific asset. C) issuing 10-year versus 20-year bonds. D) deciding whether or not to increase the price of its products. Answer: C Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) Which of the following is a capital budgeting decision? A) Should the firm borrow money from a bank or sell bonds? B) Should the firm shut down an unprofitable factory? C) Should the firm buy or lease a new machine that it is committed to acquiring? D) Should the firm issue preferred stock or common stock? Answer: B Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) Which of these duties are responsibilities of the corporate treasurer? A) Financial statements and taxes B) Cash management and tax reporting C) Cash management and banking relationships D) Raising capital and financial statements Answer: C Difficulty: 1 Easy Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 61) The term "capital structure" refers to: A) the mix of long-term debt and equity financing. B) the length of time needed to repay debt. C) whether or not the firm invests in capital budgeting projects. D) the types of assets a firm acquires. Answer: A Difficulty: 1 Easy Topic: Capital structure Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

62) Firms can alter their capital structure by: A) not accepting any new capital budgeting projects. B) investing in intangible assets. C) issuing stock to repay debt. D) becoming a limited liability company. Answer: C Difficulty: 1 Easy Topic: Capital structure Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 63) Which one of these statements is correct? A) Financial managers have a fiduciary duty to stockholders. B) Financial managers are concerned only with funds that flow to investors. C) The chief financial officer generally reports directly to the corporate treasurer. D) The corporate controller is primarily responsible for overseeing a firm's cash functions. Answer: A Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) A firm decides to pay for a small investment project through a $1 million increase in shortterm bank loans. This is best described as an example of a(n): A) financing decision. B) investment decision. C) capital budgeting decision. D) capital expenditure decision. Answer: A Difficulty: 1 Easy Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

65) Which of the following is NOT a claim on the assets of a company? A) Bond B) Patent C) Promissory Note D) Stock Answer: B Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) The short-term decisions of financial managers are comprised of: A) capital structure decisions only. B) investment decisions only. C) financing decisions only. D) both investment and financing decisions. Answer: D Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) A block holder is commonly defined as an investor who: A) owns 5 percent or more of a firm's outstanding shares. B) invests in more than one firm within the same industry. C) is another corporation. D) is also one of the firm's managers or directors. Answer: A Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

68) Which of the firm's financial managers is most likely to be involved with obtaining financing for the firm? A) Treasurer B) Controller C) Chief Operating Officer D) Board of directors Answer: A Difficulty: 1 Easy Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 69) In a large corporation, preparation of the firm's financial statements would most likely be conducted by the: A) treasurer. B) controller. C) chief financial officer. D) financial manager. Answer: B Difficulty: 1 Easy Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 70) In a firm having both a treasurer and a controller, which of the following would most likely be handled by the controller? A) Internal auditing B) Credit management C) Banking relationships D) Insurance Answer: A Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

71) Which one of the following statements more accurately describes the controller than the treasurer? A) Reports directly to the chief executive officer B) Monitors capital expenditures to make sure that they are not misappropriated C) Responsible for investing the firm's spare cash D) Responsible for arranging any issue of common stock Answer: B Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 72) A chief financial officer would typically: A) report to the treasurer, but supervise the controller. B) report to the controller, but supervise the treasurer. C) report to both the treasurer and controller. D) supervise both the treasurer and controller. Answer: D Difficulty: 1 Easy Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) Which one of these determines the minimum acceptable rate of return on a capital investment? A) The alternative investment opportunities available to investors B) The profit margin of the existing firm C) The rate of return on the firm's outstanding shares D) The rate of return on risk-free debt securities Answer: A Difficulty: 1 Easy Topic: Introduction to corporate finance Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

74) A financial analyst in a corporation may be involved with all of the following EXCEPT: A) analyzing a new investment project. B) monitoring risk. C) managing investment of the company's cash. D) purchasing the firm's plant and equipment. Answer: D Difficulty: 1 Easy Topic: Management organization and roles Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) Investment banks like Morgan Stanley or Goldman Sachs: A) collect deposits and relend the cash to corporations and individuals. B) help companies sell their securities to investors. C) design and sell insurance policies for businesses. D) lend to corporations and investors in commercial real estate. Answer: B Difficulty: 1 Easy Topic: Introduction to corporate finance Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) The primary goal of corporate management should be to: A) maximize the number of shareholders. B) maximize the firm's profits. C) minimize the firm's costs. D) maximize the shareholders' wealth. Answer: D Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

77) A corporate board of directors should provide support for the top management team: A) under all circumstances. B) in all decisions related to cash dividends. C) only when the board approves of management's actions. D) if shareholders are pleased with the firm's performance. Answer: C Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Bloom's: Apply AACSB: Ethics Accessibility: Keyboard Navigation 78) Which of the following appears to be the most appropriate goal for corporate management? A) Maximizing market value of the company's shares B) Maximizing the company's market share C) Maximizing the current profits of the company D) Minimizing the company's liabilities Answer: A Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 79) A firm with spare cash A) should always reinvest it in new equipment. B) should pay it out to shareholders unless the firm can earn a higher rate of return on the cash than the shareholders can earn by investing in the capital market. C) should invest it in the safest projects available. D) Should always invest it in U.S. equities. Answer: B Difficulty: 3 Hard Topic: Goal of financial management Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

80) Financial managers should only accept investment projects that: A) increase the current profits of the firm. B) can increase the firm's market share. C) earn a higher rate of return than the firm currently earns on its existing projects. D) earn a higher rate of return than shareholders can get by investing on their own. Answer: D Difficulty: 3 Hard Topic: Goal of financial management Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) Agency problems can least be controlled by: A) establishing good internal controls and procedures. B) designing compensation packages that align manager's goals with those of the shareholders. C) good systems of corporate governance. D) electing senior managers to the board of directors. Answer: D Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 82) Which one of these best defines the objective of a well-functioning financial market? A) Establishing accurate security prices B) Creating higher security prices C) Eliminating short-selling profits D) Increasing shareholder value by any means possible Answer: A Difficulty: 1 Easy Topic: Introduction to corporate finance Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation

83) Corporate raiders will be looked upon most favorably if they: A) divide up large profitable entities. B) take actions that increase current shareholder wealth. C) create value for themselves through their actions. D) change the capital structure of a firm by increasing its debt. Answer: B Difficulty: 3 Hard Topic: Goal of financial management Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 84) Ethical decision making by management has a payoff for shareholders in terms of: A) improved capital structure. B) enhanced firm reputation value. C) increased managerial benefits. D) higher current dividend payments. Answer: B Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 85) Ethical decision making in business: A) reduces the firm's profits. B) requires adherence to implied rules as well as written rules. C) is not in the best interests of shareholders. D) is less important than good capital budgeting decisions. Answer: B Difficulty: 3 Hard Topic: Ethics, governance, and regulation Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation

86) A corporate director: A) is selected by and can be removed by management. B) can be voted out of power by the shareholders. C) has a lifetime appointment to the board. D) is selected by a vote of all corporate stakeholders. Answer: B Difficulty: 2 Medium Topic: Management organization and roles Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 87) In which of the following organizations would agency problems be least likely to occur? A) A sole proprietorship B) A partnership C) A corporation D) A closely held corporation Answer: A Difficulty: 1 Easy Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 88) Sole proprietorships resolve the issue of agency problems primarily by: A) avoiding excessive expense accounts. B) discharging those who violate the rules. C) allowing owners to share the cost of their actions with others. D) forcing owners to bear the full cost of their actions. Answer: D Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation

89) Which one of the following can best be characterized as an agency problem? A) differing opinions among directors as to the merits of paying a higher dividend. B) differing incentives between managers and owners. C) persistently late delivery times by a major supplier. D) Geological problems in the company's new gold mine. Answer: B Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation 90) Which of the following is least likely to represent an agency problem? A) Lavish spending on expense accounts B) Plush remodelling of the executive suite C) Excessive avoidance of taxes D) Executive incentive compensation plans Answer: D Difficulty: 3 Hard Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Apply AACSB: Ethics Accessibility: Keyboard Navigation 91) When managers' compensation plans are tied in a meaningful manner to the value of the firm, agency problems: A) can be reduced. B) will be created. C) are shifted to other stakeholders. D) are eliminated entirely from the firm. Answer: A Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation

92) A firm's reputation: A) has no value. B) is an important firm asset. C) is irrelevant to shareholders. D) can be easily restored once damaged. Answer: B Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 93) Which of the following groups is least likely to be considered a stakeholder of the firm? A) Government B) Customers C) Competitors D) Employees Answer: C Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) A manager's compensation plan that offers financial incentives for increases in quarterly profitability may create agency problems in that: A) the managers are not motivated by personal gain. B) the board of directors may claim the credit. C) short-term, not long-term profits become the focus. D) investors desire stable profits. Answer: C Difficulty: 3 Hard Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

95) One continuing problem with managerial incentive compensation plans is that: A) the plans increase agency problems. B) managers prefer guaranteed salaries. C) their effectiveness is difficult to evaluate. D) the plans do not reward shareholders. Answer: C Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 96) Which one of the following forms of compensation is most apt to align the interests of managers and shareholders? A) A fixed salary B) A salary that is linked to current company profits C) A salary that is paid partly in the form of the company's shares D) A salary that is linked to the company's market share Answer: C Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Which of the following is a real asset? A) A patent B) A share of stock issued by Bank of New York C) An IOU ("I owe you") from your brother-in-law D) A mortgage loan taken out to help pay for a new home Answer: A Difficulty: 2 Medium Topic: Financial management decisions Learning Objective: 01-02 Distinguish between real and financial assets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

98) Which one of these statements is correct? A) A dollar received next year has the same value as a dollar received today. B) Risky cash flows are more valuable than certain cash flows. C) Smart investment decisions create more value than smart financing decisions. D) Corporate governance is irrelevant. Answer: C Difficulty: 2 Medium Topic: Introduction to corporate finance Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 99) Short selling involves selling a security: A) you do not own. B) that you have owned for less than one year. C) at a price below current market value. D) for less than you originally paid to purchase it. Answer: A Difficulty: 1 Easy Topic: Introduction to corporate finance Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 2 Financial Markets and Institutions 1) Only small companies can go through financial markets to obtain financing. Answer: FALSE Difficulty: 1 Easy Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 2) The reinvestment of cash back into the firm's operations is an example of a flow of savings to investment. Answer: TRUE Difficulty: 1 Easy Topic: Financial institution functions Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) Smaller businesses are especially dependent upon internally generated funds. Answer: TRUE Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

4) An individual can save and invest in a corporation by lending money to it or by purchasing additional shares. Answer: TRUE Difficulty: 1 Easy Topic: Financial institution functions Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) Previously issued securities are traded among investors in the secondary markets. Answer: TRUE Difficulty: 1 Easy Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) Only the IPOs for large corporations are sold in primary markets. Answer: FALSE Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 7) Hedge fund managers, unlike mutual fund managers, do not receive fund-performance-related fees. Answer: FALSE Difficulty: 2 Medium Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

8) The markets for long-term debt and equity are called capital markets. Answer: TRUE Difficulty: 1 Easy Topic: Capital markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 9) The stocks of major corporations trade in many markets throughout the world on a continuous or near-continuous basis. Answer: TRUE Difficulty: 1 Easy Topic: Stock trading Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 10) The market for derivatives is also a source of financing for corporations. Answer: FALSE Difficulty: 2 Medium Topic: Derivatives and other securities Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) During the Financial Crisis of 2007-2009, the U.S. government bailed out all firms in danger of failing. Answer: FALSE Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

12) In the United States, banks are the most important source of long-term financing for corporations. Answer: FALSE Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) A financial intermediary invests in financial assets rather than real assets. Answer: TRUE Difficulty: 1 Easy Topic: Financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) Households hold directly three quarters of U.S. corporate equities. Answer: FALSE Difficulty: 1 Easy Topic: Raising capital Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 15) The key to the banks' ability to make illiquid loans is their ability to pool liquid deposits from thousands of depositors. Answer: TRUE Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

16) From June 2001 to June 2006, house prices in the United States rose sharply. Answer: TRUE Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) For corporate bonds, the higher the credit quality of an issuer, the higher the interest rate. Answer: FALSE Difficulty: 2 Medium Topic: Bond ratings and credit risk Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) The cost of capital is the interest rate paid on a loan from a bank or some other financial institution. Answer: FALSE Difficulty: 2 Medium Topic: Cost of capital-general Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) Like public companies, private companies can also use their stock price as a measure of performance. Answer: FALSE Difficulty: 2 Medium Topic: Stock market prices and reporting Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

20) The opportunity cost of capital is the expected rate of return that shareholders can obtain in the financial markets on investments with the same risk as the firm's capital investments. Answer: TRUE Difficulty: 2 Medium Topic: Expected (required) return Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) Once Apple Computer had become a public company, it was able to raise financing from venture capital companies. Answer: FALSE Difficulty: 2 Medium Topic: Raising capital Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) Insurance companies provide a mechanism for individuals to pool their risks. Answer: TRUE Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) Financial markets and intermediaries allow investors and businesses to reduce and reallocate risk. Answer: TRUE Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

24) The effects of the financial crisis of 2007-2009 were confined to the U.S. and domestic companies. Answer: FALSE Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) The cost of capital is the minimum acceptable rate of return for capital investment. Answer: TRUE Difficulty: 2 Medium Topic: Expected (required) return Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) One root of the financial crisis of 2007-2009 was the strict money policies promoted by the U.S. Federal Reserve and other central banks after the technology bubble burst (i.e., money was relatively expensive during this time). Answer: FALSE Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) The rates of return on investments outside the corporation set the minimum return for investment projects inside the corporation. Answer: TRUE Difficulty: 2 Medium Topic: Expected (required) return Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

28) Financing for public corporations must flow through financial markets. Answer: FALSE Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) Financing for private companies must flow through financial intermediaries such as mutual funds. Answer: FALSE Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) Most securities sold via NASDAQ are sold in the secondary market. Answer: TRUE Difficulty: 1 Easy Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 31) Almost all foreign exchange trading occurs on the floors of the FOREX exchanges in New York and London. Answer: FALSE Difficulty: 2 Medium Topic: Foreign exchange markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

32) Exchange traded funds are tied to an index or basket of securities. Answer: TRUE Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33) Corporate financing comes ultimately from: A) savings by households and foreign investors. B) cash generated from the firm's operations. C) the financial markets and intermediaries. D) the issue of shares in the firm. Answer: A Difficulty: 1 Easy Topic: Financial institution functions Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) A company can pay for its expansion in all the following ways except: A) by using the earnings generated from its sale of obsolete equipment. B) by persuading a director's mother to make a personal loan to the company. C) by purchasing bonds in the secondary market. D) by plowing back part of its profits. Answer: C Difficulty: 2 Medium Topic: Raising capital Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

35) "Reinvestment" means: A) new investment in new operations. B) additional investment in existing operations. C) new investment by new shareholders. D) the reinvestment of earnings into new projects. Answer: D Difficulty: 2 Medium Topic: Raising capital Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 36) Financing for public corporations flows through: A) the financial markets only. B) financial intermediaries only. C) derivatives markets. D) the financial markets, financial intermediaries, or both. Answer: D Difficulty: 1 Easy Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) Which security is more efficient because it allows trading throughout the day and does not have managers with discretionary investment authority? A) Bond fund B) Exchange traded fund C) Mutual fund D) Stock fund Answer: B Difficulty: 3 Hard Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

38) When corporations need to raise funds through stock issues, they rely on the: A) primary market. B) secondary market. C) tertiary market. D) centralized NASDAQ exchange. Answer: A Difficulty: 2 Medium Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 39) A primary market would be utilized when: A) investors buy or sell existing securities. B) shares of common stock are exchanged. C) securities are initially issued. D) a commission must be paid on the transaction. Answer: C Difficulty: 1 Easy Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 40) The primary distinction between securities sold in the primary and secondary markets is: A) the riskiness of the securities. B) the price of the securities. C) whether the securities are new or already exist. D) the profitability of the issuing corporation. Answer: C Difficulty: 2 Medium Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

41) The New York Stock Exchange mostly serves as what kind of financial market? A) Foreign Exchange market B) Over the counter market C) Primary market D) Secondary market Answer: D Difficulty: 2 Medium Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 42) Which of the following are both a financial intermediary and a financial institution? A) Mutual funds B) Pension funds C) Insurance companies D) Hedge funds Answer: C Difficulty: 2 Medium Topic: Financial institutions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 43) A share of IBM stock is purchased by an individual investor for $75 and later sold to another investor for $125. Who profits from this sale? A) IBM B) The first investor C) The second investor D) IBM and both investors Answer: B Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

44) Which of the following financial assets is least likely to have an active secondary market? A) Common stock of a large public firm B) Bank loans made to smaller firms C) Bonds of a major, multinational corporation D) Debt issued by the U.S. Treasury Answer: B Difficulty: 3 Hard Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) When Patricia sells her General Motors common stock at the same time that Brian purchases the same amount of GM stock, GM receives: A) the dollar value of the transaction. B) the dollar amount of the transaction, less brokerage fees. C) only the par value of the common stock. D) nothing. Answer: D Difficulty: 2 Medium Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 46) Which one of these is a money market security? A) Commercial paper B) Common stock C) 2-year bond D) 20-year bond Answer: A Difficulty: 2 Medium Topic: Money and capital markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

47) A mother in a developing country wants to borrow the equivalent of $20 to enable her to start a small restaurant run by her family. Which type of financing is she looking to obtain? A) Public bond issue B) IPO C) Micro loan D) Futures contract on a commodity Answer: C Difficulty: 2 Medium Topic: Debt Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) Corporate debt instruments are most commonly traded: A) on the NYSE. B) on NASDAQ. C) in the money market. D) in the over-the-counter market. Answer: D Difficulty: 2 Medium Topic: Primary and secondary markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 49) A bond differs from a share of stock in that a bond: A) represents a claim on the firm. B) has more risk. C) has guaranteed returns. D) has a maturity date. Answer: D Difficulty: 2 Medium Topic: Bond features Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

50) Short-term financing transactions commonly occur in the: A) primary markets. B) secondary markets. C) capital markets. D) money markets. Answer: D Difficulty: 1 Easy Topic: Money and capital markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 51) Long-term financing decisions commonly occur in the: A) option markets. B) secondary markets. C) capital markets. D) money markets. Answer: C Difficulty: 1 Easy Topic: Money and capital markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 52) You can buy silver in the: A) capital markets. B) foreign exchange markets. C) commodities markets. D) option markets. Answer: C Difficulty: 1 Easy Topic: Money and capital markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

53) Commodity and derivative markets: A) are additional sources of financing for corporate projects. B) enable the financial manager to adjust a firm's exposure to various business risks. C) are always over-the-counter markets. D) deal only in foreign currencies. Answer: B Difficulty: 3 Hard Topic: Derivatives and other securities Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) Foreign currencies are traded: A) only by banks in New York and London. B) over the counter. C) on both the NYSE and NASDAQ. D) on the Intercontinental Exchange. Answer: B Difficulty: 2 Medium Topic: Foreign exchange markets Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 55) Which one of the following statements is not characteristic of mutual funds? A) They are always considered to be financial institutions. B) They raise money by selling shares to investors. C) They pool the savings of many investors. D) They offer professional management and portfolio diversification. Answer: A Difficulty: 2 Medium Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

56) In which of the following financial markets is an investor least likely to interact with a public corporation? A) Bond market B) Foreign exchange market C) Primary market D) Secondary market Answer: B Difficulty: 2 Medium Topic: Financial institutions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) Which one of these correctly applies to mutual funds? A) Mutual funds are a costly means of achieving portfolio diversification. B) Funds are required to limit their annual fees and expenses to less than 1 percent of the portfolio value. C) You can generally buy additional shares in the fund at any time. D) Shareholders sell their shares to other shareholders. Answer: C Difficulty: 2 Medium Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) "Balanced" mutual funds: A) invest in both stocks and bonds. B) spread their investments equally over a specified geographic area. C) spread their investments equally over various industries. D) charge a management fee that is proportionate to the investment return. Answer: A Difficulty: 2 Medium Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

59) Who was responsible for the financial crisis of 2007-2009? A) The U.S. Federal Reserve, for its policy of easy money B) The U.S. government, for pushing banks to expand credit for low-income housing C) Bankers, who aggressively promoted and resold subprime mortgages D) The U.S. Federal Reserve, the U.S. government, rating agencies, and bankers Answer: D Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) Which one of the following funds provides a tax advantage to individual investors? A) Balanced funds B) Pension funds C) Bond funds D) Funds that invest in foreign countries Answer: B Difficulty: 2 Medium Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 61) A financial institution: A) is a kind of financial intermediary. B) simply pools and invests savings. C) raises financing by selling shares. D) invests primarily in commodities. Answer: A Difficulty: 3 Hard Topic: Financial institutions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

62) Which type of financial institution generally does not accept deposits but does underwrite stock offerings? A) Insurance company B) Mutual fund C) Commercial bank D) Investment bank Answer: D Difficulty: 2 Medium Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 63) Which one of the following financial intermediaries has shown the greatest preference for investing in long-term financial assets? A) Commercial banks B) Insurance companies C) Finance companies D) Savings banks Answer: B Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

64) Which one of these may provide a financial return to some investors while not providing any financial return to other investors? A) Mutual funds B) Pension funds C) Insurance companies D) Hedge fund Answer: C Difficulty: 1 Easy Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 65) Insurance companies can usually cover the claims of policyholders because: A) the incidence of claims normally averages out across all policyholders. B) they issue a very limited number of policies. C) they are fully insured by the U.S. government. D) their stockholders will cover any cash shortfalls encountered by the company. Answer: A Difficulty: 2 Medium Topic: Types of financial institutions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) Which of the following is not typically considered a function of financial intermediaries? A) Providing a payment mechanism B) Investing in real assets C) Accumulating funds from smaller investors D) Spreading, or pooling risk among individuals Answer: B Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

67) U.S. bonds and other debt securities are mostly held by: A) institutional investors. B) households. C) foreign investors. D) state and local governments. Answer: A Difficulty: 2 Medium Topic: Raising capital Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 68) Approximately what percentage of U.S. corporate equities are held by households? A) 20% B) 40% C) 60% D) 80% Answer: B Difficulty: 2 Medium Topic: Raising capital Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 69) Which of the following are major holders of corporate bonds? A) households. B) banks. C) insurance companies. D) New York Stock Exchange. Answer: C Difficulty: 2 Medium Topic: Raising capital Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

70) Which of the following is not a function of financial markets? A) allow individuals to diversify their risk. B) provide convenient ways to make large payments. C) allow individuals to purchase a range of goods online. D) provide funds to companies that wish to expand. Answer: C Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Thinking Accessibility: Keyboard Navigation 71) Which one of these transports income forward in time? A) Retirement savings B) Car loan C) Bank line of credit D) Credit card purchase Answer: A Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 72) Which one of these assists in shifting an individual's consumption forward in time? A) A bank line of credit B) A bank savings account C) A life insurance policy D) A retirement savings plan Answer: A Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

73) One reason suggesting that banks may be better than individuals at matching lenders to borrowers is that banks: A) can shift loan risk to their deposit customers. B) are motivated by the potential for profit. C) do not have any income tax liability. D) have information to evaluate creditworthiness. Answer: D Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) Which one of the following is least liquid? A) Foreign currency B) U.S. Treasury bonds C) Real estate D) Bank deposit Answer: C Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) Financial markets and intermediaries: A) channel savings to real investment. B) increase risks for businesses. C) generally reduce the liquidity of securities. D) prevent the transportation of cash across time. Answer: A Difficulty: 1 Easy Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

76) Which of the following functions does not require financial markets? A) Retention of cash by corporations B) Provision of liquidity C) Risk reduction by investment in diversified portfolios D) Provision of pricing information Answer: A Difficulty: 3 Hard Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 77) Liquidity is important to a mutual fund primarily because: A) a fund that is less liquid will attract more investors. B) the fund's shareholders may want to redeem their shares at any time. C) new investors may invest in the fund at any time. D) the fund requires cash to pay its taxes. Answer: B Difficulty: 3 Hard Topic: Financial institution functions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 78) Which one of the following is the biggest provider of payment mechanisms? A) Hedge funds B) Banks C) Mutual funds D) Insurance companies Answer: B Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

79) Which of the following actions does not help reduce risk? A) Extending the service warranty for your notebook B) Converting your money market account to a mutual fund account C) Contracting to sell your farm produce to the neighborhood grocery D) Buying Japanese yen now when you plan to study in Japan next year Answer: B Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 80) Insurance companies primarily reduce an individual's risk by: A) transporting that risk forward in time. B) providing payment services. C) spreading that risk across many individuals. D) providing low-interest-rate loans. Answer: C Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) Which of the following information is not provided by the financial markets? A) The price of six ounces of gold B) The cost of borrowing $500,000 for 5 years C) Microsoft's earnings in 2013 D) The cost of one million yen in U.S. dollars Answer: C Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

82) A capital investment that generates a 10% rate of return is worthwhile if: A) corporate bonds of similar risk offer 8% rates of return. B) corporate bonds of similar risk offer 11% rates of return. C) top-quality corporate bonds offer 10% rates of return. D) the expected rate of return on the stock market is 12%. Answer: A Difficulty: 1 Easy Topic: Expected (required) return Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) The cost of capital: A) is the expected rate of return on a capital investment. B) is an opportunity cost determined by the risk-free rate of return. C) is the interest rate that the firm pays on a loan from a bank or insurance company. D) for risky investments is normally higher than the firm's borrowing rate. Answer: D Difficulty: 3 Hard Topic: Cost of capital-general Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) Excess cash held by a firm should be: A) reinvested by the firm in projects offering the highest rate of return. B) reinvested by the firm in projects offering rates of return higher than the cost of capital. C) reinvested by the firm in the financial markets. D) distributed to bondholders in the form of extra coupon payments. Answer: B Difficulty: 2 Medium Topic: Goal of financial management Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) One contributing factor to the 2007-2009 financial crisis was the structuring of mortgage loans with: A) high initial payments, offset by significantly lower payments later. B) low initial payments, offset by significantly higher payments later. C) high initial payments, offset by high payments later. D) very short maturities. Answer: B Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) The opportunity cost of capital: A) is the interest rate that the firm pays on a loan from a financial institution. B) is the maximum acceptable rate of return on a project. C) is the minimum acceptable rate of return on a project. D) is always less than 10%. Answer: C Difficulty: 2 Medium Topic: Expected (required) return Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 87) During the Financial Crisis of 2007-2009, the U.S. government bailed out all of the following firms except: A) AIG. B) Fannie Mae. C) Lehman Brothers. D) Freddie Mac. Answer: C Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

88) If Apple Computer Inc. is used as the model, then new firms should expect to raise capital in which one of these orders? Start with the first money raised. A) Owners, venture capitalists, suppliers, public investors B) Owners, suppliers, venture capitalists, public investors C) Venture capitalists, owners, public investors, suppliers D) Owners, public investors, venture capitalists, suppliers Answer: B Difficulty: 2 Medium Topic: Raising capital Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) Which one of these parties cannot invest in a hedge fund? A) Small retail investors B) Pension funds C) Insurance companies D) Wealthy individuals Answer: A Difficulty: 1 Easy Topic: Hedging Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) Which one of these enterprises generally acts as an underwriter for an initial public offering? A) Commercial bank B) Government C) Investment bank D) Insurance company Answer: C Difficulty: 1 Easy Topic: Underwriting Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

91) Which of these institutions are not major investors in U.S. equities? A) mutual funds B) banks C) pension funds D) hedge funds Answer: B Difficulty: 2 Medium Topic: Raising capital Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 92) Firms can often determine the price of any commodities they use in their production process by consulting the price quotes provided by: A) their investment bank. B) the New York Mercantile Exchange. C) the New York Stock Exchange. D) the Standard & Poor's market indexes. Answer: B Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 93) How is the relationship between a bond's credit rating and its interest rate best defined? A) Inverse relationship B) Direct relationship C) Unrelated D) Logarithmic Answer: A Difficulty: 2 Medium Topic: Bond ratings and credit risk Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

94) The financial crisis of 2007-2009 contributed to the largest sovereign default in history by which one of these countries? A) Italy B) Portugal C) Ireland D) Greece Answer: D Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 95) Which one of these was a contributing factor to the need for many foreign banks to seek aid from their governments as a result of the financial crisis of 2007-2009? A) Decrease in their exchange rates B) Investments in U.S. subprime mortgages C) Interest rate spikes D) Currency controls Answer: B Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

96) Which one of these was a major cause of the deep recession and severe unemployment throughout much of Europe that followed the financial crisis of 2007-2009? A) Government actions to raise interest rates B) Investor speculation C) Risk-adverse investor attitudes D) Government actions to lower government debt Answer: D Difficulty: 2 Medium Topic: Financial distress Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Which one of these is generally a key difference between U.S. and foreign commercial banks? A) Pooling and investing savings B) Accepting investor deposits C) Providing debt financing to corporations D) Making equity investments in corporations Answer: D Difficulty: 2 Medium Topic: Financial institution functions Learning Objective: 02-03 Explain the functions of financial markets and institutions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 3 Accounting and Finance 1) An asset's liquidity is determined by how readily the asset can be converted to an appropriate amount of cash. Answer: TRUE Difficulty: 1 Easy Topic: Liquidity Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) The principal reason for excluding many intangible assets from the balance sheet is that they are difficult to value. Answer: TRUE Difficulty: 2 Medium Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) Based on generally accepted accounting principles, assets are recorded on the balance sheet at their current market value. Answer: FALSE Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

4) Assets can be either tangible or intangible. Answer: TRUE Difficulty: 1 Easy Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 5) There is generally a bigger difference between the book value and the market value of fixed assets as compared to cash. Answer: TRUE Difficulty: 1 Easy Topic: Market and book values Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) All items in the common-size balance sheet are expressed as a percentage of total assets. Answer: TRUE Difficulty: 2 Medium Topic: Standardized financial statements Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 7) The income statement resembles a snapshot of the firm at a specific time. Answer: FALSE Difficulty: 1 Easy Topic: Income statement Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

8) If the market value of assets is high, then the market value of liabilities must be high also. Answer: FALSE Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) One reason for the difference between profits and cash is that the cost of capital equipment is spread over the forecast life. Answer: TRUE Difficulty: 1 Easy Topic: Noncash items Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) Accrual accounting aims to provide a fairer measure of the firm's profitability. Answer: TRUE Difficulty: 1 Easy Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) If net income is positive, then cash flow from operations must be positive for that period. Answer: FALSE Difficulty: 2 Medium Topic: Operating activities Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

12) Dividends paid are treated as a financing activity on the statement of cash flows. Answer: TRUE Difficulty: 2 Medium Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) An increase in the accounts receivable balance increases the cash flow of a firm. Answer: FALSE Difficulty: 2 Medium Topic: Operating activities Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) The payment of interest expense is considered a financing activity in the statement of cash flows. Answer: FALSE Difficulty: 3 Hard Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Accounting practices are currently standardized across all countries. Answer: TRUE Difficulty: 1 Easy Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

16) Businesses that aggressively exploit any means possible to increase current earnings may cross over into fraudulent account practices. Answer: TRUE Difficulty: 2 Medium Topic: Ethics, governance, and regulation Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Ethics Accessibility: Keyboard Navigation 17) A company may deduct the interest paid to debtholders and the dividends paid to shareholders when calculating its taxable income. Answer: FALSE Difficulty: 2 Medium Topic: Income statement Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 18) Both the dividends and interest payments that companies make to individuals are subject to personal tax. Answer: TRUE Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

19) The balance sheet presents a snapshot of the firm's assets and liabilities at one particular moment. Answer: TRUE Difficulty: 2 Medium Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20) Book values are "forward-looking" measures of value. Answer: FALSE Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) The difference between the market values of assets and liabilities is the market value of the shareholders' equity claim. Answer: TRUE Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) To calculate free cash flow, you must deduct capital expenditures from the cash flow from operations. Answer: TRUE Difficulty: 2 Medium Topic: Free cash flow Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

23) Depreciation charge is a cash payment. Answer: FALSE Difficulty: 1 Easy Topic: Noncash items Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) An expenditure on new capital equipment is a cash payment. Answer: TRUE Difficulty: 1 Easy Topic: Investing activities Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) The statement of cash flows shows the firm's cash inflows and outflows from operations as well as from its investments and financing activities. Answer: TRUE Difficulty: 1 Easy Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) An increase in inventories uses cash, reducing the firm's net cash balance. Answer: TRUE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

27) IFRS uses a more "principles based" approach to financial reporting as does GAAP. Answer: TRUE Difficulty: 1 Easy Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 28) A reduction in accounts receivable uses cash, reducing the firm's net cash balance. Answer: FALSE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) The purchase of new equipment is a use of cash, and it reduces the firm's net cash balance. Answer: TRUE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

30) In general, what is changing as you read down the left-hand side of a balance sheet? A) The assets are becoming more fully depreciated. B) The assets are increasing in value. C) The assets are increasing in maturity. D) The assets are becoming less liquid. Answer: D Difficulty: 1 Easy Topic: Liquidity Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) A balance sheet portrays the value of a firm's assets and liabilities: A) over an annual period. B) over any stated period of time. C) at any stated point in time. D) only at the end of the calendar year. Answer: C Difficulty: 1 Easy Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 32) Which of the following items should not be included in a listing of current assets? A) Marketable securities B) Accounts payable C) Accounts receivable D) Inventories Answer: B Difficulty: 1 Easy Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

33) Which of the following assets is likely to be considered the most liquid? A) Marketable securities B) Net fixed assets C) Accounts payable D) Inventories Answer: A Difficulty: 1 Easy Topic: Liquidity Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) If the value of a firm's net fixed assets equals the value of the accumulated depreciation, from an accounting context the fixed assets are: A) new. B) fully depreciated. C) one-half depreciated. D) equal in value to the firm's current assets. Answer: C Difficulty: 3 Hard Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35) If the balance sheet of a firm indicates that total assets exceed current liabilities plus shareholders' equity, then the firm has: A) no retained earnings. B) long-term debt. C) no accumulated depreciation. D) current assets. Answer: B Difficulty: 2 Medium Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10

36) Which one of the following is an intangible asset? A) Goodwill B) Retained earnings C) Deferred income taxes D) Treasury stock Answer: A Difficulty: 1 Easy Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) If Company X were to purchase Company Y's assets for a price above their book value, how would the overpayment be classified? A) Intangible Asset B) Long term investment C) Marketable security D) Prepaid expense Answer: A Difficulty: 3 Hard Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

38) Suppose Dee's just acquired the assets of Flo's Flowers. The book value of Flo's Flowers assets was $68,000 but Dee's paid a total of $75,000. The additional $7,000 paid by Dee's will be recorded on Dee's balance sheet as: A) accounts payable. B) goodwill. C) other current assets. D) property, plant, and equipment. Answer: B Difficulty: 2 Medium Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) What happens to a firm's net worth as it uses cash to repay accounts payable? A) Net worth increases. B) Net worth decreases. C) Net worth remains constant. D) Net worth decreases temporarily, until cash is replenished. Answer: C Difficulty: 2 Medium Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

40) If a payment of principal is due in 13 months on a long-term liability, that payment will now appear on the balance sheet as: A) a current liability. B) long-term debt. C) cash. D) interest expense. Answer: B Difficulty: 1 Easy Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 41) Net working capital is a measure of a company's: A) goodwill. B) short-term liabilities. C) estimated cash reservoir. D) shareholders' equity. Answer: C Difficulty: 1 Easy Topic: Net working capital Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) Net working capital is calculated by taking the difference between: A) total assets and total liabilities. B) inventory and accounts payable. C) current assets and current liabilities. D) cash and accounts payable. Answer: C Difficulty: 1 Easy Topic: Net working capital Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

43) Which of the following statements about net working capital (NWC) is correct? A) NWC is positive for all firms. B) As NWC decreases, potential liquidity increases. C) NWC excludes inventory, which is deemed illiquid. D) NWC is negative if current liabilities exceed current assets. Answer: D Difficulty: 1 Easy Topic: Net working capital Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) The existence of goodwill on a corporate balance sheet indicates that the corporation has: A) been profitable in the past. B) depreciated its tangible assets. C) intangible assets from past acquisitions. D) retained earnings resulting from past income. Answer: C Difficulty: 2 Medium Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) A balance sheet may be considered backward-looking from the perspective that it: A) works backward, starting with net income. B) records historic, not current values. C) cannot forecast the future. D) records costs over many previous periods. Answer: B Difficulty: 1 Easy Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

46) According to GAAP, assets and liabilities are typically recorded on the balance sheet at: A) historical cost plus depreciation. B) market value. C) salvage value. D) historical cost less depreciation. Answer: D Difficulty: 1 Easy Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 47) Which of the following statements about depreciation is correct A) Each year the accountant adds an amount for depreciation when calculating the company's profit. B) The annual depreciation charge measures the cash that the company has spent on maintaining and renewing its plant and equipment. C) To calculate the cash produced by the business, it is necessary to deduct the depreciation charge from accounting profits. D) To calculate the cash produced by the business, it is necessary to add the depreciation charge back to accounting profits. Answer: D Difficulty: 2 Medium Topic: Depreciation Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

48) Depreciation expense is used to: A) allocate costs to all departments of the firm. B) determine when an asset is fully paid off. C) allocate historical cost over the life of an asset. D) equate the historical cost and market values of an asset. Answer: C Difficulty: 1 Easy Topic: Noncash items Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 49) If a firm has not had a significant change in its financial health, which balance sheet item is most likely to have a book value very close to its market value over the course of time? A) Shareholder's equity B) Real estate C) Finished goods inventory D) Bonds Answer: D Difficulty: 1 Easy Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 50) When subtracting an asset's accumulated depreciation from its historic cost, the resulting value is termed the: A) book value of the asset. B) market value of the asset. C) depreciation expense. D) current asset value. Answer: A Difficulty: 1 Easy Topic: Market and book values Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

51) ABC Corp.'s balance sheet shows its long-term debt to be $20 million. The debt was issued with a 10% interest rate, and the current interest rate is 7%. Based on this information alone, the market value of this debt is most likely: A) less than $20 million. B) more than $20 million. C) equal to $20 million. D) unknown without knowing the maturity of the debt. Answer: B Difficulty: 3 Hard Topic: Market and book values Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) Which of the following statements about depreciation is correct? A) Depreciation is subtracted from cost of goods sold to calculate net income. B) When depreciation expense is incurred, cash balances are reduced. C) Depreciation expense does not affect net income. D) Depreciation reduces the book value of assets. Answer: D Difficulty: 1 Easy Topic: Noncash items Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 53) If market interest rates have increased since a company last borrowed long-term funds, the market value of these long-term funds will likely be: A) greater than their book value. B) less than their book value. C) equal to their book value. D) unknown without knowing the maturity of the debt. Answer: B Difficulty: 3 Hard Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17

54) Which of the following values would most likely interest a shareholder? A) Book value of equity B) Market value of equity C) Retained earnings D) Net working capital Answer: B Difficulty: 1 Easy Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) What happens to the market value of a firm's equity as the book value of the firm's equity increases? A) It increases by the same amount. B) It decreases by the same amount. C) It remains constant. D) There is no set relationship to determine this outcome. Answer: D Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) Which of the following statements is true for a corporation with $1 million market value of equity, $2 million market value of assets, and 1,000 shares of outstanding stock? A) Market value of liabilities exceeds book value of liabilities. B) Market value of liabilities equals $1 million. C) Book value per share equals $1,000. D) Market value per share equals $2,000. Answer: B Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

57) Which of the following is more likely to be correct if market value of equity is less than book value of equity? A) Investors anticipate excellent earning potential. B) Investors anticipate low earning potential. C) Assets have been fully depreciated. D) The company is bankrupt. Answer: B Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) Market-value balance sheets differ from book-value balance sheets in that market values: A) are higher than book values. B) are lower than book values. C) reflect GAAP accounting. D) reflect investors' expectations. Answer: D Difficulty: 1 Easy Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 59) If market values of equity exceed book values of equity, then: A) equity has been depreciated too rapidly. B) the firm uses accrual-based accounting. C) profit potential is expected to be attractive. D) the firm is holding too much cash. Answer: C Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

60) Perhaps the best method for estimating the market value of shareholders' equity is to: A) review the firm's balance sheet. B) review the firm's income statement. C) multiply number of shares outstanding by the price of each share. D) add the retained earnings to the total liabilities. Answer: C Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 61) In which of the following balance-sheet entries are you least likely to find a difference between market value and book value? A) Cash B) Inventory C) Land D) Shareholders' equity Answer: A Difficulty: 1 Easy Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 62) Amy wants to know if inventory is increasing as a percentage of total assets. Which one of these statements most easily provides the information she is seeking? A) Statement of cash flows B) Balance sheet C) Common-size balance sheet D) Income statement Answer: C Difficulty: 1 Easy Topic: Standardized financial statements Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) Which one of the following expense categories is subtracted from total revenues to help arrive at a firm's EBIT? A) Cash dividends B) Depreciation expense C) Interest expense D) Tax liability Answer: B Difficulty: 1 Easy Topic: Income statement Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) Which one of the following does not reduce a firm's net income? A) Income taxes B) Interest expense C) Dividends D) Depreciation expense Answer: C Difficulty: 2 Medium Topic: Income statement Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

65) Calculate the EBIT for a firm with $4 million total revenues, $3.5 million cost of goods sold, $500,000 depreciation expense, and $120,000 interest expense. A) $500,000 B) $380,000 C) $0 D) ($120,000) Answer: C Explanation: EBIT = $4,000,000 − 3,500,000 − 500,000 = $0 Difficulty: 2 Medium Topic: Income statement Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 66) The net income figure on an income statement is calculated before deducting the: A) interest expense. B) depreciation expense. C) cash dividends. D) tax liability. Answer: C Difficulty: 2 Medium Topic: Income statement Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) An increase in depreciation expense will (other things equal): A) increase net income. B) decrease net income. C) increase taxable income. D) decrease the market value of assets. Answer: B Difficulty: 2 Medium Topic: Income statement Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22

68) Current period depreciation expense is listed: A) on the balance sheet. B) in the investment section of the cash flow statement. C) on the income statement. D) on neither the balance sheet nor the income statement; it is a noncash expense. Answer: C Difficulty: 1 Easy Topic: Noncash items Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 69) Retained earnings result from: A) the sale of additional shares of stock to investors. B) income not paid to shareholders. C) an excess of assets over liabilities. D) market values that exceed book values. Answer: B Difficulty: 2 Medium Topic: Balance sheet Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) The gathering of related revenues and expenses into the same period, regardless of when they were incurred, is: A) cash-basis accounting. B) market-value accounting. C) book-value accounting. D) accrual accounting. Answer: D Difficulty: 1 Easy Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

71) According to accrual accounting, when goods are not sold until the period after they were produced, then the cost of goods sold will be: A) recognized when the goods are produced. B) recognized when the goods are sold. C) recognized when payment is received. D) split between the production and the sale periods. Answer: B Difficulty: 2 Medium Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 72) Accrual accounting, which attempts to match sales revenues and the expenses associated with the production of the goods, is conducted in an attempt to: A) reduce income-tax liability. B) reduce bias in reported profitability measures. C) speed up the receipt of accounts receivable. D) reduce the time necessary to depreciate assets. Answer: B Difficulty: 2 Medium Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

73) Which of the firm's financial statements most clearly recognizes the payment for new equipment? A) Balance sheet B) Income statement C) Statement of cash flows D) Common-size balance sheet Answer: C Difficulty: 1 Easy Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) If a firm pays taxes, which one of these will reduce net income but increase cash flow? A) Depreciation expense B) Income taxes C) Cash sales D) Interest expense Answer: A Difficulty: 3 Hard Topic: Noncash items Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 75) Which one of the following will reduce the cash flow during an accounting period? A) High depreciation expense B) Reduction of inventory levels C) Acquisition of equipment D) Increase in accounts payable Answer: C Difficulty: 3 Hard Topic: Statement of cash flows Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

76) Assume a firm generates $2,000 in sales and has a $500 increase in accounts receivable during an accounting period. Based solely on this information, cash flow will increase by: A) $2,500. B) $2,000. C) $1,500. D) $500. Answer: C Difficulty: 2 Medium Topic: Operating activities Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 77) In a statement of cash flows, which category includes depreciation expense as a line item? A) Cash provided by operations. B) Cash flows from investments. C) Cash provided by (used for) financing activities. D) Current liabilities. Answer: A Difficulty: 1 Easy Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 78) Which of the following will occur in a statement of cash flows as a result of paying cash dividends? A) Cash flows from operations will increase. B) Cash flows from investments will decrease. C) Cash flows from financing will decrease. D) Cash balances will not be affected. Answer: C Difficulty: 1 Easy Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

79) Which of the following changes in working capital will result in an increase in cash flows? A) Increase in accounts payable B) Increase in inventories C) Increase in accounts receivable D) Decrease in other current liabilities Answer: A Difficulty: 2 Medium Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 80) Which of the following statements is more likely if cash and marketable securities increase by $5,000 during a period in which cash provided by operations increases by $1,000 and cash used by investments decreases by $500? A) Cash provided by financing increases by $6,500. B) Cash used by financing decreases by $1,000. C) Debt increases by more than cash dividends paid. D) Debt is reduced by more than cash dividends paid. Answer: C Explanation: Cash provided by financing increased. This could occur by increasing debt by a larger amount than the amount paid out in dividends. Difficulty: 3 Hard Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

81) If a firm's net income is positive and its noncash expenses are positive, which of the following could account for a negative amount of cash provided by operations? A) Current assets decrease more than current liabilities decrease. B) Current assets increase more than current liabilities increase. C) Current assets decrease more than current liabilities increase. D) A large addition is made to plant and equipment. Answer: B Difficulty: 3 Hard Topic: Operating activities Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 82) What is the most likely conclusion for a firm whose statement of cash flows shows an increase in cash balances and has negative cash flows from both operations and financing? A) The firm has low depreciation expense. B) The firm did not pay any dividends. C) The firm sold more equipment than it purchased. D) The firm has a low interest rate on its debt. Answer: C Difficulty: 3 Hard Topic: Statement of cash flows Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 83) Johnson's Nursery has net income of $42,500, depreciation expense of $1,800, interest expense of $900, taxes of $1,600, additions to net working capital of $2,300, and capital expenditures of $11,700. What is the amount of the free cash flow? A) $30,300 B) $34,400 C) $31,200 D) $28,700 Answer: C Explanation: Free cash flow = $42,500 + 900 + 1,800 − 2,300 − 11,700 = $31,200 Difficulty: 2 Medium Topic: Free cash flow Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 28

84) According to the statement of cash flows, cash flows from financing could be positive if: A) the firm repaid more debt than it added. B) the firm added more debt than it repaid. C) interest rates were low on outstanding debt. D) the firm sold portions of its plant and equipment. Answer: B Difficulty: 2 Medium Topic: Financing activities Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 85) Which of the following categories of a statement of cash flows is affected by the payment of interest expense? A) Cash flows from operations B) Cash flows from noncash expenses C) Cash flows from investments D) Cash flows from financing Answer: A Difficulty: 3 Hard Topic: Operating activities Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) Which of the following could account for a firm that has a negative net income, yet has a positive amount of cash provided by operations? A) The net loss was greater than the amount of depreciation expense. B) Inventory increased significantly more than accounts payable. C) Accounts receivable decreased by significantly more than accounts payable. D) The cash balance increased significantly. Answer: C Difficulty: 2 Medium Topic: Operating activities Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

87) If a firm's statement of cash flows shows that cash was used for investments, which of the following would seem most likely? A) The inventory balance increased. B) Common stock was repurchased. C) New machines were acquired. D) Cash dividends were paid. Answer: C Difficulty: 2 Medium Topic: Investing activities Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Interest expense appears in the operations section of the statement of cash flows because: A) firms cannot operate without incurring interest expense. B) its payment is not within managerial discretion. C) it is paid to finance a firm's inventory. D) none of the options; interest expense appears in the financing section of the statement of cash flows. Answer: B Difficulty: 3 Hard Topic: Operating activities Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) Which one of these would not be paid from free cash flow? A) Cash dividends B) Repayment of principal on a long-term debt C) Repurchase of outstanding shares of common stock D) New equipment purchase Answer: D Difficulty: 2 Medium Topic: Free cash flow Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30

90) Which of the following statements correctly describes international accounting standards? A) The standards are becoming less similar over time. B) They are concerned only with assets and not liabilities. C) Compared with standards in the United States international standards involve less detailed rules. D) Balance sheets differ, but income statements are similar in all countries. Answer: C Difficulty: 1 Easy Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 91) Which of these statements related to free cash flow is correct? A) Free cash flow must be fully distributed to the firm's debtors and shareholders. B) Free cash flow must be positive for a firm to acquire new fixed assets. C) All, or part, of free cash flow can be used to increase a firm's cash reserves. D) When capital expenditures are positive, free cash flow will exceed the cash flow from operations. Answer: C Difficulty: 2 Medium Topic: Free cash flow Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 92) What is the fundamental difference between IFRS and GAAP? A) GAAP relies more on general principles but ignores the spirit of those principles. B) GAAP relies more on specific rules and the spirit of the rules. C) GAAP relies more on specific rules but not the spirit of the rules. D) GAAP relies more on general principles as well as the spirit of those rules. Answer: C Difficulty: 2 Medium Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31

93) What is the marginal corporate tax rate for large companies? A) 15% B) 21% C) 35% D) 39% Answer: B Difficulty: 1 Easy Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) Which of the following cannot be used to reduce taxable corporate income? A) Cash dividends B) Depreciation expense C) Interest expense D) Administrative expenses Answer: A Difficulty: 1 Easy Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 95) Assume a firm increases its revenue by $100 while increasing its cost of goods sold by $85. How much additional tax will the firm owe if its marginal tax rate is 21%? A) $3.15 B) $7.50 C) $13.75 D) $25.00 Answer: A Explanation: Increase in taxes = 0.21 × ($100 − 85) = $3.15 Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32

96) According to the U.S. tax code at the beginning of 2018, the highest marginal tax rate for personal taxpayers is: A) 25.0%. B) 28.5%. C) 35.0%. D) 37.0%. Answer: D Difficulty: 1 Easy Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 97) Which one of the following statements is correct for a corporation with a negative net income in both the present and the last fiscal year? A) This year's loss can be carried back, but last year's loss cannot be used. B) Neither of the losses can be used to reduce taxes. C) 80% of the loss can be carried forward. D) Both losses can be carried forward and backward, without limit. Answer: C Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

98) Assume a single taxpayer is taxed at 10% on the first $9,525 of taxable income, 12% on the next $29,175 of income, and at 22% for the following $43,800 of income. What is the average tax rate for that individual if her taxable income is $42,000? A) 12.33% B) 16.67% C) 16.13% D) 25% Answer: A Explanation: Tax = (0.1 × 9,525) + (0.12 × 29,175) + (0.22 × (42,000 – 9,525 – 29,175)) = $5,179.50. Average tax rate= $5,179.50/$42,000 = 0.1233, or 12.33%. Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 99) An individual's income for the year includes both dividend and interest payments. Which of these statements correctly applies to that individual's tax liability? A) Dividends are taxed; tax on interest payments is paid at the corporate level. B) Interest is taxed; tax on dividend payments is paid at the corporate level. C) Both dividend and interest payments are taxed at the personal level. D) All taxes on dividend and interest payments are paid at the corporate level. Answer: C Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

100) A major goal of the Sarbanes-Oxley Act is to: A) increase transparency in the financial reporting of a firm's activities. B) require firms to provide common-size balance sheets to shareholders. C) lower corporate tax rates. D) require U.S. firms to abide by international accounting standards. Answer: A Difficulty: 2 Medium Topic: Ethics, governance, and regulation Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Remember AACSB: Ethics Accessibility: Keyboard Navigation 101) Which one of the following is not a requirement imposed by the Sarbanes-Oxley Act? A) Accounting firms may not offer other services to companies they audit. B) Any one individual is prohibited from serving as the chairman of a firm's board of directors for more than 5 years. C) A board's audit committee must consist of directors who are independent of the firm's management. D) Management must certify that the financial statements present a fair view of the firm's financial position. Answer: B Difficulty: 2 Medium Topic: Ethics, governance, and regulation Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Remember AACSB: Ethics Accessibility: Keyboard Navigation

102) Who pays taxes on earnings distributed as dividends? A) The issuing corporation B) The shareholder receiving the dividend C) Both the issuing corporation and the shareholder D) Neither the issuing corporation nor the shareholder Answer: C Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 103) Assume a single taxpayer is taxed at 10% on the first $9,525 of taxable income, 12% on the next $29,175 of income, and at 22% for the following $43,800 of income. What is the tax liability for a single individual with $52,000 of taxable income, which includes $2,000 of dividends? A) $7,379.50 B) $9,103.50 C) $8,603.50 D) $8,356.25 Answer: A Explanation: Tax = (0.1 × 9,525) + (0.12 × 29,175) + (0.22 × (52,000 – 9,525 – 29,175)) + ($2000 × 0) = $7,379.50. Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

104) Which of the following forms of income can individuals defer from taxation? A) Dividends B) Interest C) Realized capital gains D) Unrealized capital gains Answer: D Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 105) Which type of income is subject to "double taxation"? A) Dividends and wages B) Capital gains C) Dividends D) Wages Answer: C Difficulty: 2 Medium Topic: Taxes Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

106) Professor Diehard found an effective antibiotic for the DEPRESS bacteria, and patented the drug. He believes that he could sell the patent for $20 million. He then formed a corporation and invested $400,000 in setting up a production plant. There are 2 million shares of stock outstanding. If the professor's belief is correct, what would be the price per share and the book value per share? A) $10.20; $0.20 B) $10.00; $0.20 C) $9.80; $0.40 D) $9.80; $0.20 Answer: A Explanation: Book value equals the $400,000 Professor Diehard has contributed in tangible assets. Market value equals the value of his patent plus the value of the production plant, or $20.4 million. Price per share = $20.4 million/2 million shares = $10.20. Book value per share = $400,000/2 million shares = $0.20. Difficulty: 2 Medium Topic: Market and book values Learning Objective: 03-02 Distinguish between market and book values. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 107) You have gathered this information on a firm: $500,000 sales, $10,000 cash dividends, $300,000 cost of goods sold, $20,000 administrative expense, $20,000 depreciation expense, $40,000 interest expense, $10,000 purchase of productive equipment, no changes in working capital, and a tax rate of 21%. What is the free cash flow? A) $94,800 B) $138,000 C) $144,800 D) $154,800 Answer: C Explanation: Net income = ($500,000 - 300,000 - 20,000 - 20,000 - 40,000) × (1 - 0.21) = $94,800 Cash flow from operations = $94,800 + 40,000 + 20,000 = $154,800 Free cash flow = $154,800 - 10,000 = $144,800 Difficulty: 3 Hard Topic: Free cash flow Learning Objective: 03-03 Explain why income differs from cash flow. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

108) What is the overall change in cash resulting from: $300 increase in inventories, $150 increase in accounts payable, $120 decrease in accounts receivable, $60 decrease in other current assets, $150 decrease in other current liabilities? A) −$120 B) −$240 C) $180 D) $120 Answer: A Explanation: Net change in cash = −$300 + 150 + 120 + 60 − 150 = −$120 Difficulty: 2 Medium Topic: Operating activities Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 109) What is the change in cash for a firm with the following: $10,000 cash flow from operations, $1,600 cash used for new investment, a reduction in the level of debt of $2,000, $1,000 in cash dividends, and $200 in depreciation expense? A) $5,600 B) $9,600 C) $9,400 D) $5,400 Answer: D Explanation: Change in cash = $10,000 − 1,600 − 2,000 − 1,000 = $5,400 Difficulty: 3 Hard Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

110) Which one of these will increase a firm's cash balance? A) An increase in inventory B) A decrease in accounts payable C) An issue of common stock D) Purchase of new equipment Answer: C Difficulty: 2 Medium Topic: Statement of cash flows Learning Objective: 03-01 Interpret the information contained in the balance sheet, income statement, and statement of cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 4 Measuring Corporate Performance 1) The income statement of a firm shows the value of its assets and liabilities over a specified period of time. Answer: FALSE Difficulty: 1 Easy Topic: Income statement Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 2) The higher the times interest earned ratio, the higher the interest expense. Answer: FALSE Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) The net working capital of a firm will decrease when unpaid bills from suppliers are later paid with cash. Answer: FALSE Difficulty: 2 Medium Topic: Net working capital Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

4) Net working capital is determined from the difference between current assets and current liabilities. Answer: TRUE Difficulty: 2 Medium Topic: Net working capital Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) Net working capital to total assets and current ratio are both liquidity ratios. Answer: TRUE Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) The net working capital to total assets ratio is always a larger number than the current ratio. Answer: FALSE Difficulty: 1 Easy Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) The asset turnover ratio and inventory turnover ratio are both efficiency ratios. Answer: TRUE Difficulty: 2 Medium Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

8) The inventory turnover ratio times the average days in inventory equals 365. Answer: TRUE Difficulty: 1 Easy Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 9) Return on assets and return on equity are both profitability ratios. Answer: TRUE Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 10) Return on assets is always a larger number than the return on equity. Answer: FALSE Difficulty: 1 Easy Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) The reduction in value over time of intangible assets is known as amortization. Answer: TRUE Difficulty: 2 Medium Topic: Depreciation methods Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

12) Receivable turnover ratio and asset turnover ratio are both efficiency ratios. Answer: TRUE Difficulty: 1 Easy Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 13) Market value added is the difference between the market value of the firm's equity and its book value. Answer: TRUE Difficulty: 1 Easy Topic: Market value ratios Learning Objective: 04-01 Calculate and interpret the market value and market value added of a public corporation. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 14) Market value added is the same as economic value added. Answer: FALSE Difficulty: 1 Easy Topic: Market value ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 15) The difference between the current and quick ratios is that inventory has been subtracted from current assets. Answer: TRUE Difficulty: 1 Easy Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

16) A healthy current ratio and an unhealthy quick ratio may be caused by excess inventory. Answer: TRUE Difficulty: 1 Easy Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) Other things equal, an increase in average accounts receivable will increase a firm's return on assets. Answer: FALSE Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 18) Residual income is another term for economic value added. Answer: TRUE Difficulty: 1 Easy Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) EVA is the net profit of the firm adjusted for the cost of capital. Answer: TRUE Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

20) The market value added by a firm is reduced by an increase in retained earnings. Answer: TRUE Difficulty: 1 Easy Topic: Market value ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 21) ROE is equal to ROC when the firm has no debt. Answer: TRUE Difficulty: 1 Easy Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) Since Hollywood movies generate most of their profit in the first few months following their release, Economic Value Added is a good way to measure their financial performance. Answer: FALSE Difficulty: 1 Easy Topic: Market value ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 23) Increasing leverage will always act to increase a firm's ROE. Answer: FALSE Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

24) Bondholders exercising their right to convert bonds to equity will cause an increase in times interest earned. Answer: TRUE Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 25) Which of the following is the least effective measure of operating performance? A) ROC B) ROA C) ROE D) All of the options are equally ineffective measures of operating performance. Answer: C Difficulty: 1 Easy Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation 26) Lease obligations are included in certain leverage ratios because leases: A) require the payment of interest. B) represent long-term fixed obligations. C) must be financed through a bank. D) are perpetual obligations. Answer: B Difficulty: 1 Easy Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

27) A firm with no leases has a long-term debt ratio of 50%. This means that the book value of equity: A) equals the book value of long-term debt. B) is less than the book value of long-term debt. C) is greater than the book value of long-term debt. D) is unknown in relation to the book value of long-term debt. Answer: A Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) When a firm's long-term debt-equity ratio is .98, the firm: A) has too much long-term debt in relation to leases. B) has less long-term debt than equity. C) is nearing insolvency. D) has as much in long-term liabilities as in equity. Answer: B Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) The market value added of a firm uses which of the following numbers in its calculation? A) Market capitalization B) Market return C) Market value of assets D) Market value of debt Answer: A Difficulty: 2 Medium Topic: Market value ratios Learning Objective: 04-01 Calculate and interpret the market value and market value added of a public corporation. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

30) If a firm's debt ratio is greater than 0.5, then: A) its current liabilities are quite high. B) its debt-equity ratio exceeds 1.0. C) it has too few total assets. D) it has more long-term debt than equity. Answer: B Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 31) A times interest earned ratio of 5 indicates the firm: A) pays 5 times its earnings in interest expense. B) earns significantly more than its interest obligations. C) has interest expense equal to 5% of EBIT. D) has a low tax liability. Answer: B Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 32) If a firm's cash coverage ratio is greater than its times interest earned ratio, then the: A) firm's assets are not fully depreciated. B) firm has no lease obligations. C) firm has very little long-term debt. D) firm has a high degree of liquidity. Answer: A Difficulty: 3 Hard Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

33) An asset's liquidity measures its: A) potential for generating a profit. B) cash requirements. C) ease and cost of being converted to cash. D) proportion of debt financing. Answer: C Difficulty: 1 Easy Topic: Liquidity Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) Which of the following actions could improve a firm's current ratio if it is now less than 1.0? A) Converting marketable securities to cash B) Paying accounts payable with cash C) Buying inventory on credit D) Selling inventory at cost Answer: C Difficulty: 3 Hard Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 35) If a firm's quick ratio is equal to its current ratio: A) It has a low level of current liabilities. B) It has no inventory. C) It faces a potentially serious liquidity crisis. D) It is in a loss-making position. Answer: B Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

36) A firm has $600,000 in current assets and $150,000 in current liabilities. Which of the following is correct if it uses cash to pay off $50,000 in accounts payable? A) Current ratio will increase to 5.0. B) Net working capital will increase to $500,000. C) Current ratio will decrease. D) Net working capital will not change. Answer: D Difficulty: 2 Medium Topic: Net working capital Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) How would you interpret an inventory turnover ratio of 10.7? A) It takes 50 days on average to collect receivables. B) Inventory is converted into sales every 50 days. C) The firm has sufficient inventories to maintain sales for 34.1 days. D) Assets are converted into sales every 50 days. Answer: C Explanation: Days' sales in inventory = 365 days / 10.7 = 34.1 days Difficulty: 2 Medium Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

38) What are the annual sales for a firm with $400,000 in debt, a total debt ratio of 0.4, and an asset turnover of 3? A) $333,333 B) $1,200,000 C) $1,800,000 D) $3,000,000 Answer: D Explanation: Total debt ratio = Total debt / Total assets, so: Assets = $400,000 / 0.4 = $1,000,000 Asset turnover ratio = Sales / Total assets, so: Sales = $1,000,000 × 3 = $3,000,000 Difficulty: 2 Medium Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) Which one of the following will cause a reduction in the NWC turnover ratio all else held constant? A) A decrease in sales B) An increase in average payables C) An increase in average inventory D) An increase in the average cash balance Answer: B Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

40) Which statement is likely true for a company with a cash ratio close to 1.95? A) Collection agencies are likely to call B) Lines of credit can be easily repaid C) Payroll may be difficult to meet D) Sufficient money exists for capital projects Answer: B Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 41) The inventory turnover ratio compares: A) current assets to inventory. B) cost of goods sold to inventory. C) average receivables to inventory. D) average assets to inventory. Answer: B Difficulty: 2 Medium Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) When Tri-C Corp. compares its ratios to industry averages, it has a higher current ratio, an average quick ratio, and a lower inventory turnover. What might you assume about Tri-C? A) Its cash balance is relatively low. B) Its cost of goods sold is relatively low. C) Its current liabilities are relatively low. D) Its average inventory is relatively high. Answer: D Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-05 Compare a company's financial standing with its competitors and its own position in previous years. Bloom's: Evaluate AACSB: Analytical Thinking Accessibility: Keyboard Navigation

43) Which one of the following statements is most likely correct for a firm with an average collection period of 90 days? A) Its average daily sales are low. B) Its average daily sales are high. C) Its current ratio will be high. D) It is providing financing for approximately 25% of its annual sales. Answer: D Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) An all-equity firm reports a net profit margin of 10% on sales of $3 million. If the tax rate is 21%, what is the pretax profit A) $103,082 B) $323,421 C) $379,746 D) $726,568 Answer: C Explanation: Net profit margin = Net profit margin = (Pretax income - Taxes)/Sales .10 = (1 - .21) × Pretax income/$3,000,000 → Pretax income = $379,746 Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

45) Which of the following will allow your firm to achieve its targeted 16% ROA with an asset turnover of 2.5? A) A leverage ratio of .0667 B) A P/E ratio of 14 C) A return on equity of 25% D) An operating profit margin of 6.4% Answer: D Explanation: ROA = Operating profit margin × Asset turnover 0.16 = Operating profit margin × 2.50 Operating profit margin = 0.064, or 6.4% Difficulty: 2 Medium Topic: DuPont identity Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 46) What is the ROA of a firm with $150,000 in receivables, which represents 60 days sales, assets of $750,000, and an operating profit margin of 9%? A) 7.50% B) 9.00% C) 10.95% D) 16.70% Answer: C Explanation: Sales = ($150,000 / 60) × 365 = $912,500 ROA = Operating profit margin × Asset turnover = 0.09 × ($912,500 / $750,000) = 0.1095, or 10.95% Difficulty: 2 Medium Topic: DuPont identity Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

47) Last year's return on equity was 30%. This year the ROE has decreased to 20% even though the firm's earnings equaled last year's earnings. The firm has no preferred stock. What caused the decrease? A) Equity decreased by 10%. B) Equity decreased by 50%. C) Equity increased by 10%. D) Equity increased by 50%. Answer: D Explanation: NI = 0.3(Old equity) NI = 0.2(Old equity + New equity) 0.3(Old equity) = 0.2(Old equity + New equity) New equity = 0.5 Old equity Difficulty: 3 Hard Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 48) Which one of these costs accounts for the difference between accounting income and economic value added? A) Depreciation B) Cost of capital C) Taxes D) Dividends Answer: B Difficulty: 1 Easy Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

49) After-tax operating income for a leveraged firm is defined as: A) net income + after-tax interest. B) EBIT × (1 − tax rate). C) net income + depreciation. D) profit margin × sales. Answer: A Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 50) Which one of these changes indicates an improvement in a firm's asset management efficiency? A) An increase in the amount of assets per dollar of sales B) An increase in the inventory turnover rate C) A decrease in the receivables turnover rate D) An increase in the average days in inventory Answer: B Difficulty: 2 Medium Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

51) What is the market price of a share of stock for a firm with 100,000 shares outstanding, a book value of equity of $3,000,000, and a market-to-book ratio of 3? A) $10 B) $30 C) $90 D) $105 Answer: C Explanation: Market price per share = ($3,000,000 / 100,000) × 3 = $90 Difficulty: 2 Medium Topic: Market value ratios Learning Objective: 04-01 Calculate and interpret the market value and market value added of a public corporation. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 52) Which one of the following may be the best measure of company performance since it accounts for the opportunity cost of capital? A) EVA B) Net income C) Increase in sales D) Current ratio Answer: A Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) Which one of these statements is correct? A) Market value added measures the difference between the total market value and the total book value of equity. B) Net income is also called economic value added. C) EVA measures the net profit of a firm after deducting the cost of the assets used in the production process. D) EVA considers the cost of long-term debt financing but excludes the cost of equity financing. Answer: A Difficulty: 2 Medium Topic: Market value ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

54) The board of directors is dissatisfied with last year's ROE of 15%. If the operating profit margin and asset turnover ratio remain unchanged at 8% and 1.25, respectively, by how much must the leverage ratio (i.e., assets/equity) increase to achieve 20% ROE? A) 0.50% B) 5% C) 16.67% D) 33.33% Answer: D Explanation: Last year: ROE = leverage ratio × asset turnover × operating profit margin 0.15 = leverage ratio × 1.25 × 0.08 Leverage ratio = 1.5

This year: ROE = leverage ratio × asset turnover × operating profit margin 0.20 = leverage ratio × 1.25 × 0.08 Leverage ratio = 2

Percentage increase = (2 - 1.5) / 1.5 = 0.3333, or 33.33% Difficulty: 3 Hard Topic: DuPont identity Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

55) What must happen to asset turnover to leave ROE unchanged from its original 16% level if the operating profit margin is reduced from 8% to 6% and the leverage ratio increases from 1.2to 1.6? Asset turnover must: A) remain constant. B) increase from 1.46 to 2.33. C) decrease from 1.74 to 1.67. D) increase from 1.38 to 1.67. Answer: A Explanation: Original: ROE = leverage ratio × asset turnover × operating profit margin 0.16 = 1.2 × asset turnover × 0.08 Asset turnover = 1.67

New: 0.16 = 1.6 × asset turnover × 0.06 Asset turnover = 1.67 Difficulty: 3 Hard Topic: DuPont identity Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 56) The use of debt in the firm's capital structure will increase ROE if the firm: A) has more debt than equity. B) pays less in taxes than in interest. C) earns a higher return than the rate paid on debt. D) has a times interest earned ratio greater than 1.0. Answer: C Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

57) To calculate which of these measures do you need to know the cost of capital? A) ROC. B) ROA. C) ROE. D) EVA. Answer: D Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) A corporation declares $25 million in net income, $1 million in preferred stock dividends, and $7 million in common stock dividends. By how much will shareholders' equity increase on the balance sheet? A) $17 million B) $18 million C) $19 million D) $25 million Answer: A Difficulty: 1 Easy Topic: Income statement Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) If a firm starts the year with receivables of $80,000 and produces sales for the year of $300,000, what is its average collection period? A) 3.75 days. B) 97.3 days. C) 52 days. D) 77.9 days Answer: B Difficulty: 2 Medium Topic: Collection Policy Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) A firm's after-tax operating income was $1,000,000 in 2017. It started the year with total capital of $8,000,000 and raised an additional $1 million of capital during the year. The additional capital raised during 2017 only started to affect the operating income in 2018. Which value best represents the return on capital for 2017? A) 12.5% B) 11.8% C) 11.1% D) 10.0% Answer: A Explanation: ROC = $1,000,000/$8,000,000 = .125, or 12.5% Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

61) If ROC is less than a firm's cost of capital, which of the following must be true? A) The firm's EVA is positive. B) The firm's EVA is negative. C) The firm's ROE is equal to zero. D) The firm's ROE is negative. Answer: B Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 62) When will ROE equal ROC? A) Whenever the firm has equal debt and equity financing B) Whenever the firm has no debt C) Whenever the value of the firm's assets exceeds the value of its equity D) ROE will never equal ROC Answer: B Difficulty: 3 Hard Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) If the ratio of total liabilities to total assets is 0.5, long-term liabilities are $3,000, and equity is $5,000, then: A) you know that current liabilities must be $ 2,000. B) you know that current assets must be $400. C) you know that retained earnings must be $800. D) you know that preferred stock must be $400. Answer: A Explanation: Total liabilities / total assets = (long-term liabilities + current liabilities) / (longterm liabilities + current liabilities + equity) 0.5 = ($3,000 + current liabilities) / ($3,000 + current liabilities + $5,000) Current liabilities = $2,000 Difficulty: 3 Hard Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 64) What is the debt ratio for a firm with a debt-equity ratio of 0.5? A) 35% B) 33.3% C) 54% D) 66.7% Answer: B Explanation: If debt / equity = 0.5, then debt / (debt + equity) = 0. 5 / 1.5 = 0.333, or 33.3% Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

65) Which one of the following will increase a firm's times interest earned ratio? A) An increase in debt B) A decrease in cost of goods sold C) An increase in interest expense D) A decrease in net income Answer: B Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) Which one of the following would be most detrimental to a firm's current ratio if that ratio is currently 2? A) Collecting payment on an accounts receivable B) Selling marketable securities at cost C) Paying off accounts payable with cash D) Purchasing inventory on credit Answer: D Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 67) A retail store with zero net working capital has: A) no cash or marketable securities. B) insufficient inventory. C) no current debt. D) a quick ratio that is less than 1. Answer: D Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

68) A deficiency of the standard measures of liquidity is that the measures: A) ignore a firm's reserve borrowing capacity. B) fail to include accounts receivable as an asset. C) give inventories equal weighting in the quick ratio. D) do not include the current portions of long-term debt. Answer: A Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 69) A firm has average daily expenses of $2.13 million and average accounts payable of $112.7 million. On average, how many days does it take the firm to pay its bills? A) 63.47 days B) 52.91 days C) 48.19 days D) 59.03 days Answer: B Explanation: $112.7m / $2.13m = 52.91 days Difficulty: 2 Medium Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

70) If a company has a healthy current ratio but a significantly lower quick ratio, then you can assume that: A) the cost of goods sold represents more than half of sales. B) current liabilities exceed current assets. C) the firm sells only on a cash basis. D) inventory represents a large portion of the firm's current assets. Answer: D Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 71) Last year's asset turnover ratio was 2.0. Sales have increased by 25% and total assets have increased by 10% since that time. What is the current asset turnover ratio? A) 1.82 B) 2.05 C) 2.15 D) 2.27 Answer: D Explanation: Asset turnover = sales / total assets = 2 2 × 1.25 / 1.1 = 2.27 Difficulty: 2 Medium Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

72) What is the inventory turnover ratio for ABC Corp. if cost of goods sold equals $5,000, current ratio equals 3, quick ratio equals 1.5, and the firm has $1,800 in current assets? A) 2.78 times B) 4.17 times C) 5.56 times D) 8.33 times Answer: C Explanation: Current ratio = current assets / current liabilities 3 = $1,800 / current liabilities Current liabilities = $600 Quick ratio = (current assets − inventory) / current liabilities 1.5 = ($1,800 − inventory) / $600 Inventory = $900

Inventory turnover = cost of goods sold / inventory Inventory turnover = $5,000 / $900 Inventory turnover = 5.56 times Difficulty: 3 Hard Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

73) Assume BDS acquired its main supplier, ABC. As a result of the acquisition, BDS finds that its profit margin increased but its ROA remained constant. A decrease in which one of these ratios is most apt to be the reason why the ROA did not increase with the increase in the profit margin? A) Leverage ratio B) Market-to-book ratio C) Asset turnover D) Debt burden Answer: C Difficulty: 2 Medium Topic: DuPont identity Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) A firm's operating profit margin is 20% with an EBIT of $1.5 million and sales of $5 million. If it has no debt, how much did the firm pay in taxes? A) $50,000 B) $300,000 C) $350,000 D) $500,000 Answer: D Explanation: Without any interest expense, the operating profit margin can be computed as: Operating profit margin = (EBIT − taxes) / sales 0.20 = ($1,500,000 − taxes) / $5,000,000 Taxes = $500,000 Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

75) What is primarily responsible for the potential distortion among the ROA of different firms when net income is used in the numerator of ROA? A) Firms have different dividend payout ratios. B) Some firms use fully depreciated assets. C) Financial leverage varies among firms. D) Unprofitable firms will not have any tax liability. Answer: C Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) Which one of the following changes will provide an increase in a firm's ROE? A) A decrease in the profit margin B) An increase in the interest rate C) An increase in equity D) A decrease in the tax rate Answer: D Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 77) An increase in which one of the following will have no effect on the cash coverage ratio? A) Depreciation B) Interest C) Sales D) Cost of goods sold Answer: A Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

78) What is the book value per share for a firm with 2 million shares outstanding at a price of $50, a market-to-book ratio of 0.75, and a dividend-payout ratio of 50%? A) $33.33 B) $37.50 C) $62.50 D) $66.67 Answer: D Explanation: Market-to-book ratio = stock price / book value per share 0.75 = $50 / book value per share Book value per share = $66.67 Difficulty: 2 Medium Topic: Market value ratios Learning Objective: 04-01 Calculate and interpret the market value and market value added of a public corporation. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 79) What is the residual income for a firm that is entirely equity-financed with $1 million in capital, $300,000 in net income, and a 20% cost of capital? A) $100,000 B) $140,000 C) $240,000 D) $500,000 Answer: A Explanation: Residual income = net income − (cost of capital × total capitalization) Residual income = $300,000 − (0.20 × $1,000,000) Residual income = $100,000 Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

80) By how much must a firm reduce its assets in order to improve ROA from 10% to 12% if the firm's operating profit margin is 5% on sales of $4 million? Assume that the reduction in assets has no effect on sales or profit margin A) $240,000 B) $333,333 C) $400,000 D) $516,167 Answer: B Explanation: ROA = (sales / assets) × operating profit margin 0.10 = ($4,000,000 / assets) × 0.05 Assets = $2,000,000

0.12 = ($4,000,000 / assets) × 0.05 Assets = $1,666,667 Reduction in assets = $2,000,000 − 1,666,667 Reduction in assets = $333,333 Difficulty: 3 Hard Topic: Profitability ratios Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

81) What is the ROE for a firm with a times interest earned ratio of 2, a tax liability of $1 million, and interest expense of $1.5 million if equity equals $1.5 million? A) 26.67% B) 30.00% C) 33.33% D) 50.00% Answer: C Explanation: Times interest earned = EBIT / Interest 2 = EBIT / $1,500,000 EBIT = $3,000,000 Net income = EBIT − interest − taxes Net income = $3,000,000 − 1,500,000 − 1,000,000 Net income = $500,000

ROE = net income / equity ROE = $500,000 / $1,500,000 ROE = 0.3333, or 33.33% Difficulty: 3 Hard Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

82) Which of the following choices would be guaranteed to increase a firm's ROE if the ROA is currently 10% and the leverage ratio equals 1? A) Decrease the leverage ratio B) Increase the debt burden from its current level C) Decrease assets from the current level D) Decrease the debt burden from its current level Answer: B Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) XYZ Corp. has an operating profit margin of 7%, a debt burden of .8, and has financed twothirds of its assets through equity. What asset turnover ratio is necessary to achieve an ROE of 18%? A) 1.26 B) 1.61 C) 2.14 D) 4.02 Answer: C Explanation: ROE = leverage ratio × asset turnover × operating profit margin × debt burden 0.18 = (1 / 0.67) × asset turnover × 0.07 × 0.8 Asset turnover = 2.14 Difficulty: 2 Medium Topic: DuPont identity Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

84) The use of financial leverage will be detrimental to a firm's ROE if the: A) firm currently has no long-term debt. B) firm's current ratio is greater than 1. C) interest expense exceeds the tax liability. D) interest rate on debt exceeds the firm's ROA. Answer: D Difficulty: 2 Medium Topic: Profitability ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 85) Efficiency ratios: A) include the quick ratio, asset turnover ratio, and return on equity. B) are used to measure how well the company uses its assets. C) are used to measure how liquid the company is. D) measure the profits generated by a firm's equity and assets. Answer: B Difficulty: 1 Easy Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) A total debt ratio of 0.35: A) indicates that the firm is financed with 35% long-term debt. B) would exist if a firm had liabilities of $700 and assets of $2,000. C) indicates that 35 cents of every dollar of capital is in the form of short-term debt. D) indicates that 35 cents of every dollar of capital is in the form of long-term debt. Answer: B Explanation: Total debt ratio = total debt / assets = $700 / $2,000 = 0.35 Difficulty: 1 Easy Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

87) A company has total assets of $1,000, current liabilities of $130, and total liabilities of $350. If debt is the only long-term liability, what is the long-term debt ratio? A) 0.19 B) 0.25 C) 0.36 D) 0.31 Answer: B Explanation: Equity = assets − liabilities Equity = $1,000 − 350 Equity = $650

Long-term debt ratio = long-term debt / (long-term debt + equity) Long-term debt ratio = ($350 − 130) / [($350 − 130) + $650] Long-term debt ratio = 0.25 Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 88) If the cash coverage ratio exceeds the times interest earned ratio, then the firm has: A) a positive cash flow. B) depreciable assets. C) no long-term debt. D) short-term debts. Answer: B Difficulty: 1 Easy Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

89) Instead of increasing its long-term debt by borrowing money from a bank to purchase new stereo equipment, Jay's Jams Inc. decides to lease the equipment on a long-term basis. How will the long-term debt ratio differ if the lease option is selected over the bank-debt option? A) The ratio will be lower under the leasing option. B) The ratio will be higher under the leasing option. C) The ratio will be the same regardless of the financing method selected. D) The ratio effects are unknown without the amount of the lease obligation. Answer: C Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) Which of these assets is generally considered to be the most liquid? A) Buildings B) Land C) Finished goods inventory D) Accounts receivable Answer: D Difficulty: 1 Easy Topic: Liquidity Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) High levels of liquidity may indicate: A) low levels of net working capital. B) low profit margins. C) high levels of economic value added. D) inefficient use of assets. Answer: D Difficulty: 1 Easy Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 38

92) The current ratio is a good proxy for a firm's: A) liquidity. B) efficiency. C) degree of leverage. D) profitability. Answer: A Difficulty: 1 Easy Topic: Liquidity Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 93) If a company uses cash to pay off some of its accounts payables, what effect will this have on its liquidity ratios, given that the ratios exceeded 1 before the payoff? A) The quick ratio and current ratio will both increase. B) The quick ratio and current ratio will both decrease. C) The quick ratio will increase but the current ratio will remain unchanged. D) The current ratio will increase but the quick ratio will remain unchanged. Answer: A Difficulty: 2 Medium Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

94) TSI Inc. has liquid assets of $1,000, enough to finance its operations for 67 days. TSI's average daily expenditures from operations are: A) $6.70. B) $8.23. C) $14.93. D) $22.28. Answer: C Explanation: Average daily expenditures = $1,000 / 67 = $14.93 Difficulty: 2 Medium Topic: Liquidity Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 95) An asset turnover ratio of 1.75 can be interpreted as: A) $1.75 in sales are generated by every $1 of assets. B) $1.75 in additional assets are generated by every $1 of sales. C) $1.75 in assets are used to generate $1 of sales. D) $1 in sales are used to generate $1.75 in assets. Answer: A Difficulty: 1 Easy Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 96) Which of these indicates that a firm is efficient? A) A high average collection period B) A high day's sales in inventories C) A low asset turnover D) A high inventory turnover Answer: D Difficulty: 1 Easy Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40

97) Calculate the average collection period for Dots Inc. if its accounts receivables were $550 at the beginning of a year in which the firm generated $3,000 of sales? A) 60 days B) 61 days C) 67 days D) 73 days Answer: C Explanation: Average collection period = $550 / ($3,000 / 365) = 67 days Difficulty: 2 Medium Topic: Asset management ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 98) Which one of these ratios is commonly referred to as the acid-test ratio? A) Times interest earned ratio B) Quick ratio C) Cash coverage ratio D) Cash ratio Answer: B Difficulty: 1 Easy Topic: Short-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

99) Balsco's balance sheet shows total assets of $238,000 and total liabilities of $107,000. The firm has 55,000 shares of stock outstanding that sell for $11 a share. What is amount of market value added? A) $389,000 B) $474,000 C) $1,073,000 D) $123,712 Answer: B Explanation: Market value added = (55,000 × $11) − ($238,000 − 107,000) = $474,000 Difficulty: 2 Medium Topic: Market value ratios Learning Objective: 04-01 Calculate and interpret the market value and market value added of a public corporation. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 100) What will be Gamma Inc.'s return on equity if total asset turnover is 0.85, operating profit margin is 0.15, two-thirds of its assets are financed through equity, and debt burden is 0.6? A) 9.56% B) 11.48% C) 16.96% D) 38.25% Answer: B Explanation: Leverage ratio = 1 / 0.67 ROE = leverage ratio × asset turnover × operating profit margin × debt burden ROE = 1.5 × 0.85 × 0.15 × 0.6 ROE = 0.1148, or 11.48% Difficulty: 2 Medium Topic: DuPont identity Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

101) Which of the following is not a problem with EVA? A) EVA cannot be used to measure the profitability of a private company B) EVA cannot be used to compare the effectiveness of managers with different amounts of assets under their control C) EVA assumes that the book values of assets are equal to their current worth D) EVA assumes that you know the cost of capital Answer: A Difficulty: 2 Medium Topic: Market value ratios Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Bloom's: Understand AACSB: Analytical Thinking Accessibility: Keyboard Navigation

102) In the past year, TVG had revenues of $3 million, cost of goods sold of $2.5 million, and depreciation expense of $200,000. The firm has a single issue of debt outstanding with a face value of $1 million, market value of $.92 million, and a coupon rate of 8%. What is the firm's times interest earned ratio? A) 3.75 B) 2.98 C) 2.80 D) 3.40 Answer: A Explanation: EBIT = revenues − COGS − depreciation EBIT = $3,000,000 − 2,500,000 − 200,000 EBIT = $300,000

Interest payments = 0.08 × $1,000,000 Interest payments = $80,000

Times interest earned = EBIT / interest payments Times interest earned = $300,000 / $80,000 Times interest earned = 3.75 Difficulty: 2 Medium Topic: Long-term solvency ratios Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 5 The Time Value of Money 1) Compound interest pays interest for each time period on the original investment plus the accumulated interest. Answer: TRUE Difficulty: 1 Easy Topic: Simple and compound interest Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) When money is invested at compound interest, the growth rate is the interest rate. Answer: TRUE Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) For a given amount, the lower the discount rate, the less the present value. Answer: FALSE Difficulty: 1 Easy Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 4) Present values decline as the time to the cash flows increases. Answer: TRUE Difficulty: 1 Easy Topic: Present value-multiple cash flows Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

5) The present value of an annuity due equals the present value of an ordinary annuity times the discount rate. Answer: FALSE Difficulty: 1 Easy Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) A perpetuity is a special form of an annuity. Answer: TRUE Difficulty: 1 Easy Topic: Perpetuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 7) An annuity factor represents the future value of $1 that is deposited today. Answer: FALSE Difficulty: 2 Medium Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 8) With a fixed-rate mortgage, the proportion of each payment used to pay interest on the loan declines over time. Answer: TRUE Difficulty: 2 Medium Topic: Amortization Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

9) Converting an annuity to an annuity due decreases the present value. Answer: FALSE Difficulty: 1 Easy Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) It is important to discount both real and nominal cash flows at the real interest rate. Answer: FALSE Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) The term "constant dollars" refers to equal payments for amortizing a loan. Answer: FALSE Difficulty: 2 Medium Topic: Present value-multiple cash flows Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 12) Nominal dollars refer to their purchasing power. Answer: FALSE Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

13) When inflation is positive, the nominal interest rate is larger than the real rate. Answer: TRUE Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) The effective annual interest rate cannot be less than the annual percentage rate. Answer: TRUE Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) The more frequent the compounding, the higher the future value, other things equal. Answer: TRUE Difficulty: 1 Easy Topic: Future value-single cash flow Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16) An annual percentage rate (APR) is determined by annualizing the rate using compound interest. Answer: FALSE Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

17) A dollar tomorrow is worth more than a dollar today. Answer: FALSE Difficulty: 2 Medium Topic: Future value-single cash flow Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) To calculate present value, we discount the future value by some interest rate r, the discount rate. Answer: TRUE Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) The discount factor is used to calculate the present value of $1 received in year t. Answer: TRUE Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20) You should never compare cash flows occurring at different times without first discounting them to a common date. Answer: TRUE Difficulty: 2 Medium Topic: Present value-multiple cash flows Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

21) Present values can always be calculated by dividing the cash flow by a discount factor. Answer: FALSE Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) The five-year discount factor is less than the four-year discount factor. Answer: TRUE Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) As long as the interest rate is positive, the future value will always be larger than the present value given any period of time. Answer: TRUE Difficulty: 2 Medium Topic: Future value-single cash flow Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) An annuity due must have a present value at least as large as an equivalent ordinary annuity. Answer: TRUE Difficulty: 2 Medium Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

25) Any sequence of equally spaced, level cash flows is called an annuity. An annuity is also known as a perpetuity. Answer: FALSE Difficulty: 2 Medium Topic: Perpetuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) Increasing the frequency in payments on a loan can decrease the annual percentage rate paid on the loan. Answer: FALSE Difficulty: 2 Medium Topic: Perpetuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) A mortgage loan is an example of an amortizing loan. "Amortizing" means that part of the monthly payment is used to pay interest on the loan and part is used to reduce the amount of the loan. Answer: TRUE Difficulty: 2 Medium Topic: Amortization Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

28) When considering compounding, a semi-annual interest rate will need to be one half the annual rate to achieve the same return. Answer: FALSE Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Understand; Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 29) What is the future value of $10,000 on deposit for 2 years at 6% simple interest? A) $10,600 B) $11,236 C) $11,200 D) $13,382.26 Answer: C Explanation: FV = $10,000 + 2 × 0.06 × 10,000 = $11,200 Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 30) If the five-year discount factor is d, what is the present value of $1 received in five years' time? A) 1/(1 + d)5 B) 1/d. C) 5d. D) d. Answer: D Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

31) How much interest is earned in just the third year on a $1,000 deposit that earns 7% interest compounded annually? A) $70.00 B) $80.14 C) $105.62 D) $140.00 Answer: B Explanation: $1000.00 × (1.07)2 = $1,144.90 after 2 years $1,144.90 × 0.07 = $80.14 Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32) How much interest will be earned in the next year on an investment paying 12% compounded annually if $100 was just credited to the account for interest? A) $88 B) $100 C) $112 D) $200 Answer: C Explanation: The investment will again pay $100 plus interest on the previous interest: $100 × 1.12 = $112 Difficulty: 3 Hard Topic: Simple and compound interest Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

33) The concept of compound interest refers to: A) earning interest on the original investment. B) payment of interest on previously earned interest. C) investing for a multiyear period of time. D) determining the APR of the investment. Answer: B Difficulty: 1 Easy Topic: Simple and compound interest Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 34) If interest is compounded semi-annually rather than annually, then: A) future values and present values will both be higher. B) futures values and present values will both be lower. C) future values will be lower and present values will be higher. D) Future values will be higher and present values will be lower. Answer: D Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

35) Assume the total expense for your current year in college equals $20,000. How much would your parents have needed to invest 21 years ago in an account paying 8% compounded annually to cover this amount? A) $952.46 B) $1,600.00 C) $1,728.08 D) $3,973.11 Answer: D Explanation: PV = $20,000 / (1.08)21 PV = $3,973.11 Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 36) An investment offers to pay $100 a year forever starting at the end of year 6. If the interest rate is 8%, what is the investment's value today? A) $787.71 B) $850.73 C) $1,250 D) $1,586.87 Answer: B Explanation: It will be worth 100 / 0.08 = $1,250 at the end of year 5, and therefore worth $1,250 / 1.085 = $850.73 today. Difficulty: 2 Medium Topic: Perpetuities Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

37) An investment of $100 pays interest of 2.5% per quarter. What will be the value of this investment at the end of 3 years? A) $107.69 B) $133.10 C) $134.49 D) $313.84 Answer: C Explanation: FV = PV(1 + r)t =100 × 1.02512 = $134.49 Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 38) To achieve an annual return of 7.0%, an investment that is compounded semi-annually, would need to earn how much every six months? A) 3.44% B) 3.50% C) 3.64% D) 7.00% Answer: A Explanation: 1.07 = (1 + r)2 R = 0.0344 or 3.44 % Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

39) A car's price is currently $20,000 and is expected to rise by 4% a year. If the interest rate is 6%, how much do you need to put aside today to buy the car one year from now? A) $18,182 B) $19,231 C) $19,623 D) $4,080.08 Answer: C Explanation: Future price of car = ($20,000 × 1.04) = $20,800 PV = $ 20,800 / (1.06) = $19,623 Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 40) If the 5-year discount factor is 0.7008, what is the interest rate? A) 5.43% B) 7.37% C) 8.00% D) 9.50% Answer: B Explanation: FV = PV(1 + r)t 0.7008 = 1/(1 + r)5 r = 0.0737, or 7.37% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

41) The bank offers a credit card with an initial promotional rate of 0.0%. After six months, the rate adjusts to 21%. If no payments are required on an initial balance of $10,000, and the bank calculates payments based on a five year repayment schedule, what will the monthly payment be after six months? A) $210.87 B) $245.25 C) $270.53 D) $302.22 Answer: C Explanation: $10,000 = PMT([1/(1.75)] - 1/{(1.75)[(2.75)]5 × 12}) PMT = $270.53 Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 42) Given the future value, which of the following will contribute to a lower present value? A) Higher discount rate B) Fewer time periods C) Less frequent discounting D) Lower discount factor Answer: A Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

43) Cash flows occurring in different periods should not be compared unless: A) interest rates are expected to be stable. B) the flows occur no more than one year from each other. C) high rates of interest can be earned on the flows. D) the flows have been discounted to a common date. Answer: D Difficulty: 1 Easy Topic: Present value-multiple cash flows Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) What will be the approximate population of the United States, if its current population of 300 million grows at a compound rate of 2% annually for 25 years? A) 413 million B) 430 million C) 488 million D) 492 million Answer: D Explanation: FV = PV(1 + r)t FV = 300 million × (1.02)25 FV = 492.2 million ≈ 492 million Difficulty: 2 Medium Topic: Future value-single cash flow Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

45) If the future value of an annuity due is $25,000 and $24,000 is the future value of an ordinary annuity that is otherwise similar to the annuity due, what is the implied discount rate? A) 1.04% B) 4.17% C) 5.00% D) 8.19% Answer: B Explanation: FVAD = FVOA × (1 + r) $25,000 = $24,000 × (1 + r) r = 0.0417, or 4.17% Difficulty: 2 Medium Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 46) A furniture store is offering free credit on purchases over $1,000. You observe that a bigscreen television can be purchased for nothing down and $4,000 due in one year. The store next door offers an identical television for $3,650 but does not offer credit terms. Which statement below best describes the cost of the "free" credit? A) 8.75% B) 9.13% C) 9.59% D) 0% Answer: C Explanation: FV = PV(1 + r)t $4,000 = $3,650(1 + r) r = 0.0959, or 9.59% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

47) How much must be invested today in order to generate a 5-year annuity of $1,000 per year, with the first payment 1 year from today, at an interest rate of 12%? A) $3,604.78 B) $3,746.25 C) $4,037.35 D) $4,604.78 Answer: A Explanation: PV = $1,000{(1 / 0.12) − [1 / 0.12(1.125)]} PV = $3,604.78 Difficulty: 2 Medium Topic: Present value-annuity Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 48) The salesperson offers, "Buy this new car for $25,000 cash or, with an appropriate down payment, pay $500 per month for 48 months at 8% interest." Assuming that the salesperson does not offer a free lunch, calculate the "appropriate" down payment. A) $1,000.00 B) $4,519.04 C) $5,127.24 D) $8,000.00 Answer: B Explanation: PV = $500 × {[1 / (0.08 / 12)] − [1/(0.08 / 12)(1 + (0.08 / 12)48)]} PV = $20,480.96 Down payment = $25,000 − 20,480.96 = $4,519.04 Difficulty: 2 Medium Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

49) What is the present value of the following payment stream, discounted at 8% annually: $1,000 at the end of year 1, $2,000 at the end of year 2, and $3,000 at the end of year 3? A) $5,022.10 B) $5,144.03 C) $5,423.87 D) $5,520.00 Answer: A Explanation: PV = $1,000 / 1.08 + $2,000 / 1.082 + $3,000 / 1.083 PV = $5,022.10 Difficulty: 2 Medium Topic: Present value-multiple cash flows Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 50) You invested $1,200 three years ago. During the three years, you earned annual rates of return of 4.8%, 9.2%, and 11.6%. What is the value of this investment today? A) $1,498.08 B) $1,512.11 C) $1,532.60 D) $1,549.19 Answer: C Explanation: FV = PV(1 + r)t FV = PV(1 + r)t (1 + r)t (1 + r)t FV = $1,200(1.048)1 (1.092)1 (1.116)1 FV = $1,532.60 Difficulty: 3 Hard Topic: Future value-single cash flow Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

51) You will be receiving cash flows of: $1,000 today, $2,000 at end of year 1, $4,000 at end of year 3, and $6,000 at end of year 5. What is the present value of these cash flows at an interest rate of 7%? A) $9,731.13 B) $10,412.27 C) $10,524.08 D) $11,524.91 Answer: B Explanation: PV = FV / (1 + r)t PV = $1,000 + $2,000 / 1.071 + $4,000 / 1.073 + $6,000 / 1.075 PV = $10,412.27 Difficulty: 3 Hard Topic: Present value-multiple cash flows Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 52) Someone offers to buy your car for four, equal annual payments, beginning 2 years from today. If you think that the present value of your car is $9,000 and the interest rate is 10%, what is the minimum annual payment that you would accept? A) $2,839.24 B) $3,435.48 C) $3,123.16 D) $2,250 Answer: C Explanation: PV = C{(1 / 0.1) − [1 / (0.1 × 1.14)]} / 1.1 = $9,000 C = $3,123.16 Difficulty: 3 Hard Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

53) How much more is a perpetuity of $1,000 worth than an annuity of the same amount for 20 years? Assume an interest rate of 10% and cash flows at the end of each period. A) $297.29 B) $1,486.44 C) $1,635.08 D) $2,000.00 Answer: B Explanation: PVPerpetuity = $1,000 / 0.10 = $10,000 PVAnnuity = $1,000[1 / 0.10 − 1 / 0.10(1.10)20] PVAnnuity = $8,513.56 Difference = $10,000 − 8,513.56 = $1,486.44 Difficulty: 3 Hard Topic: Perpetuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 54) A stream of equal cash payments lasting forever is termed: A) an annuity. B) an annuity due. C) an installment plan. D) a perpetuity. Answer: D Difficulty: 1 Easy Topic: Perpetuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

55) If the interest rate is 6%, which of these investments would you prefer? A) A single payment of $500 in year 3. B) A payment of $40 a year for 20 years starting in one year's time. C) A perpetuity of $30 a year starting in one year's time. D) A payment of $342.17 today Answer: C Explanation: PV($500 in year 3) = 500 / 1.063 = $419.81 PV ($40 a year for 20 years) = 40(1 / 0.06 − 1 / (0.06 × 1.0620)) = $458.80 PV ($30 in perpetuity) = 30 / 0.06 = $500 Difficulty: 3 Hard Topic: Present value-multiple cash flows Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) The present value of a perpetuity can be determined by: A) multiplying the payment by the interest rate. B) dividing the interest rate by the payment. C) multiplying the payment by the number of payments to be made. D) dividing the payment by the interest rate. Answer: D Difficulty: 1 Easy Topic: Perpetuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

57) You are borrowing $245,000 to purchase a home. The loan agreement requires a monthly payment based upon a 4.5% quoted APR over 20 years. What is your monthly mortgage payment? (Round to two decimal places) A) $1,326.33 B) $1,549.99 C) $1,783.87 D) $1,803.65 Answer: B Explanation: $245,000 = PMT([1/(.00375)] - 1/{(.00375)[(1.00375)]20 × 12}) PMT = $1,549.99 Difficulty: 2 Medium Topic: Loan payments Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 58) A perpetuity of $5,000 per year beginning today offers a 15% return. What is its present value? A) $33,333.33 B) $37,681.16 C) $38,333.33 D) $65,217.39 Answer: C Explanation: PV = $5,000 + $5,000 / r PV = $5,000 + $5,000 / 0.15 PV = $5,000 + $5,000 / 0.15 PV = $38,333.33 Difficulty: 3 Hard Topic: Perpetuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

59) A bond promises to pay $1,000 20 years from today. No interest will be paid on the bonds during the 20 years If the interest rate is 7%, what is the bond's present value? A) $50 B) $258.42 C) $629.56 D) $1,000 Answer: B Explanation: PV = FV / (1 + r)t = $1,000 / 1.0720 = $258.42 Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 60) Your car loan requires payments of $200 per month for the first year and payments of $400 per month during the second year. The APR is 12% and payments begin in one month. What is the present value of this 2-year loan? A) $6,246.34 B) $6,389.78 C) $6,428.57 D) $6,753.05 Answer: A Explanation: PV = {$200 {(1 / 0.01) − [1 / 0.01(1.01)12]}} + ({$400 {(1 / 0.01) − [1 / 0.01(1.01)12]} / 1.0112)} PV = $6,246.34 Difficulty: 3 Hard Topic: Present value-annuity Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

61) Which one of the following will increase the present value of an annuity, other things equal? A) Increasing the interest rate B) Decreasing the interest rate C) Decreasing the number of payments D) Decreasing the amount of the payment Answer: B Difficulty: 1 Easy Topic: Present value-annuity Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 62) What is the present value of a five-period annuity of $3,000 if the interest rate per period is 12% and the first payment is made today? A) $9,655.65 B) $10,814.33 C) $12,112.05 D) $13,200.00 Answer: C Explanation: PVAD = PVOA × (1 + r) PVAD = {$3,000[1 / 0.12 − 1 / 0.12(1.12)5]} × 1.12 PVAD = $12,112.05 Difficulty: 2 Medium Topic: Present value-annuity Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

63) The sum of $3,000 is deposited into an account paying 10% annually. If $1,206 is withdrawn at the end of years 1 and 2, how much then remains in the account?" A) $1,326.97 B) $1,206.34 C) $1,097.40 D) $587.32 Answer: C Explanation: FVYear 1 = PV(1 + r) − Withdrawal FVYear 1 = $3,000(1.1) − $1,206 FVYear 1 = $2,094 FVYear 2 = FVYear 1 (1 + r) − Withdrawal FVYear 2 = $2,094(1.1) − $1,206FVYear 2 = $1,097.40 Difficulty: 3 Hard Topic: Future value-single cash flow Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

64) Suppose you take out a 30-year mortgage for $100,000 with annual payments. The interest rate on the mortgage is 8%. When you have paid off half the mortgage, so that the value of the remaining payments is reduced to $50,000, how many more payments need to be made? A) Approximately 15 payments B) Approximately 12 payments C) Approximately 8 payments D) Approximately 20 payments Answer: C Explanation: Solve first for the annual payment: $100,000 = PMT(1 / 0.08 − 0.08 × 1.0830). PMT = $8,882.74 PV = PMT [(1 / r) − 1 / r(1 + r)t] $50,000 = 8,882.74{1 / 0.08−1 / (0.08 × 1.08t} Either use logs or trial and error to find t ≈ 8 Difficulty: 3 Hard Topic: Amortization Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 65) What is the present value of a four-year annuity of $100 per year that makes its first payment 2 years from today if the discount rate is 9%? A) $297.22 B) $323.97 C) $356.85 D) $272.68 Answer: A Explanation: PV = {$100[(1 / 0.09) − 1 / 0.09(1.09)4]} / 1.09 PV = $297.22 Difficulty: 3 Hard Topic: Present value-annuity Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

66) If $120,000 is borrowed for a home mortgage, to be repaid at 9% interest over 30 years with annual payments of $11,680.36, how much interest (as opposed to return of capital) is paid in the last year of the loan? A) $918.25 B) $942.51 C) $978.43 D) $964.43 Answer: D Explanation: Value of loan at start of last year = $11,680.36 / 1.09 = $10,715.93 Interest on loan in last year = 0.09 × $10,715.93 = $964.43 Difficulty: 2 Medium Topic: Amortization Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 67) $50,000 is borrowed, to be repaid in three equal, annual payments with 10% interest. Approximately how much principal is amortized with the first payment? A) $2,010.60 B) $5,000.00 C) $15,105.74 D) $20,105.74 Answer: C Explanation: Payment = $50,000 / [1 / 0.1 − 1 / 0.1(1.1)3] Payment = $20,105.74 Principal payment = $20,105.74 − ($50,000 × 0.1) Principal payment = $15,105.74 Difficulty: 2 Medium Topic: Amortization Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

68) An amortizing loan is one in which: A) the principal remains unchanged with each payment. B) accrued interest is paid regularly. C) the maturity of the loan is variable. D) the principal balance is reduced with each payment. Answer: D Difficulty: 1 Easy Topic: Amortization Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 69) You're ready to make the last of four equal, annual payments on a $1,000 loan with a 10% interest rate. If the amount of the payment is $315.47, how much of that payment is accrued interest? A) $28.68 B) $31.55 C) $100.00 D) $315.47 Answer: A Explanation: $315.47 − ($315.47 / 1.1) = $28.68 Difficulty: 3 Hard Topic: Amortization Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

70) What will be the monthly payment on a $75,000 30-year home mortgage at 1% interest per month? A) $771.46 B) $775.90 C) $1,028.61 D) $1,034.53 Answer: A Explanation: Payment = $75,000 / [(1 / 0.01) − 1 / 0.01(1.01)360] Payment = $771.46 Difficulty: 2 Medium Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 71) Your real estate agent mentions that homes in your price range require a payment of $1,200 per month for 30 years at 0.75% interest per month. What is the size of the mortgage with these terms? A) $128,035.05 B) $147,940.29 C) $149,138.24 D) $393,120.03 Answer: C Explanation: PV = $1,200[(1 / 0.0075) − 1 / 0.0075(1.0075)360] PV = $149,138.24 Difficulty: 2 Medium Topic: Present value-annuity Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

72) Assume you are making $989 monthly payments on your amortized mortgage. The amount of each payment that is applied to the principal balance: A) decreases with each succeeding payment. B) increases with each succeeding payment. C) is constant throughout the loan term. D) fluctuates monthly with changes in market interest rates. Answer: B Difficulty: 1 Easy Topic: Amortization Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) How much must be saved at the end of each year for the next 10 years in order to accumulate $50,000, if you can earn 9% annually? Assume you contribute the same amount to your savings every year. A) $3,291.00 B) $3,587.87 C) $4,500.33 D) $4,587.79 Answer: A Explanation: Payment = $50,000 / [(1.0910 − 1) / 0.09] Payment = $3,291.00 Difficulty: 2 Medium Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

74) Your retirement account has a current balance of $50,000. You plan to add $6,000 a year to the account for each of the next 30 years. Use a financial calculator or Excel to find what interest rate you need to earn in order to have $1,000,000 in the account at the end of the 30 years? A) 5.02% B) 7.24% C) 9.80% D) 10.07% Answer: B Explanation: Financial calculator: n = 30; PV = −50,000; PMT = −6,000; FV = 1,000,000; CPT i = 7.24%, or Excel function Rate(nper, PMT, PV, FV) Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 75) How much do you need when you retire to provide a $2,500 monthly check that will last for 25 years? Assume that your savings can earn 0.5% a month. A) $361,526.14 B) $388,017.16 C) $402,766.67 D) $414,008.24 Answer: B Explanation: Monthly interest rate = 0.06 / 12 = 0.005 PV = $2,500 {(1 / 0.005) − [1 / 0.005(1.005)12 × 25]} PV = $388,017.16 Difficulty: 2 Medium Topic: Present value-annuity Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

76) The present value of an annuity stream of $100 per year is $614 when valued at a 10% rate. By approximately how much would the value change if these were annuities due? A) $10 B) $61.40 C) $10 × Number of years in annuity stream D) $6.14 × Number of years in annuity stream Answer: B Explanation: PVAnnuity due = PV ordinary annuity × (1 + r) Difference = $614(1.1) − $614 = $61.40 Difficulty: 2 Medium Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 77) Approximately how much must be saved for retirement in order to withdraw $100,000 per year for the next 25 years if the balance earns 8% annually, and the first payment occurs one year from now? A) $1,067,477.62 B) $1,128,433.33 C) $1,487,320.09 D) $1,250,000.00 Answer: A Explanation: PV = $100,000 {(1 / 0.08) − [1 / 0.08(1.08)25]} PV = $1,067,477.62 Difficulty: 2 Medium Topic: Present value-annuity Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

78) You have just retired with savings of $1.5 million. If you expect to live for 30 years and to earn 8% a year on your savings, how much can you afford to spend each year? Assume that you spend the money at the start of each year. A) $112,148.50 B) $120,000.00 C) $123,371.44 D) $133,241.15 Answer: C Explanation: $1,500,000 = PmtOA {(1 / 0.08) − [1 / 0.08(1.08)30]} PMTOA = $133,241.15 PMTAD = PMTOA / (1 + r) PMTAD = $133,241.15 / 1.08 PMTAD = $123,371.44 Difficulty: 2 Medium Topic: Annuities Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 79) How much can be accumulated for retirement if $2,000 is put aside at the end of each of the next 40 years? Assume that you can earn 9% a year on your savings. A) $87,200.00 B) $675,764.89 C) $736,583.73 D) $802,876.27 Answer: B Explanation: FV = $2,000 {[(1 + 0.09)40 − 1] / 0.09} FV = $675,764.89 Difficulty: 2 Medium Topic: Future value-annuity Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

80) If inflation in Wonderland was 3% per month in 2016, what was the annual rate of inflation? A) 36.00% B) 42.58% C) 40.09% D) 41.27% Answer: B Explanation: (1.03)12 − 1 = 0.4258, or 42.58% Difficulty: 2 Medium Topic: Simple and compound interest Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 81) Assume your uncle recorded his salary history during a 40-year career and found that it had increased 10-fold. If inflation averaged 4% annually during the period, then over his career his purchasing power: A) remained on par with inflation. B) increased by nearly 1% annually. C) increased by nearly 2% annually. D) decreased. Answer: C Explanation: FV = PV(1 + r)t 10 = 1(1 + i)40 r = 5.93% Real rate = (1.0593 / 1.04) − 1 = 0.0186, or 1.86% Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

82) Real interest rates: A) always exceed inflation rates. B) can decline to zero but no lower. C) can be negative, zero, or positive. D) traditionally exceed nominal rates. Answer: C Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) On the day you retire you have $1,000,000 saved. You expect to live another 25 years during which time you expect to earn 6.19% on your savings while inflation averages 2.5% annually. Assume you want to spend the same amount each year in real terms and die on the day you spend your last dime. What real amount will you be able to spend each year? A) $61,334.36 B) $79,644.58 C) $79,211.09 D) $61,931.78 Answer: A Explanation: Real rate = (1.0619 / 1.025) − 1 = 0.036 $1,000,000 = PMT {(1 / 0.036) − [1 / 0.036(1.036)25]} PMT = $61,334.36 Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

84) What is the expected real rate of interest for an account that offers a 12% nominal rate of return when the rate of inflation is 6% annually? A) 5.00% B) 5.66% C) 6.00% D) 9.46% Answer: B Explanation: 1 + real interest rate = (1 + nominal interest rate) / (1 + inflation) 1 + real interest rate = 1.12 / 1.06 Real interest rate = 5.66% Difficulty: 1 Easy Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 85) What happens over time to the real cost of purchasing a home if the mortgage payments are fixed in nominal terms and inflation is in existence? A) The real cost is constant. B) The real cost is increasing. C) The real cost is decreasing. D) The price index must be known to answer this question. Answer: C Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

86) What is the minimum nominal rate of return that you should accept if you require a 4% real rate of return and the rate of inflation is expected to average 3.5% during the investment period? A) 7.36% B) 7.50% C) 7.64% D) 8.01% Answer: C Explanation: 1 + nominal rate = (1 + real rate)(1 + inflation rate) Nominal rate = (1.04 × 1.035) − 1 Nominal rate = 7.64% Difficulty: 1 Easy Topic: Nominal and real rates Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 87) What APR is being earned on a deposit of $5,000 made 10 years ago today if the deposit is worth $9,848.21 today? The deposit pays interest semiannually. A) 3.56% B) 6.76% C) 6.89% D) 7.12% Answer: C Explanation: FV = PV (1 + r)t $9,848.21 = $5,000 [1 + (r / 2)]10 × 2 r = 6.89% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

88) An interest rate that has been annualized using compound interest is termed the: A) discount factor. B) annual percentage rate. C) discounted interest rate. D) effective annual interest rate. Answer: D Difficulty: 1 Easy Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) What is the effective annual rate of interest on a deposit that pays interest of 10% continuously compounded? A) 10.000% B) 10.517% C) 1.105% D) 9.531% Answer: B Explanation: Effective interest rate = e0.1 − 1 = 0.10517, or 10.517% Difficulty: 3 Hard Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

90) What is the relationship between an annually compounded rate and the annual percentage rate (APR) which is calculated for truth-in-lending laws for a loan requiring monthly payments? A) The APR is lower than the annually compounded rate. B) The APR is higher than the annually compounded rate. C) The APR equals the annually compounded rate. D) The answer depends on the interest rate. Answer: A Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) What is the APR on a loan that charges interest at the rate of 1.4% per month? A) 10.20% B) 14.00% C) 16.80% D) 18.16% Answer: C Explanation: APR = 1.4% × 12 = 16.80% Difficulty: 1 Easy Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 92) If interest is paid m times per year, then the per-period interest rate equals the: A) effective annual rate divided by m. B) compound interest rate times m. C) effective annual rate. D) annual percentage rate (APR) divided by m. Answer: D Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39

93) If the effective annual rate of interest is known to be 16.08% on a debt that has quarterly payments, what is the annual percentage rate? A) 4.02% B) 10.02% C) 14.50% D) 15.19% Answer: D Explanation: APR = [(1.1608)0.25 − 1] × 4 APR = 0.1519, or 15.19% Difficulty: 3 Hard Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 94) Would a depositor prefer an APR of 8% with monthly compounding or an APR of 8.5% with semiannual compounding? A) 8.0% with monthly compounding B) 8.5% with semiannual compounding C) The depositor would be indifferent. D) The time period must be known to select the preferred account. Answer: B Explanation: EAR = [1 + (0.08 / 12)]12 − 1 = 8.30% EAR = [1 + (0.085 / 2)]2 − 1 = 8.68% The depositor will prefer the option with the higher EAR (effective annual rate). Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

95) What is the annually compounded rate of interest on an account with an APR of 10% and monthly compounding? A) 10.00% B) 10.47% C) 10.52% D) 11.05% Answer: B Explanation: EAR = [1 + (0.10 / 12)] 12 − 1 = 0.1047, or 10.47% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 96) What is the APR on a loan with an effective annual rate of 15.26% and weekly compounding of interest? A) 14.35% B) 14.49% C) 13.97% D) 14.22% Answer: D Explanation: APR = [(1.1526)1 / 52 − 1] × 52 = 0.1422, or 14.22% Difficulty: 3 Hard Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

97) What is the effective annual interest rate on a 9% APR automobile loan that has monthly payments? A) 9.00% B) 9.38% C) 9.81% D) 10.94% Answer: B Explanation: EAR = [1 + (0.09 / 12)]12 − 1 = 0.0938, or 9.38% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 98) Other things being equal, the more frequent the compounding period, the: A) higher the annual percentage rate. B) lower the annual percentage rate. C) higher the effective annual interest rate. D) lower the effective annual interest rate. Answer: C Difficulty: 1 Easy Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

99) How much interest will be earned in an account into which $1,000 is deposited for one year with continuous compounding at a 13% rate? A) $130.00 B) $138.83 C) $169.00 D) $353.34 Answer: B Explanation: Interest = $1,000(e0.13) − $1,000 = $138.83 Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 100) What is the present value of $100 to be deposited today into an account paying 8%, compounded semiannually for 2 years? A) $85.48 B) $100.00 C) $116.00 D) $116.99 Answer: B Difficulty: 1 Easy Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

101) If a borrower promises to pay you $1,900 nine years from now in return for a loan of $1,000 today, what effective annual interest rate is being offered if interest is compounded annually? A) 5.26% B) 7.39% C) 9.00% D) 10.00% Answer: B Explanation: FV = PV × (1 + r)t $1,900 = $1,000 × (1 + r)9 r = 1.91 / 9 − 1 r = 0.0739, or 7.39% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 102) What is the present value of your trust fund if you have projected that it will provide you with $50,000 7 years from today and it earns 10% compounded annually? A) $25,000.00 B) $25,657.91 C) $28,223.70 D) $29,411.76 Answer: B Explanation: PV = FV / (1 + r)t PV = $50,000 / 1.107 PV = $25,657.91 Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

103) What is the discount factor for $1 to be received in 5 years at a discount rate of 8%? A) 0.4693 B) 0.5500 C) 0.6000 D) 0.6806 Answer: D Explanation: PV = FV / (1 + r)t PV = 1 / 1.085 PV = 0.6806 Difficulty: 2 Medium Topic: Present value-single cash flow Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 104) How much more would you be willing to pay today for an investment offering $10,000 in 4 years rather than in 5 years? Your discount rate is 8%. A) $544.47 B) $681.48 C) $740.74 D) $800.00 Answer: A Explanation: Difference = FV / (1 + r)t − 1 − FV / (1 + r) Difference = $10,000 / 1.084 − $10,000 / 1.085 Difference = $544.47 Difficulty: 2 Medium Topic: Present value-multiple cash flows Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

105) "Give me $5,000 today and I'll return $10,000 to you in 5 years," offers the investment broker. To the nearest percent, what annual interest rate is being offered? A) 12.29% B) 13.67% C) 14.87% D) 12.84% Answer: C Explanation: FV = PV(1 + r)t $10,000 = $5,000(1 + r)5 r = 21 / 5 − 1 r = 0.1487, or 14.87% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 106) The APR on a loan must be equal to the effective annual rate when: A) compounding occurs monthly. B) compounding occurs annually. C) the loan is for less than one year. D) the loan is for more than one year. Answer: B Difficulty: 1 Easy Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

107) A car dealer offers payments of $522.59 per month for 48 months on a $25,000 car after making a $4,000 down payment. What is the loan's APR? A) 6% B) 9% C) 11% D) 12% Answer: B Explanation: $25,000 − 4,000 = $522.59 {(1 / r) − [1 / r(1 + r)48]} Using a financial calculator or Excel, r = 0.0075 APR = 0.0075 × 12 APR = 0.09, or 9% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 108) A credit card account that charges interest at the rate of 1.25% per month would have an annually compounded rate of and an APR of . A) 16.08%; 15.00% B) 14.55%; 16.08% C) 12.68%; 15.00% D) 15.00%; 14.55% Answer: A Explanation: EAR = (1 + 0.0125)12 − 1 = 0.1608, or 16.08% APR = 1.25% × 12 = 15.00% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

109) Eighteen years from now, 4 years of college are expected to cost $150,000. How much more must be deposited into an account today to fund this expense if you can earn only 8% on your savings rather than the 11% you hope to earn? A) $12,211.18 B) $13,609.21 C) $14,006.41 D) $14,614.03 Answer: D Explanation: Additional deposit = $150,000 / 1.0818 − $150,000 / 1.1118 Additional deposit = $14,614.03 Difficulty: 2 Medium Topic: Present value-multiple cash flows Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 110) Prizes are often not "worth" as much as claimed. What is the value of a prize of $5,000,000 that is to be received in 20 equal yearly payments, with the first payment beginning today? Assume an interest rate of 7%. A) $2,833,898.81 B) $2,911,015.68 C) $2,609,144.14 D) $2,738,304.13 Answer: A Explanation: Annual payment = $5,000,000 / 20 = $250,000 PV = ($250,000 {(1 / 0.07) − [1 / 0.07(1.07)20]}) × (1.07) PV = $2,833,898.81 Difficulty: 2 Medium Topic: Present value-annuity Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

111) A loan officer states, "Thousands of dollars can be saved by switching to a 15-year mortgage from a 30-year mortgage." Calculate the difference in payments on a 30-year mortgage at an interest rate of .75% a month versus a 15-year mortgage with an interest rate of .7% a month. Both mortgages are for $100,000 and have monthly payments. What is the difference in total dollars that will be paid to the lender under each loan? (Round the monthly payment amounts to 2 decimal places.) A) $89,211 B) $98,406 C) $113,465 D) $124,300 Answer: C Explanation: $100,000 = PMT([1 / (0.0075)] − 1 / {(0.0075)[(1.0075)]30 × 12}) PMT = $804.62 $100,000 = PMT([1 / (0.007)] − 1 / {(0.007 )[ 1.007)]15 × 12}) PMT = $ 978.87 Total difference = ($804.62 × 12 × 30) − ($978.87 × 12 × 15) = $113,465 Difficulty: 2 Medium Topic: Loan payments Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

112) Would you prefer a savings account that paid 7% interest compounded quarterly, 6.8% compounded monthly, 7.2% compounded weekly, or an account that paid 7.5% with annual compounding? A) 7% compounded quarterly B) 6.8% compounded monthly C) 7.2% compounded weekly D) 7.5% compounded annually Answer: D Explanation: EAR = [1 + (0.07 / 4)]4 − 1 = 0.0719, or 7.19% EAR = [1 + (0.068 / 12)]12 − 1 = 0.0702, or 7.02% EAR = [1 + (0.072 / 52)]52 − 1 = 0.0746, or 7.46% EAR = APR = 7.5% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 113) After reading the fine print in your credit card agreement, you find that the "low" interest rate is actually an 18% APR, or 1.5% per month. What is the effective annual rate? A) 18.47% B) 19.56% C) 18.82% D) 19.41% Answer: B Explanation: EAR = 1.01512 − 1 = 0.1956, or 19.56% Difficulty: 2 Medium Topic: Interest rates Learning Objective: 05-04 Compare interest rates quoted over different time intervals--for example, monthly versus annual rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

114) You are considering the purchase of a home that would require a mortgage of $150,000. How much more in total interest will you pay if you select a 30-year mortgage at 5.65% rather than a 15-year mortgage at 4.9%? (Round the monthly payment amount to 2 decimal places.) A) $86,311.18 B) $78,487.92 C) $99,595.80 D) $102,486.68 Answer: C Explanation: $150,000 = PMT([1 / (0.0565 / 12)] − 1 / {(0.0565 / 12)[1 + (0.0565 / 12)]30 × 12}) PMT = $865.85 $150,000 = PMT([1 / (0.049 / 12)] − 1 / {(0.049 / 12)[1 + (0.049 / 12)]15 × 12}) PMT = $1,178.39 Total difference = ($865.85 × 12 × 30) − ($1,178.39 × 12 × 15) = $99,595.80 Difficulty: 3 Hard Topic: Loan payments Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 115) Lester's just signed a contract that will provide the firm with annual cash inflows of $28,000, $35,000, and $42,000 over the next three years with the first payment of $28,000 occurring one year from today. What is this contract worth today at a discount rate of 7.25%? A) $88,311.08 B) $89,423.91 C) $90,580.55 D) $91,341.41 Answer: C Explanation: PV = $28,000 / 1.0725 + $35,000 / 1.07252 + $42,000 / 1.07253 PV = $90,580.55 Difficulty: 2 Medium Topic: Present value-multiple cash flows Learning Objective: 05-02 Calculate the present value of a future payment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 51

116) Miller's Hardware plans on saving $42,000, $54,000, and $58,000 at the end of each year for the next three years, respectively. How much will the firm have saved at the end of the three years if it can earn 4.5% on its savings? A) $160,295.05 B) $158,098.15 C) $167,508.33 D) $165,212.57 Answer: A Explanation: FV = ($42,000 × 1.0452) + ($54,000 × 1.045) + $58,000 FV = $160,295.05 Difficulty: 2 Medium Topic: Future value-multiple cash flows Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 6 Valuing Bonds 1) When a bond matures, the issuer repays the bond's face value. Answer: TRUE Difficulty: 1 Easy Topic: Bond features Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) When the market interest rate exceeds the coupon rate, bonds sell for less than face value. Answer: TRUE Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) Current yield overstates the return of premium bonds since investors who buy a bond at a premium face a capital loss over the life of the bond. Answer: TRUE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

4) A bond's rate of return is equal to its coupon payment divided by the price paid for the bond. Answer: FALSE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) A bond's bid price will be lower than the ask price. Answer: TRUE Difficulty: 2 Medium Topic: Bond quotes and trading Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) A long-term investor would more likely be interested in a bond's current yield rather than its yield to maturity. Answer: FALSE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) Bonds that have a Standard & Poor's rating of BBB or better are considered to be investmentgrade bonds. Answer: TRUE Difficulty: 2 Medium Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

8) Speculative-grade bonds have default risk; investment grade bonds do not. Answer: FALSE Difficulty: 2 Medium Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) TIPS are unlike most bonds in that their cash flows increase when the national rate of gross domestic product increases. Answer: FALSE Difficulty: 1 Easy Topic: Bond types Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) The return to bondholders is guaranteed to equal the yield to maturity only if the bond is held until maturity. Answer: TRUE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 11) It would be realistic to read an ask price listed as 100.127 and a bid price of 100.143. Answer: FALSE Difficulty: 2 Medium Topic: Bond quotes and trading Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

12) Indexed bonds in the United States are known as Treasury Interest-Paid Securities, or TIPS. Answer: FALSE Difficulty: 1 Easy Topic: Bond types Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 13) The current yield measures the bond's total rate of return. Answer: FALSE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) When a financial calculator or spreadsheet program finds a bond's yield to maturity, it uses a trial-and-error process. Answer: TRUE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Technology Accessibility: Keyboard Navigation 15) Even when the yield curve is upward-sloping, investors might rationally stay away from long-term bonds. Answer: TRUE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-04 Understand why investors are interested in the plot of bond yields against time to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

16) Bonds with a rating of Ba or below by Moody's are referred to as speculative grade, highyield, or junk bonds. Answer: TRUE Difficulty: 2 Medium Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 17) Bonds rated BB or above by Standard & Poor's are called investment grade. Answer: FALSE Difficulty: 2 Medium Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 18) Bonds rated Ba by Moody's have the same safety rating as the bonds rated BB by Standard & Poor's. Answer: TRUE Difficulty: 2 Medium Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 19) Zero-coupon bonds are issued at prices below face value, and the investor's return comes from the difference between the purchase price and the payment of face value at maturity. Answer: TRUE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5

20) Issuers compensate investors for default risk by putting a high face value on their bonds. Answer: FALSE Difficulty: 1 Easy Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 21) Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. Answer: TRUE Difficulty: 1 Easy Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) Bond ratings measure a bond's credit risk. Answer: TRUE Difficulty: 1 Easy Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

23) The coupon rate of a bond equals: A) its yield to maturity. B) a defined percentage of its face value. C) the yield to maturity when the bond sells at a discount. D) the annual interest divided by the current market price. Answer: B Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) Periodic receipts of interest by the bondholder are known as: A) the coupon rate. B) principal payments. C) coupon payments. D) the default premium. Answer: C Difficulty: 1 Easy Topic: Bond coupons Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 25) As the coupon rate of a bond increases, the bond's: A) face value increases. B) current price decreases. C) interest payments increase. D) maturity date is extended. Answer: C Difficulty: 1 Easy Topic: Bond coupons Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

26) Assume a bond is currently selling at par value. What will happen in the future if the yield on the bond is lower than the coupon rate? A) The price of the bond will increase. B) The coupon rate of the bond will increase. C) The par value of the bond will decrease. D) The coupon payments will be adjusted to the new discount rate. Answer: A Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) If a bond's asked price is 97.162, the investor: A) receives 97.162% of the stated coupon payments. B) receives $971.62 upon the maturity date of the bond. C) pays 97.162% of face value for the bond. D) pays $10,971.62 for a $10,000 face value bond. Answer: C Difficulty: 2 Medium Topic: Bond quotes and trading Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) How much does the $1,000 to be received upon a bond's maturity in 4 years add to the bond's price if the appropriate discount rate is 6%? A) $209.91 B) $260.00 C) $760.00 D) $792.09 Answer: D Explanation: $1,000 / 1.064 = $792.09 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 8

29) What happens to a discount bond as the time to maturity decreases? A) The coupon rate increases. B) The bond price increases. C) The coupon rate decreases. D) The bond price decreases. Answer: B Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) How much should you pay for a $1,000 bond with 10% coupon, annual payments, and 5 years to maturity if the interest rate is 12%? A) $927.90 B) $981.40 C) $1,000.00 D) $1,075.82 Answer: A Explanation: Price = (0.10 × $1,000) {(1 / 0.12) − [1 / 0.12(1.12)5]} + $1,000/1.125 Price = $927.90 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

31) How much would an investor expect to pay for a $1,000 par value bond with a 9% annual coupon that matures in 5 years if the interest rate is 7%? A) $696.74 B) $1,075.82 C) $1,082.00 D) $1,123.01 Answer: C Explanation: Price = (0.09 × $1,000) {(1 / 0.07) − [1 / 0.07(1.07)5]} + $1,000 / 1.075 Price = $1,082.00 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32) Which of the following statements is correct for a 10% coupon bond that has a current yield of 7%? A) The face value of the bond has decreased. B) The bond's maturity value exceeds the bond's price. C) The bond's internal rate of return is 7%. D) The bond's market value is higher than its face value. Answer: D Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

33) If an investor purchases a bond when its current yield is higher than the coupon rate, then the bond's price will be expected to: A) decline over time, reaching par value at maturity. B) increase over time, reaching par value at maturity. C) be less than the face value at maturity. D) exceed the face value at maturity. Answer: B Difficulty: 3 Hard Topic: Interest rate risk Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) The current yield of a bond can be calculated by: A) multiplying the price by the coupon rate. B) dividing the price by the annual coupon payments. C) dividing the price by the par value. D) dividing the annual coupon payments by the price. Answer: D Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

35) What is the current yield of a bond with a 6% coupon, 4 years until maturity, and a price quote of 84? A) 6.00% B) 7.14% C) 5.04% D) 6.38% Answer: B Explanation: Current yield = $60 / (0.84 × $1,000) = 0.0714, or 7.14% Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 36) What is the coupon rate for a bond with 6 years until maturity, a price of $984.32, and a yield to maturity of 7%? Interest is paid semi-annually. A) 3.34% B) 3.50% C) 6.68% D) 7.00% Answer: C Explanation: $984.32 = PMT {(1 / 0.035) − [1 / 0.035(1.035)12]} + $1,000 / 1.03512 PMT = $33.38 Coupon rate = ($33.38 × 2) / $1,000 = 0.06675, or 6.68% Difficulty: 2 Medium Topic: Bond coupons Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

37) A bond's par value can also be called its: A) coupon payment. B) present value. C) market value. D) face value. Answer: D Difficulty: 1 Easy Topic: Bond features Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 38) A bond's yield to maturity takes into consideration: A) current yield but not any price changes. B) price changes but not the current yield. C) both the current yield and any price changes. D) neither the current yield nor any price changes. Answer: C Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) The discount rate that makes the present value of a bond's payments equal to its price is termed the: A) dividend yield. B) yield to maturity. C) current yield. D) coupon rate. Answer: B Difficulty: 1 Easy Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

40) What is the coupon rate for a bond with 3 years until maturity, a price of $1,053.46, and a yield to maturity of 6%? Interest is paid annually. A) 6% B) 8% C) 10% D) 11% Answer: B Explanation: $1,053.46 = PMT {(1 / 0.06) − [1 / 0.06(1.06)3]} + $1,000 / 1.063 PMT = $80 Coupon rate = $80 / $1,000 = 0.08, or 8% Difficulty: 2 Medium Topic: Bond coupons Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 41) What price will be paid for a Eurobond with an ask price of 116.08 if the face value is 30,000 euros? A) $26765 B) $34000 C) $35727 D) $34824 Answer: D Explanation: Price = 1.11608 × 30,000 = 34824 Difficulty: 2 Medium Topic: Bond quotes and trading Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

42) What is the yield to maturity for a bond paying $100 annually that has 6 years until maturity and sells for $1,000? A) 6.0% B) 8.5% C) 10.0% D) 12.5% Answer: C Explanation: Since the bond is selling at par, the yield to maturity must equal the coupon rate which is: Coupon rate = $100 / $1,000 = 0.10, or 10% Difficulty: 1 Easy Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 43) Consider a 3-year bond with a par value of $1,000 and an 8% annual coupon. If interest rates change from 8 to 6% the bond's price will: A) increase by $51.54. B) decrease by $51.54. C) increase by $53.46. D) decrease by $53.46. Answer: C Explanation: Price = (0.08 × $1,000) {(1 / 0.06) − [1 / 0.06(1.06)3]} + $1,000 / 1.063 Price = $1,053.46 This is a price increase of $53.46, since the bond sold at par. Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

44) A Eurobond with a par value of 30,000 euros is priced at 108.40 of par and has 10 years remaining until maturity. The bond has an 8% coupon rate, paid semi-annually. What is the amount of the next interest payment? A) 1,200 euros B) 2,400 euros C) 4,000 euros D) 8,000 euros Answer: A Explanation: Coupon payment = (0.08 × 30,000) / 2 = 1,200 Difficulty: 2 Medium Topic: Bond coupons Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 45) Which one of the following bond values will change when interest rates change? A) The expected cash flows B) The present value C) The coupon payment D) The maturity value Answer: B Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

46) What happens to the coupon rate of a $1,000 face value bond that pays $80 annually in interest if market interest rates change from 9% to 10%? A) The coupon rate increases to 10%. B) The coupon rate remains at 9%. C) The coupon rate remains at 8%. D) The coupon rate decreases to 8%. Answer: C Difficulty: 2 Medium Topic: Bond coupons Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 47) Which one of the following is fixed for the life of a given bond? A) Current price B) Current yield C) Yield to maturity D) Coupon rate Answer: D Difficulty: 1 Easy Topic: Bond coupons Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

48) What is the rate of return for an investor who pays $1,054.47 for a 3-year bond with an annual coupon payment of 6.5% and sells the bond 1 year later for $1,037.19? A) 4.53% B) 5.33% C) 5.16% D) 4.92% Answer: A Explanation: Rate of return = [$1,037.19 + (0.065 × $1,000) − $1,054.47] / $1,054.47 = 0.0453, or 4.53% Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 49) If a bond investor's yield for a particular period does not change, then during that period, the bond's return: A) is zero. B) increases. C) equals the yield. D) is indeterminate. Answer: C Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

50) An investor purchases a Eurobond for 108.93 and sells it one year later at 107.30. The bond pays an annual coupon of 6% and has 10 years until maturity. If the par value of the bond is 30,000 euros, what is the rate of return on the bond over year? A) 3.0% B) 4.0% C) 6.0% D) 8.0% Answer: B Explanation: Rate of return = [107.30 – 108.93 + 6] / 108.93 = 0.0401, or 4.01% Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) What is the relationship between a bondholder's rate of return and the bond's yield to maturity if he does not hold the bond until it matures? A) The rate of return will be lower than the yield to maturity. B) The rate of return will be higher than the yield to maturity. C) The rate of return will equal the yield to maturity. D) It could be higher or lower. Answer: D Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

52) If the coupon rate on an outstanding bond is lower than the relevant current interest rate, then the yield to maturity will be: A) lower than current interest rates. B) equal to the coupon rate. C) higher than the coupon rate. D) lower than the coupon rate. Answer: C Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 53) If a 4-year bond with a 7% coupon and a 10% yield to maturity is currently worth $904.90, how much will it be worth 1 year from now if interest rates are constant? A) $904.90 B) $925.39 C) $947.93 D) $1,000.00 Answer: B Explanation: Price = (0.07 × $1,000) {(1 / 0.10) − [1 / 0.10(1.10)3]} + $1,000 / 1.103 Price = $925.39 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

54) What price will be paid for a U.S. Treasury bond with an ask price of 135.4062 if the face value is $100,000? A) $100,135.41 B) $135,000.41 C) $136,269.38 D) $135,406.20 Answer: D Explanation: Price = 1.354062 × $100,000 = $135,406.20 Difficulty: 2 Medium Topic: Bond quotes and trading Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 55) You purchased a 6% annual coupon bond at face value and sold it one year later for $1,015.16. What was your rate of return on this investment if the face value at maturity was $1,000? A) 4.48% B) 6.15% C) 7.52% D) 6.07% Answer: C Explanation: Rate of return = [$1,015.16 + (0.06 × $1,000) − $1,000] / $1,000 = 0.0752, or 7.52% Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

56) How does a bond dealer generate profits when trading bonds? A) By maintaining bid prices lower than ask prices B) By maintaining bid prices higher than ask prices C) By retaining the bond's next coupon payment D) By lowering the bond's coupon rate upon resale Answer: A Difficulty: 1 Easy Topic: Bond quotes and trading Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) A bond is priced at $1,100, has 10 years remaining until maturity, and has a 10% coupon, paid semiannually. What is the amount of the next interest payment? A) $50 B) $55 C) $100 D) $110 Answer: A Explanation: Coupon payment = (0.10 × $1,000) / 2 = $50 Difficulty: 2 Medium Topic: Bond coupons Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 58) The yield curve depicts the current relationship between: A) bond yields and default risk. B) bond maturity and bond ratings. C) bond yields and maturity. D) promised yields and default premiums. Answer: C Difficulty: 1 Easy Topic: Treasury yield curve Learning Objective: 06-04 Understand why investors are interested in the plot of bond yields against time to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22

59) When the yield curve is upward-sloping, then: A) short-maturity bonds offer the highest coupon rates. B) long-maturity bonds are priced above par value. C) short-maturity bonds yield less than long-maturity bonds. D) long-maturity bonds increase in price when interest rates increase. Answer: C Difficulty: 1 Easy Topic: Treasury yield curve Learning Objective: 06-04 Understand why investors are interested in the plot of bond yields against time to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) Nominal U.S. Treasury bond yields: A) are constant over time. B) are equal to the real yields. C) include a default premium. D) include an inflation premium. Answer: D Difficulty: 1 Easy Topic: Bond yields and returns Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

61) If the tax law changes to reduce or eliminate the deductibility of state and local taxes, what is the impact on tax free municipal bonds for high tax rate individuals? A) The demand will be higher since insurance companies and banks have a lower tax rate. B) The demand will be lower since insurance companies and banks have a lower tax rate. C) The demand will be higher since state income taxes are not deductible and mini coupons are not taxed. D) The demand will be higher since state income taxes are not deductible and muni coupons are not taxed. Answer: C Difficulty: 1 Easy Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 62) Which one of these is included in the yield of a bond with a low credit rating but not included in a U.S. Treasury bond yield? Assume both bonds are selling at a premium. A) Real rate of return B) Inflation premium C) Default premium D) Loss of premium Answer: C Difficulty: 1 Easy Topic: Bond yields and returns Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) The purpose of a floating-rate bond is to: A) save interest expense for corporate issuers. B) avoid making interest payments until maturity. C) shift the yield curve. D) offer rates that adjust to current market conditions. Answer: D Difficulty: 2 Medium Topic: Bond types Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) Which of the following would not be associated with a zero-coupon bond? A) Yield to maturity B) Discount bond C) Current yield D) Interest-rate risk Answer: C Difficulty: 2 Medium Topic: Bond types Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 65) Which one of the following bonds would be likely to exhibit a greater degree of interest rate risk? A) A zero-coupon bond with 20 years until maturity B) A coupon-paying bond with 20 years until maturity C) A floating-rate bond with 20 years until maturity D) A zero-coupon bond with 30 years until maturity Answer: D Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

66) A "convertible bond" provides the option to convert: A) a bond into shares of common stock. B) fixed-rate coupon payments into variable-rate payments. C) a zero-coupon bond to a coupon-paying bond. D) a junk bond to a zero-coupon investment-grade bond. Answer: A Difficulty: 2 Medium Topic: Bond features Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 67) Rosita purchased a bond for $989 that had a 7% coupon and semiannual interest payments. She sold the bond after 6 months and earned a total return of 4.8% on this investment. At what price, did she sell the bond? A) $1,001.47 B) $974.28 C) $981.06 D) $1,003.18 Answer: A Explanation: 0.048 = (Selling price + [(0.07 × $1,000) / 2] − $989) / $989 Selling price = $1,001.47 Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

68) A U.S. Treasury security that pays a fixed coupon and has an initial maturity of 2 to 10 years is called a: A) TIPS. B) Treasury bill. C) Treasury bond. D) Treasury note. Answer: D Difficulty: 1 Easy Topic: Bond features Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 69) Which one of the following must be correct for a bond currently selling at a premium? A) Its coupon rate is variable. B) Its current yield is lower than its coupon rate. C) Its yield to maturity is higher than its coupon rate. D) Its coupon rate is lower than the current market rate on similar bonds. Answer: B Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

70) A bond has a coupon rate of 8%, pays interest semiannually, sells for $960, and matures in 3 years. What is its yield to maturity? A) 4.78% B) 5.48% C) 9.57% D) 12.17% Answer: C Explanation: Using a financial calculator: n = 6; PV = −$960; PMT = $40; FV = $1,000, CPT i = 4.7826% YTM = 2 × 4.7826% = 9.57% Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Technology Accessibility: Keyboard Navigation 71) Which type of bond is certain to provide a capital loss if held to maturity? A) Discount bond B) Premium bond C) Zero-coupon bond D) Junk bond Answer: B Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

72) Investors who purchase bonds having lower credit ratings should expect: A) lower yields to maturity. B) higher default possibilities. C) lower coupon payments. D) higher purchase prices. Answer: B Difficulty: 2 Medium Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) A bond has a face value of $1,000, has 5 years until maturity, and an annual coupon rate of 7%? It yields 5% currently. By how much will the price change over the next year if the yield remains constant? A) zero B) decline by $86.59 C) decline by $15.67 D) rise by $15.67 Answer: C Explanation: Price today = $70(1 / 0.05+1 / (0.05 × 1.054)) + $1,070 / 1.055 = $1,086.59 Price next year = $70(1 / 0.05+1 / (0.05 × 1.053)) + $1,070 / 1.054 = $1,070.92 Price declines by $15.67 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

74) If a bond is priced at par value, then: A) it has a very low level of default risk. B) its coupon rate equals its yield to maturity. C) it must be a zero-coupon bond. D) the bond is quite close to maturity. Answer: B Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) The existence of an upward-sloping yield curve suggests that: A) bonds should be selling at a discount to par value. B) bonds will not return as much as common stocks. C) interest rates may be increasing in the future. D) real interest rates will be increasing soon. Answer: C Difficulty: 2 Medium Topic: Treasury yield curve Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

76) What is the amount of the annual coupon payment for a bond that has 6 years until maturity, sells for $1,050, and has a yield to maturity of 9.37%? A) $98.64 B) $95.27 C) $101.38 D) $104.97 Answer: D Explanation: $1,050 = PMT {(1 / 0.0937) − [1 / 0.0937(1.0937)6]} + $1,000 / 1.09376 PMT = $104.97 Difficulty: 2 Medium Topic: Bond coupons Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 77) This morning, you purchased a TIPS. Which one of these should you expect to occur if you hold this bond during an inflationary period? A) The coupon payment will increase in real terms. B) The maturity value will increase in nominal terms. C) The market price will remain constant at par. D) The market price will decrease. Answer: B Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

78) Many investors may be drawn to municipal bonds because of the bonds': A) speculative grade ratings. B) high coupon payments. C) long periods until maturity. D) income exemption from federal taxes. Answer: D Difficulty: 1 Easy Topic: Bond features Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 79) Two years ago bonds were issued at par with 10 years until maturity and a 7% annual coupon. If interest rates for that grade of bond are currently 8.25%, what will be the market price of these bonds? A) $917.06 B) $928.84 C) $987.50 D) $1,000.00 Answer: B Explanation: Price = (0.07 × $1,000) {(1 / 0.0825) − [1 / 0.0825(1.0825)10 − 2]} + $1,000 / 1.082510 − 2 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

80) If a bond offers a current yield of 5% and a yield to maturity of 5.45%, then the: A) bond is selling at a discount. B) bond has a high default premium. C) promised yield is not likely to materialize. D) bond must be a Treasury Inflation-Protected Security. Answer: A Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) What is the total return to an investor who buys a bond for $1,100 when the bond has a 9% annual coupon and 5 years until maturity, then sells the bond after 1 year for $1,085? A) 6.82% B) 6.91% C) 7.64% D) 9.00% Answer: A Explanation: Total return = [$1,085 + (0.09 × $1,000) − $1,100] / $1,100 = 0.0682, or 6.82% Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

82) How much would an investor lose the first year if she purchased a 30-year zero-coupon bond with a $1,000 par value and a 10% yield to maturity, only to see market interest rates increase to 12% one year later? A) $19.93 B) $20.00 C) $23.93 D) $25.66 Answer: A Explanation: Price = $1,000 / 1.1030 = $57.31 New price = $1,000 / 1.1229 = $37.38 Loss = $57.31 − 37.38 = $19.93 Difficulty: 3 Hard Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 83) Assume a bond has been owned by four different investors during its 20-year history. Which one of the following is most likely to have been different for each of these owners? A) Coupon rate B) Coupon frequency C) Par value D) Yield to maturity Answer: D Difficulty: 1 Easy Topic: Bond yields and returns Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

84) If an investor purchases a 3%, 5-year TIPS at its par value of $1,000 and the CPI increases 3% over each of the next 5 years, what will be the real value of the principal at maturity? A) $1,000.00 B) $1,030.00 C) $1,060.90 D) $1,061.36 Answer: A Explanation: The real value of the principal will remain constant at the par value. Difficulty: 2 Medium Topic: Bond features Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 85) Which one of the following is correct concerning real interest rates? A) Real interest rates are constant. B) Real interest rates must be positive. C) Real interest rates must be less than nominal interest rates. D) Real interest rates, if positive, increase purchasing power over time. Answer: D Difficulty: 1 Easy Topic: Nominal and real rates Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) An investor holds two bonds, one with 5 years until maturity and the other with 20 years until maturity. Which of the following is more likely if interest rates suddenly increase by 2%? A) The 5-year bond will decrease more in price. B) The 20-year bond will decrease more in price. C) Both bonds will decrease in price by the same proportion. D) Neither bond will decrease in price, but their yields will increase. Answer: B Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

87) How much should you be prepared to pay for a 10-year bond with an annual coupon of 6% and a yield to maturity of 7.5%? A) $411.84 B) $897.04 C) $985.00 D) $1,000.00 Answer: B Explanation: Price = (0.06 × $1,000) {(1 / 0.075) − [1 / 0.075(1.075)10]} + $1,000 / 1.07510 Price = $897.04 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 88) How much should you be prepared to pay for a 10-year bond with a 6% coupon, semiannual payments, and a semiannually compounded yield of 7.5%? A) $895.78 B) $897.04 C) $938.40 D) $1,312.66 Answer: A Explanation: Semiannual interest rate = 0.075 / 2 = 0.0375 Price = [(0.06 / 2) × $1,000)] {(1 / 0.0375) − [1 / 0.0375(1.0375)10 × 2]} + $1,000 / 1.037510 × 2 Price = $895.78 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

89) The market price of a bond with 12 years until maturity and an annual coupon rate of 8% increased yesterday. Which one of these may have caused this price increase? A) The bond's rating was downgraded. B) The issuing firm announced the next interest payment. C) The issuing firm announced that its annual earnings met investor expectations. D) Market interest rates decreased. Answer: D Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 90) An investor buys a 5-year, 9% coupon bond for $975, holds it for 1 year, and then sells the bond for $985. What was the investor's rate of return? A) 9.00% B) 9.23% C) 9.65% D) 10.26% Answer: D Explanation: Rate of return = [$985 + (0.09 × $1,000) − $975] / $975 = 0.1026, or 10.26% Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

91) An investor buys a 10-year, 7% coupon bond for $1,050, holds it for 1 year, and then sells it for $1,040. What was the investor's rate of return? A) 5.71% B) 6.00% C) 6.67% D) 7.00% Answer: A Explanation: Rate of return = [$1,040 + (0.07 × $1,000) − $1,050] / $1,050 = 0.0571, or 5.71% Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 92) An investor purchased a fixed-coupon bond at a time when the bond's yield to maturity was 6.9%. The investor sold the bond prior to maturity and realized a total return of 7.1%. Which of these most likely occurred while the investor owned the bond? A) The bond's current yield increased above the bond's coupon rate. B) The inflation rate increased. C) Market interest rates declined. D) Market interest rates increased. Answer: C Difficulty: 3 Hard Topic: Interest rate risk Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

93) A bond has an ask quote of 99.5625 and a bid quote of 99.5475. How much will the bond dealer make on the purchase and resale of a $100,000 bond? A) $150 B) $1,500 C) $15 D) $1.50 Answer: C Explanation: Dealer profit = (0.995625 − 0.995475) × $100,000 = $15 Difficulty: 2 Medium Topic: Bond quotes and trading Learning Objective: 06-01 Distinguish among a bond's coupon rate, current yield, and yield to maturity. Bloom's: Analyze AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) What are the conditions imposed on a debt issuer that are designed to protect bondholders? A) Collateral agreements B) Vanilla wrappers C) Protective covenants D) Default provisions Answer: C Difficulty: 1 Easy Topic: Bond features Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 95) The holder of which one of these securities has first claim on the assets of a firm? A) Senior debt B) Common stock C) Subordinated debt D) Preferred stock Answer: A Difficulty: 2 Medium Topic: Bond features Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 39

96) When market interest rates exceed a bond's coupon rate, the bond will: A) sell for less than par value. B) sell for more than par value. C) decrease its coupon rate. D) increase its coupon rate. Answer: A Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Which one of the following is most likely for a CCC-rated bond, compared to a BBB-rated bond? A) The CCC bond will have a variable-coupon rate. B) The CCC bond will have a shorter term. C) The CCC bond will offer a higher promised yield to maturity. D) The CCC bond will have a higher price for the same term. Answer: C Difficulty: 1 Easy Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 98) Which of these bond ratings is the lowest of Moody's investment-grade ratings? A) A B) Ba C) Aa D) Baa Answer: D Difficulty: 1 Easy Topic: Bond ratings and credit risk Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

99) If a bond offers an investor 11% in nominal return during a year in which the rate of inflation is 4%, then the investor's real return is: A) 6.73%. B) 6.31%. C) 15.44%. D) 10.56%. Answer: A Explanation: 1 + real return = 1.11 / 1.04 − 1 = 0.0673, or 6.73% Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 100) What nominal return would an investor need to receive if he desires a real return of 4% and the rate of inflation is 5%? A) 4.20% B) 8.64% C) 9.00% D) 9.20% Answer: D Explanation: Nominal return = (1.04 × 1.05) − 1 = 0.0920, or 9.20% Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

101) If you purchase a 5-year, zero-coupon bond for $691.72, how much could it be sold for 3 years later if interest rates have remained stable? A) $848.12 B) $923.50 C) $862.92 D) $911.15 Answer: C Explanation: $691.72 = $1,000 / (1 + i)5 i = 0.0765 Price = $1,000 / 1.07652 Price = $862.92 Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 102) An investor buys a 10-year annual coupon bond at a yield of 8.7% and sells it 2 years later when it still yields 8.7%. What is his rate of return over this period? A) zero. B) 8.7%. C) Can't say without knowing the coupon. D) 17.4%. Answer: B Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

103) What causes bonds to sell for a premium? A) Investment-quality ratings B) Long periods until maturity C) Coupon rates that exceed market rates D) Speculative-grade ratings Answer: C Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 104) The current yield tends to overstate a bond's total return when the bond sells for a premium because: A) the bond's price will decline each year. B) coupon payments can change at any time. C) bonds selling for a premium have low default risk. D) taxes must be paid on the current yield. Answer: A Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 105) The current yield tends to understate a bond's total return when the bond sells for a discount because: A) increases in interest rates will increase the current yield. B) the bond's price will increase each year. C) current yields show only nominal returns. D) the bond may have a higher face value. Answer: B Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

106) When comparing a highly liquid bond with a comparable but less liquid bond, the highly liquid bond is most apt to have: A) a lower yield. B) a shorter maturity. C) a higher yield. D) a longer maturity. Answer: A Difficulty: 1 Easy Topic: Bond yields and returns Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond's yield given its price, and demonstrate why prices and yields move in opposite directions. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 107) Which one of these statements is not correct? A) When a foreign government borrows dollars, investors worry that in some future crisis the government will not have sufficient dollars to repay the debt. B) When the Japanese government borrows yen, investors worry that in some future crisis the government will not have sufficient yen to repay the debt. C) When a Eurozone government borrows euros, investors worry that in some future crisis the government will not have sufficient euros to repay the debt. D) When the U.S. government issues Treasury bonds, investors never need to worry that they will not be paid back. Answer: C Difficulty: 2 Medium Topic: Sovereign debt Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 7 Valuing Stocks 1) The dividend discount model states that the value of a stock is the present value of the dividends it will pay over the investor's horizon, plus the present value of the expected stock price at the end of that horizon. Answer: TRUE Difficulty: 1 Easy Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 2) An excess of market value over the book value of equity can be attributed to going concern value. Answer: TRUE Difficulty: 2 Medium Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) Securities with the same expected risk should offer the same expected rate of return. Answer: TRUE Difficulty: 2 Medium Topic: Risk and return relationship Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

4) If investors believe a company will have the opportunity to make very profitable investments in the future, they will pay more for the company's stock today. Answer: TRUE Difficulty: 1 Easy Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) The dividend discount model should not be used to value stocks if the dividend does not grow. Answer: FALSE Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) If the stock prices follow a random walk, successive stock prices are not related. Answer: FALSE Difficulty: 2 Medium Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

7) The liquidation value of a firm is equal to the book value of the firm. Answer: FALSE Difficulty: 2 Medium Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8) Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout ratio. Answer: FALSE Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) If the market is efficient, stock prices should be expected to react only to new information. Answer: TRUE Difficulty: 1 Easy Topic: Market efficiency-foundations and types Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

10) If stock prices follow a random walk, their prices bear no relation to the company's real activities. Answer: FALSE Difficulty: 1 Easy Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 11) A negative free cash flow for a business is always sign that it is not performing well. Answer: FALSE Difficulty: 2 Medium Topic: Valuing an entire business Learning Objective: 07-03 Apply valuation models to an entire business. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12) Evidence that stock prices follow a random walk does not imply that there aren't predictable cycles in prices. Answer: FALSE Difficulty: 1 Easy Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) Market efficiency implies that security prices impound new information quickly. Answer: TRUE Difficulty: 1 Easy Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

14) If security prices follow a random walk, then on any particular day the odds are that an increase or decrease in price is about equally likely. Answer: TRUE Difficulty: 1 Easy Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Many professional investors attempt to beat the market by buying index funds. Answer: FALSE Difficulty: 1 Easy Topic: Market efficiency-studies and challenges Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 16) Market efficiency implies that one could earn above-average returns by examining the history of a firm's stock price. Answer: FALSE Difficulty: 1 Easy Topic: Market efficiency-foundations and types Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 17) Market value, unlike book value and liquidation value, treats the firm as a going concern. Answer: TRUE Difficulty: 1 Easy Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5

18) The dividend yield of a stock is much like the current yield of a bond. Both ignore prospective capital gains or losses. Answer: TRUE Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) Historically, since 1926, growth stocks have earned higher average returns than value stocks. Answer: FALSE Difficulty: 1 Easy Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20) A majority of active managers consistently earn higher returns than a simple a simple strategy of just buying a slice of the entire large-cap universe. Answer: FALSE Difficulty: 1 Easy Topic: Market efficiency-foundations and types Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

21) The dividend discount model states that today's stock price equals the present value of all expected future dividends. Answer: TRUE Difficulty: 1 Easy Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 22) The growth of mature companies is primarily funded by: A) issuing new shares of stock. B) issuing new debt securities. C) reinvesting company earnings. D) increasing accounts payable. Answer: C Difficulty: 1 Easy Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 23) The sustainable growth rate represents the rate at which a firm can grow: A) maximum; while maintaining a constant debt-equity ratio. B) maximum; based solely on internal financing. C) minimum; while maintaining a constant debt-equity ratio. D) minimum; based solely on internal financing. Answer: A Difficulty: 1 Easy Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

24) Wilt's has earnings per share of $2.98 and dividends per share of $0.35. What is the firm's sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%? A) 2.14% B) 1.71% C) 12.89% D) 16.06% Answer: D Explanation: Sustainable growth rate = ROE × plowback ratio Sustainable growth rate = 0.182 × [($2.98 − 0.35)/$2.98] Sustainable growth rate = 0.1606, or 16.06% Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 25) The sustainable rate of growth: A) increases as the dividend payout ratio increases. B) must be moderate over the long-term even if it is high in the short-term. C) assumes the debt-equity ratio will increase at the same rate as the growth rate. D) must exceed the required rate of return to be used in the dividend discount model. Answer: B Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

26) For a firm that repurchases its stock, firm value is most easily estimated by discounting A) dividends plus repurchases per share. B) repurchases rather than dividends. C) free cash flows. D) pre-repurchase earnings per share. Answer: C Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-03 Apply valuation models to an entire business. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 27) A firm has 120,000 shares of stock outstanding, a sustainable rate of growth of 3.8%, and $648,200 in next year's free cash flow. What value would you place on a share of this firm's stock if you require a 14% rate of return? A) $48.09 B) $52.96 C) $54.02 D) $61.58 Answer: B Explanation: Price = [$648,200/(0.14 − 0.038)]/120,000 = $52.96 Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

28) Which item indicates a flaw in the efficient market hypothesis? A) A bubble in asset prices B) Inflation fears increase interest rates C) Insiders earn excess returns D) Market indexes drop when GDP falls Answer: A Difficulty: 2 Medium Topic: Behavioral finance Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) The semi-strong form of the efficient market hypothesis states that: A) the efficient market hypothesis is only half true. B) professional investors make superior profits but amateurs can't. C) stock prices do not follow a random walk. D) prices reflect all publicly available information. Answer: D Difficulty: 1 Easy Topic: Market efficiency-foundations and types Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 30) If the general sentiment of investors is pessimistic, stock prices are more apt to: A) increase significantly. B) increase slightly. C) remain constant. D) decline. Answer: D Difficulty: 1 Easy Topic: Behavioral finance Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

31) If investors expect a 14% return on a $50 stock that pays a dividend of $2.50, what is the implied capital gain rate? A) 5% B) 7% C) 9% D) 14% Answer: C Explanation: Capital gain rate = 0.14 - $2.50/$50 = 0.09 or 9% Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32) Which of these statements is correct? Free cash flow A) is available to be paid out to investors as interest or dividends, or to repay debt or buy back stock. B) is positive if the company is issuing debt or stock. C) is equal to net income. D) is another term for retained earnings. Answer: A Difficulty: 2 Medium Topic: Valuing an entire business Learning Objective: 07-03 Apply valuation models to an entire business. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

33) If markets are efficient, when new information about a stock becomes available, the price will: A) remain unchanged because it already reflects this information. B) accurately and rapidly adjust to include this new information. C) adjust to accurately reflect this new information over the course of the next few days. D) most likely increase because all new information has a positive effect on stock prices. Answer: B Difficulty: 2 Medium Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) Which statement is correct? A) Stock repurchases invalidate the dividend discount model B) Stock repurchases do not add value to a business and can be ignored. C) When there are repurchases, it is simpler to value a business by discounting the free cash flow. D) Stock repurchases increase the number of shares and make it difficult to forecast dividends per share Answer: C Difficulty: 2 Medium Topic: Valuing an entire business Learning Objective: 07-03 Apply valuation models to an entire business. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

35) What dividend yield would be reported in the financial press for a stock that currently pays a $1 dividend per quarter and the most recent stock price was $40? A) 2.5% B) 4.0% C) 10.0% D) 5.0% Answer: C Explanation: Dividend yield = ($1 × 4)/$40 = 0.100, or 10.0% Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 36) Which of the following values treats the firm as a going concern? A) Market value B) Book value C) Liquidation value D) Both market and book values Answer: A Difficulty: 1 Easy Topic: Market and book values Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

37) A stock is selling for $37.50 and is expected to pay a dividend of $3 at the end of the year. If investors expect a return of 14%, what must be the sustainable growth rate? A) 4% B) 5% C) 6% D) 7% Answer: C Explanation: 37.50 = 3 / (0.14 – g) Sustainable growth rate = 0.06 or 6% Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 38) If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year and the dividend payout ratio is 40%, what is the stock's current price? A) $24.30 B) $18.00 C) $22.22 D) $40.50 Answer: D Explanation: Price = 13.5 × $3 = $40.50 Difficulty: 1 Easy Topic: Stock valuation using multiples Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

39) With respect to the notion that stock prices follow a random walk, many researchers have concluded that: A) stock prices reflect a majority of available information about the firm. B) successive price changes are predictable. C) past stock price changes provide little useful information about future stock price changes. D) stock prices always rise excessively in January. Answer: C Difficulty: 2 Medium Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) What is the current price of a share of stock for a firm with $5 million in balance-sheet equity, 500,000 shares of stock outstanding, and a price/book value ratio of 4? A) $2.50 B) $10.00 C) $20.00 D) $40.00 Answer: D Explanation: Price = 4 × ($5,000,000/500,000) = $40 Difficulty: 2 Medium Topic: Stock valuation using multiples Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

41) A firm's liquidation value is the amount: A) necessary to repurchase all outstanding shares of common stock. B) realized from selling all assets and paying off all creditors. C) a purchaser would pay to acquire all of the firm's assets. D) shown on the balance sheet as total owners' equity. Answer: B Difficulty: 1 Easy Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) Which one of the following is least likely to account for an excess of market value over book value of equity? A) Inaccurate depreciation methods B) High rate of return on assets C) The presence of growth opportunities D) Valuable off-balance sheet assets Answer: A Difficulty: 2 Medium Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

43) Firms with valuable intangible assets are more likely to show a(n): A) excess of book value over market value of equity. B) high going-concern value. C) low liquidation value. D) low P/E ratio. Answer: B Difficulty: 2 Medium Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) Which of the following is inconsistent with a firm that sells for very near book value? A) Low current earnings B) Few, if any, intangible assets C) High future earning power D) Low, unstable dividend payment Answer: C Difficulty: 1 Easy Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

45) A stock paying $5 in annual dividends currently sells for $80 and has an expected return of 14%. What might investors expect to pay for the stock one year from now after the next dividend has been paid? A) $82.20 B) $86.20 C) $87.20 D) $91.20 Answer: B Explanation: 0.14 = (P1 + $5 − 80)/$80 P1 = $86.20 Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 46) A stock currently sells for $50 per share, has an expected return of 15%, and an expected capital gain rate of 10%. What is the amount of the expected dividend? A) $2.50 B) $2.75 C) $3.00 D) $3.50 Answer: A Explanation: Dividend yield = 0.15 − 0.10 = 0.05 Expected dividend = 0.05 × $50 = $2.50 Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

47) The expected return on a common stock is equal to: A) [(1 + dividend yield) × (1 + capital gain rate)] − 1. B) the capital gain rate + dividend yield. C) (1 + capital gain rate) / (1 + dividend yield). D) the capital gain rate − dividend yield. Answer: B Difficulty: 1 Easy Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) It is possible to ignore cash dividends that occur very far into the future when using a dividend discount model because those dividends: A) will most likely be paid to a different investor. B) will most likely not be paid. C) have an insignificant present value. D) have a minimal, if any, potential rate of growth. Answer: C Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

49) If the dividend yield for year 1 is expected to be 5% based on a stock price of $25, what will the year 4 dividend be if dividends grow annually at a constant rate of 6%? A) $1.33 B) $1.49 C) $1.58 D) $1.67 Answer: B Explanation: DIV4 = (0.05 × $25) × 1.063 = $1.49 Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 50) Dani's just paid an annual dividend of $6 per share. What is the dividend expected to be in five years if the growth rate is 4.2%? A) $7.07 B) $7.37 C) $7.14 D) $7.44 Answer: B Explanation: DIV3 = $6 × 1.0425 = $7.37 Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

51) The value of common stock will likely decrease if: A) the investment horizon decreases. B) the growth rate of dividends increases. C) the discount rate increases. D) dividends are discounted back to the present. Answer: C Difficulty: 1 Easy Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) When valuing stock with the dividend discount model, the present value of future dividends will: A) change depending on the time horizon selected. B) remain constant regardless of the time horizon selected. C) remain constant regardless of the rate of growth. D) always equal the present value of the terminal price. Answer: B Difficulty: 1 Easy Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) What should be the price for a common stock paying $3.50 annually in dividends if the growth rate is zero and the discount rate is 8%? A) $22.86 B) $28.00 C) $42.00 D) $43.75 Answer: D Explanation: Price = $3.50/0.08 = $43.75 Difficulty: 2 Medium Topic: Perpetuities Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 54) What should you pay for a stock if next year's annual dividend is forecast to be $5.25, the constant-growth rate is 2.85%, and you require a 15.5% rate of return? A) $31.25 B) $38.87 C) $41.50 D) $42.68 Answer: C Explanation: Price = $5.25/(0.155 − 0.0285) = $41.50 Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

55) What price would you pay today for a stock if you require a rate of return of 13%, the dividend growth rate is 3.6%, and the firm recently paid an annual dividend of $2.50? A) $27.55 B) $30.28 C) $26.60 D) $31.37 Answer: A Explanation: Price = ($2.50 × 1.036)/(0.13 − 0.036) = $27.55 Difficulty: 3 Hard Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 56) What constant-growth rate in dividends is expected for a stock valued at $32.40 if next year's dividend is forecast at $2.20 and the appropriate discount rate is 13.6%? A) 7.02% B) 6.59% C) 6.81% D) 7.38% Answer: C Explanation: $32.40 = $2.20/(0.136 − g); g = 0.0681, or 6.81% Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

57) What rate of return is expected from a stock that sells for $30 per share, pays $1.54 annually in dividends, and is expected to sell for $32.80 per share in one year? A) 15.03% B) 14.28% C) 14.09% D) 14.47% Answer: D Explanation: Expected return = ($32.80 + 1.54 − 30)/$30 = 0.1447, or 14.47% Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 58) ABC common stock is expected to have extraordinary growth in earnings and dividends of 20% per year for 2 years, after which the growth rate will settle into a constant 6%. If the discount rate is 15% and the most recent dividend was $2.50, what should be the approximate current share price? A) $31.16 B) $33.23 C) $37.39 D) $47.77 Answer: C Explanation: Price = ($2.50 × 1.2)/1.15 + ($2.50 × 1.22)/1.152 + [($2.50 × 1.22 × 1.06)/(0.15 − 0.06)]/1.152 = $37.39 Difficulty: 3 Hard Topic: Two-stage growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

59) What would be the approximate expected price of a stock when dividends are expected to grow at a 25% rate in each of years 2 and 3, and then grow at a constant rate of 5% if the stock's required return is 13% and next year's dividend will be $4.00? A) $67.60 B) $62.08 C) $68.64 D) $76.44 Answer: C Explanation: Price = $4/1.13 + ($4 × 1.25)/1.132 + ($4 × 1.252)/1.133 + [($4 × 1.252 × 1.05)/(0.13 − 0.05)]/1.133 = $68.64 Difficulty: 3 Hard Topic: Two-stage growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 60) A company with a return on equity of 15% and a plowback ratio of 60% would expect a constant-growth rate of: A) 4%. B) 9%. C) 21%. D) 25%. Answer: B Explanation: g = 0.15 × 0.60 = 0.09, or 9% Difficulty: 1 Easy Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

61) What is the plowback ratio for a firm that has earnings per share of $2.68 and pays out $1.75 per share in dividends? A) 28.20% B) 34.70% C) 66.67% D) 71.80% Answer: B Explanation: Plowback ratio = ($2.68 − 1.75)/$2.68 = 0.3470, or 34.70% Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 62) A positive value for PVGO suggests that the firm has: A) a positive return on equity. B) a positive plowback ratio. C) investment opportunities with superior returns. D) a high rate of constant growth. Answer: C Difficulty: 1 Easy Topic: Net present value growth opportunity Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) Which of the following situations accurately describes a growth stock, assuming that each firm has a required return of 12%? A) A firm with PVGO = $0. B) A firm with investment opportunities yielding 10%. C) A firm with investment opportunities yielding 15%. D) A firm with PVGO < $0. Answer: C Difficulty: 2 Medium Topic: Net present value growth opportunity Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) Other things equal, a firm's sustainable growth rate could increase as a result of: A) increasing the plowback ratio. B) increasing the payout ratio. C) decreasing the return on equity. D) increasing total assets. Answer: A Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

65) Under which of the following forms of market efficiency would stock prices always reflect fair value? A) Weak-form efficiency B) Semi-strong-form efficiency C) Strong-form efficiency D) Semi-weak-form efficiency Answer: C Difficulty: 1 Easy Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) Investors are willing to purchase stocks having high P/E ratios because: A) they expect these shares to sell for a lower price. B) they expect these shares to offer higher dividend payments. C) these shares are accompanied by guaranteed earnings. D) they expect these shares to have greater growth opportunities. Answer: D Difficulty: 1 Easy Topic: Stock valuation using multiples Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

67) Which of the following is least likely to contribute to going concern value? A) High liquidation value B) Extra earning power C) Future investment opportunities D) Intangible assets Answer: A Difficulty: 2 Medium Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 68) What happens to a firm that reinvests its earnings at a rate equal to the firm's required return? A) Its stock price will remain constant. B) Its stock price will increase by the sustainable growth rate. C) Its stock price will decline unless the dividend payout ratio is zero. D) Its stock price will decline unless the plowback rate exceeds the required return. Answer: A Difficulty: 2 Medium Topic: Net present value growth opportunity Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

69) What can be expected to happen when stocks having the same expected risk do not have the same expected return? A) At least one of the stocks becomes temporarily mispriced. B) This is a common occurrence indicating that one stock has more PVGO. C) This cannot happen if the shares are traded in an auction market. D) The expected risk levels will change until the expected returns are equal. Answer: A Difficulty: 2 Medium Topic: Risk and return relationship Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) The terminal value of a share of stock: A) is similar to the maturity value of a bond. B) refers to the share value at the end of an investor's holding period. C) is the value received by investors upon liquidation of the firm. D) is the price for shares traded through a dealers' market. Answer: B Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

71) A stock is expected to pay dividends of $1.20 per share in Year 1 and $1.35 per share in Year 2. After that, the dividend is expected to increase by 2.5% annually. What is the current value of the stock at a discount rate of 14.5%? A) $11.29 B) $10.87 C) $12.07 D) $13.39 Answer: B Explanation: Price = $1.20/1.145 + $1.35/1.1452 + [($1.35 × 1.025)/(0.145 − 0.025)]/1.1452 = $10.87 Difficulty: 2 Medium Topic: Nonconstant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 72) Jefferson's recently paid an annual dividend of $1.31 per share. The dividend is expected to decrease by 4% each year. How much should you pay for this stock today if your required return is 16%? A) $6.29 B) $5.74 C) $10.48 D) $11.57 Answer: A Explanation: Price = [$1.31 × (1 − 0.04)]/[0.16 − (−0.04)] = $6.29 Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

73) Which one of the following is more likely to be responsible for a firm having a low PVGO? A) ROE exceeds required return. B) Plowback is very high. C) Market value of equity is close to book value. D) Book value of equity is low. Answer: C Difficulty: 2 Medium Topic: Net present value growth opportunity Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) What is the most likely value of the PVGO for a stock with a current price of $50, expected earnings of $6 per share, and a required return of 20%? A) $10 B) $20 C) $25 D) $30 Answer: B Explanation: With a 100% payout ratio, the stock would be valued at $30 ($6/0.20 = $30). Thus, the $20 of additional price must represent the PVGO. Difficulty: 2 Medium Topic: Net present value growth opportunity Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

75) What is the expected constant-growth rate of dividends for a stock with a current price of $87, an expected dividend payment of $5.40 per share, and a required return of 16%? A) 8.48% B) 6.25% C) 9.79% D) 5.23% Answer: C Explanation: $87 = $5.40/(0.16 − g); g = 0.0979, or 9.79% Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 76) Which of the following is true for a firm having a stock price of $42, an expected dividend of $3, and a sustainable growth rate of 8%? A) It has a required return of 15.14%. B) It has a dividend yield of 7.35%. C) The stock price is expected to be $45 next year. D) It has a capital gain rate of 7.14%. Answer: A Explanation: Required return = $3/$42 + 0.08 = 0.1514, or 15.14% Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

77) What is the value of the expected dividend per share for a stock that has a required return of 16%, a price of $45, and a constant-growth rate of 12%? A) $1.80 B) $3.60 C) $4.50 D) $7.20 Answer: A Explanation: $45 = DIV1/(0.16 − 0.12); Div1 = $1.80 Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 78) What is the required return for a stock that has a constant-growth rate of 3.3%, a price of $25, an expected dividend of $2.10, and a P/E ratio of 14.4? A) 12.40% B) 10.92% C) 11.70% D) 11.26% Answer: C Explanation: $25 = $2.10/(r − 0.033); r = 11.70% Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

79) What should be the price of a stock that offers a $4.32 annual dividend with no prospects of growth, and has a required return of 12.5%? A) $0 B) $4.86 C) $34.56 D) $30.24 Answer: C Explanation: P = $4.32/0.125 = $34.56 Difficulty: 1 Easy Topic: Perpetuities Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 80) Psychologists have observed that: A) once investors have made a loss, they become much more willing to take risks. B) investors tend to place too much faith in their ability to spot mispriced stocks. C) when forecasting the future, people tend to place too little weight on recent events. D) investors like stocks of companies whose names begin with letters that occur early in the alphabet. Answer: B Difficulty: 2 Medium Topic: Behavioral finance Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

81) If The Wall Street Journal lists a stock's dividend as $1, then it is most likely the case that the stock: A) pays $1 per share per quarter. B) paid $.25 per share per quarter for the past year. C) paid $1 during the past quarter, with no future dividends forecast. D) is expected to pay a dividend of $1 per share at the end of next year. Answer: B Difficulty: 2 Medium Topic: Common stock features Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 82) Suzi owns 100 shares of AB stock. She expects to receive a $238 in dividends next year. Investors expect the stock to sell for $46 a share one year from now. What is the intrinsic value of this stock if the dividend payout ratio is 40% and the discount rate is 13.5%? A) $38.19 B) $42.63 C) $40.53 D) $45.77 Answer: B Explanation: Intrinsic value = [($238/100) + $46]/1.135 = $42.63 Difficulty: 2 Medium Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

83) What is the minimum amount shareholders should expect to receive in the event of a complete corporate liquidation? A) Market value of equity B) Book value of equity C) Zero D) Shareholders may be required to pay to be liquidated. Answer: C Difficulty: 2 Medium Topic: Common stock features Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) If the price of a stock falls on 4 consecutive days of trading, then stock prices: A) cannot be following a random walk. B) can still be following a random walk. C) are almost certain to increase the following day. D) are almost certain to decrease the following day. Answer: B Difficulty: 2 Medium Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) What should be the stock value one year from today for a stock that currently sells for $35, has a required return of 15%, an expected dividend of $2.80, and a constant dividend growth rate of 7%? A) $37.45 B) $37.80 C) $40.25 D) $43.05 Answer: A Explanation: $2.80 × 1.07/(0.15 − 0.07) = $37.45 Difficulty: 1 Easy Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 86) The required return on an equity security is comprised of a: A) dividend yield and ROE. B) current yield and a terminal value. C) sustainable growth rate and a plowback yield. D) dividend yield and a capital gains yield. Answer: D Difficulty: 1 Easy Topic: Stock returns and yields Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

87) What should be the current price of a share of stock if a $5 dividend was just paid, the stock has a required return of 20%, and a constant dividend growth rate of 6%? A) $19.23 B) $25.00 C) $35.71 D) $37.86 Answer: D Explanation: Price = ($5 × 1.06)/(0.20 − 0.06) = $37.86 Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 88) What should be the current price of a stock if the expected dividend is $5, the stock has a required return of 20%, and a constant dividend growth rate of 6%? A) $19.23 B) $25.00 C) $35.71 D) $37.86 Answer: C Explanation: Price = $5.00/(0.20 − 0.06) = $35.71 Difficulty: 2 Medium Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

89) Reinvesting earnings into a firm will not increase the stock price unless: A) the new paradigm of stock pricing is maintained. B) true depreciation is less than reported depreciation. C) the firm's dividends are growing also. D) the return on the new investments exceeds the firm's required return. Answer: D Difficulty: 2 Medium Topic: Net present value growth opportunity Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) What proportion of earnings is being plowed back into the firm if the sustainable growth rate is 8% and the firm's ROE is 20%? A) 60% B) 80% C) 20% D) 40% Answer: D Explanation: 8% = 20% × plowback; Plowback = 40% Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

91) How much of a stock's $30 price is reflected in PVGO if it expects to earn $4 per share, has an expected dividend of $2.50, and a required return of 20%? A) $0 B) $6 C) $8 D) $10 Answer: D Explanation: PVGO = $30 − ($4/0.2) = $10 Difficulty: 2 Medium Topic: Net present value growth opportunity Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 92) What is the expected constant-growth rate of dividends for a stock currently priced at $50, that just paid a dividend of $4, and has a required return of 18%? A) 3.41% B) 5.50% C) 9.26% D) 12.5% Answer: C Explanation: $50 = $4(1 + g)/(0.18 - g); g = 9.26% Difficulty: 3 Hard Topic: Constant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

93) According to random-walk theory, what are the (approximate) odds that a stock will increase in price after having increased on two consecutive days of trading? A) 0% B) 25% C) 50% D) 100% Answer: C Difficulty: 1 Easy Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) If the liquidation value of a corporation exceeds the market value of the equity, then the: A) firm has no value as a going concern. B) firm's stock will sell for book value. C) firm is not taking advantage of available growth opportunities. D) dividend payout ratio has been too high. Answer: A Difficulty: 2 Medium Topic: Market and book values Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

95) In a valuation of a nonconstant dividend growth stock, the terminal value represents the: A) point at which the present value of future dividends equals zero. B) maturity date of the stock. C) present value of future dividends from that point on. D) highest value that the stock will attain. Answer: C Difficulty: 2 Medium Topic: Nonconstant-growth stock Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 96) Which one of the following situations is most likely to occur today for a stock that went down in price yesterday? A) The stock will increase in price. B) The stock will decrease in price. C) The stock has a 30% chance of decreasing in price. D) The stock has no predictable price-change pattern. Answer: D Difficulty: 2 Medium Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

97) Based on the random walk theory, if a stock's price decreased last week, then this week the price: A) will reverse last week's loss and go up. B) will continue last week's decline. C) will stand still until new information is released. D) has an equal chance of going either up or down. Answer: D Difficulty: 2 Medium Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 98) Research indicates that the correlation coefficient between successive days' stock price changes is: A) quite close to +1. B) quite close to C) quite close to zero. D) directly related to the stock's beta. Answer: C Difficulty: 2 Medium Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 99) An analyst who relies on past cycles of stock pricing to make investment decisions is: A) performing fundamental analysis. B) relying on strong-form market efficiency. C) assuming that the market is not even weak-form efficient. D) relying on the random walk of stock prices. Answer: C Difficulty: 2 Medium Topic: Random walk Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44

100) Which statement is correct? A) When stock prices barely change for a while, they are said to be stuck in a "bubble." B) Bubbles can result when prices rise rapidly and investors join the game on the assumption that prices will continue to rise. C) Most bubbles with hindsight can be justified by the improved fundamentals. D) "Bubbles" is another term for stocks in high-tech industries. Answer: B Difficulty: 2 Medium Topic: Behavioral finance Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 101) If it proves possible to make abnormal profits based on information regarding past stock prices, then the market is: A) weak-form efficient. B) not weak-form efficient. C) semi strong-form efficient. D) strong-form efficient. Answer: B Difficulty: 1 Easy Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 102) Which statement is correct? A) The momentum factor refers to the tendency for stock price changes to reverse. B) The momentum factor refers to the tendency for stock price changes to persist for a while and then revert. C) The momentum factor implies that stock prices are rather like a pendulum. D) The momentum factor is inconsistent with the strong form of the efficient market hypothesis. Answer: B Difficulty: 1 Easy Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 45

103) Which statement is correct? A) It is much easier to judge whether the absolute level of stock prices is correct rather than whether their relative levels are correct. B) It is much easier to judge whether relative stock prices are correct than to judge whether their absolute level is correct. C) Most tests of market efficiency are concerned with the absolute level of stock prices. D) If relative prices are correct, then absolute prices must be correct also. Answer: B Difficulty: 2 Medium Topic: Market efficiency-foundations and types Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 104) Market efficiency implies A) that investors are irrational. B) that there is no point to buying common stocks. C) that consistently superior performance is very difficult even for professional investors. D) that there are no taxes. Answer: C Difficulty: 2 Medium Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

105) If no price change occurs in a stock on the day that it announces its next dividend, it can be assumed that: A) the stock market is inefficient. B) the dividend was reduced. C) the market was expecting this information. D) technical analysts are not following this stock. Answer: C Difficulty: 1 Easy Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 106) When investors are not capable of making superior investment decisions on a consistent basis based on past prices or public or private information, the market is said to be: A) weak-form efficient. B) semi strong-form efficient. C) strong-form efficient. D) fundamentally efficient. Answer: C Difficulty: 2 Medium Topic: Market efficiency-foundations and types Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

107) Evidence that newly issued stocks tend to underperform the market over the following years: A) is a natural result of risk aversion. B) is exactly what you would expect in an efficient market. C) is inconsistent with the semi-strong form of the efficient market hypothesis. D) is evidence against the random walk hypothesis. Answer: C Difficulty: 1 Easy Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 108) For corporate financial managers an important lesson of market efficiency is: A) Trust market prices unless you have a clear advantage that ensures the odds are in your favor. B) Issue stock after a rise in price. C) Be on the lookout for undervalued companies to take over. D) Your company should be able to make healthy profits from its foreign exchange dealings. Answer: A Difficulty: 2 Medium Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 109) When new information becomes available in the market, evidence generally suggests that: A) insiders will be the only investors to gain. B) it takes at least ten trading days for stock prices to adjust. C) stock prices will adjust to the information rapidly. D) transaction costs will erase any benefit of trading on the information. Answer: C Difficulty: 1 Easy Topic: Market efficiency-studies and challenges Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

110) Suppose that the total value of dividends to be paid by companies in the Narnian stock market index is $100 billion. Investors expect dividends to grow over the long term by 5% annually, and they require a 10% return. Now a collapse in the economy leads investors to revise their growth estimate down to 4%. By how much should market values change? A) −16.67%. B) zero. C) −20%. D) +20%. Answer: A Explanation: Before the collapse: PV = 100/(0.10 − 0.05) = $2,000 bn After the collapse: PV = 100/(0.10 − 0.04) =$1,667 bn Change = 1,667/2,000 − 1 = −16.67% Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 111) Your broker suggests that you can make consistent, excess profits by purchasing stocks on the 20th of the month and selling them on the last day of the month. If this is true, then: A) the market is only semi strong-form efficient. B) the market violates even weak-form efficiency. C) insiders will be the only investors to profit. D) prices follow a random walk. Answer: B Difficulty: 2 Medium Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

112) If a firm unexpectedly raises its dividend permanently and by a substantial amount, the firm's stock price: A) should rise, given dividend discount models. B) should decline, given discounted cash flow analysis. C) will remain constant, due to market efficiency. D) remain constant, due to random-walk behavior. Answer: A Difficulty: 2 Medium Topic: Dividend discount model Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 113) The statement that there are no free lunches on Wall Street suggests that: A) the market is strong-form efficient. B) there is no return to technical or fundamental analysis. C) security prices reflect all available information. D) food stocks offer the lowest rates of return. Answer: C Difficulty: 2 Medium Topic: Market efficiency-implications Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 8 Net Present Value and Other Investment Criteria 1) As the opportunity cost of capital decreases, the net present value of a project increases. Answer: TRUE Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 2) The IRR is the rate of return on the cash flows of the investment, also known as the opportunity cost of capital. Answer: FALSE Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) Projects with an NPV of zero decrease shareholders' wealth by the cost of the project. Answer: FALSE Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 4) When calculating IRR with a trial and error process, discount rates should usually be raised when NPV is positive. Answer: TRUE Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 1

5) Unlike using IRR, selecting projects according to their NPV will always lead to a correct accept-reject decision. Answer: TRUE Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) For mutually exclusive projects, the project with the higher IRR is the correct selection. Answer: FALSE Difficulty: 2 Medium Topic: Mutually exclusive projects Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) When using a profitability index to select projects, a high value is preferred over a low value. Answer: TRUE Difficulty: 1 Easy Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8) A project's payback period is the length of time necessary to generate an NPV of zero. Answer: FALSE Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

9) The payback period considers all project cash flows. Answer: FALSE Difficulty: 1 Easy Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) Both the NPV and the internal rate of return methods recognize that the timing of cash flows affects project value. Answer: TRUE Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) If a project has multiple IRRs, the lowest one is incorrect. Answer: FALSE Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12) Because of deficiencies associated with the payback method, it is seldom used in corporate financial analysis today. Answer: FALSE Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

13) A risky dollar is worth more than a safe one. Answer: FALSE Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) When choosing among mutually exclusive projects with similar lives, the choice is easy using the NPV rule. As long as at least one project has positive NPV, simply choose the project with the highest NPV. Answer: TRUE Difficulty: 2 Medium Topic: Mutually exclusive projects Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) When we compare assets with different lives, we should select the one that has the lowest equivalent annual cost. Answer: TRUE Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

16) For many firms the limits on capital funds are "soft." By this we mean that the capital rationing is not imposed by investors. Answer: TRUE Difficulty: 2 Medium Topic: Capital rationing Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) Soft rationing should never cost the firm anything. Answer: TRUE Difficulty: 2 Medium Topic: Capital rationing Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) For most managers, discounted cash-flow analysis is in fact the dominant tool for project evaluation. Answer: TRUE Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

19) The payback rule states that a project is acceptable if you get your money back within a specified period. Answer: TRUE Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 20) The payback rule always makes shareholders better off. Answer: FALSE Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) When you have to choose between projects with different lives, you should put them on an equal footing by computing the equivalent annual annuity or benefit of the two projects. Answer: TRUE Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

22) When you are considering whether to replace an aging machine with a new one, you should compare the equivalent annual cost of operating the old one with the equivalent annual cost of the new one. Answer: TRUE Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) The equivalent annual cost method should be used when comparing projects with different life spans and different initial investments. Answer: TRUE Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) A project's opportunity cost of capital is: A) the return that shareholders could expect to earn by investing in the financial markets. B) the return earned by investing in the project. C) equal to the average return on all company projects. D) designed to be less than the project's IRR. Answer: A Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

25) Which one of the following statements is correct for a project with a positive NPV? A) The IRR must be greater than 0. B) Accepting the project has an indeterminate effect on shareholders. C) The discount rate exceeds the cost of capital. D) The profitability index equals 1. Answer: A Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) If the net present value of a project that costs $20,000 is $5,000 when the discount rate is 10%, then the: A) project's IRR equals 10%. B) project's rate of return is greater than 10%. C) net present value of the cash inflows is $4,500. D) project's cash inflows total $25,000. Answer: B Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) What is the NPV of a project that costs $100,000 and returns $50,000 annually for 3 years if the opportunity cost of capital is 14%? A) $13,397.57 B) $14,473.44 C) $16,081.60 D) $33,748.58 Answer: C Explanation: NPV = −$100,000 + $50,000[(1 / 0.14) − 1 / 0.14(1.14)3] = $16,081.60 Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

28) The decision rule for net present value is to: A) accept all projects with cash inflows exceeding the initial cost. B) reject all projects with rates of return exceeding the opportunity cost of capital. C) accept all projects with positive net present values. D) reject all projects lasting longer than 10 years. Answer: C Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 29) Given the various investment options listed, what investment criteria concept might make an investor select Project B over other projects? Project A B C D

NPV Profitability Index $ 1.3 mil 0.23 $ 2.2 mil 0.54 $ 3.5 mil 0.49 $ 4.6 mil 0.38

A) The Gold Standard B) The Rate of Return Rule C) Capital rationing D) Selection bias criteria Answer: C Explanation: Capital rationing allows investors to select lower NPV projects if they do not have sufficient resources. Difficulty: 2 Medium Topic: Capital rationing Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

30) If a project's NPV is calculated to be negative what should a project manager do? A) The discount rate should be decreased. B) The profitability index should be calculated. C) The present value of the project cost should be determined. D) The project should be rejected. Answer: D Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 31) Which one of the following changes will increase the NPV of a project? A) A decrease in the discount rate B) A decrease in the size of the cash inflows C) An increase in the initial cost of the project D) A decrease in the number of cash inflows Answer: A Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32) What is the maximum that should be invested in a project at time zero if the inflows are estimated at $50,000 annually for 3 years, and the cost of capital is 9%? A) $101,251.79 B) $109,200.00 C) $126,564.73 D) $130,800.00 Answer: C Explanation: The maximum investment would equate CF0 with the present value of the inflows thereby producing a zero net present value. CF0 = $50,000(1 / 0.09) − [1 / 0.09(1.09)3] = $126,564.73 Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 10

33) When a manager does not accept a positive-NPV project, shareholders face an opportunity cost in the amount of the: A) project's initial cost. B) project's NPV. C) project's discounted cash inflows. D) soft capital rationing budget. Answer: B Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) What is the maximum amount a firm should pay for a project that will return $15,000 annually for 5 years if the opportunity cost is 10%? A) $24,157.65 B) $56,861.80 C) $62,540.10 D) $48,021.19 Answer: B Explanation: The maximum investment would equate CF0 with the present value of the inflows thereby producing a zero net present value. CF0 = $15,000(1 / 0.10) − [1 / 0.10(1.10)5] = $56,861.80 Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

35) Which of the following projects would you feel safest in accepting? Assume the opportunity cost of capital to be 12% for each project. A) "A" has a small, but negative, NPV. B) "B" has a positive NPV when discounted at 10%. C) "C's" cost of capital exceeds its rate of return. D) "D" has a zero NPV when discounted at 14%. Answer: D Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) As the discount rate is increased, the NPV of a specific project will: A) increase. B) decrease. C) remain constant. D) decrease to zero, then remain constant. Answer: B Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) A project requires an initial outlay of $10 million. If the cost of capital exceeds the project IRR, then the project has a(n): A) positive NPV. B) negative NPV. C) acceptable payback period. D) positive profitability index. Answer: B Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

38) Using the "gold standard" of investment criteria, which project should be selected? Project A B C D

NPV $ 2.3 mil $ 1.2 mil $ 3.5 mil $ 4.4 mil

Investment $ 5.2 mil $ 2.8 mil $ 6.9 mil $ 8.9 mil

A) Project A B) Project B C) Project C D) Project D Answer: D Explanation: Project D should be selected because it has the highest NPV. The NPV is the Gold Standard of selection criteria. Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 39) The modified internal rate of return can be used to correct for: A) negative NPV calculations. B) multiple internal rates of return. C) undefined payback periods. D) borrowing projects. Answer: B Difficulty: 2 Medium Topic: Modified internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

40) The internal rate of return is most reliable when evaluating: A) a single project with alternating cash inflows and outflows over several years. B) mutually exclusive projects of differing sizes. C) a single project with only cash inflows following the initial cash outflow. D) a single project with cash outflows at time 0 and the final year and inflows in all other time periods. Answer: C Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 41) When a project's internal rate of return equals its opportunity cost of capital, then the: A) project should be rejected. B) project has no cash inflows. C) net present value will be positive. D) net present value will be zero. Answer: D Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

42) Firms that make investment decisions based on the payback rule may be biased toward rejecting projects: A) with short lives. B) with long lives. C) with late cash inflows. D) that have negative NPVs. Answer: B Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 43) One way to increase the NPV of a project is to decrease the: A) project's payback period. B) profitability index. C) time until the receipt of cash inflows. D) number of project IRRs. Answer: C Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

44) What is the IRR for a project that costs $100,000 and provides annual cash inflows of $30,000 for 6 years starting one year from today? A) 19.91% B) 16.67% C) 15.84% D) 22.09% Answer: A Explanation: Using a financial calculator: n = 6; PV = −$100,000; PMT = $30,000; FV = 0; CPT i = 19.91% Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Apply AACSB: Technology Accessibility: Keyboard Navigation

45) Using the Profitability Index rule, which of the four projects is the best investment? Project A B C D

NPV $ 2.3 mil $ 1.2 mil $ 3.5 mil $ 4.4 mil

Investment $ 5.2 mil $ 2.8 mil $ 6.9 mil $ 8.9 mil

NPV $ 2.3 mil $ 1.2 mil $ 3.5 mil $ 4.4 mil

Investment $ 5.2 mil $ 2.8 mil $ 6.9 mil $ 8.9 mil

A) Project A B) Project B C) Project C D) Project D Answer: C Explanation: Project A B C D

PI 2.3/5.2 = 0.44 1.2/2.8 = 0.43 3.5/6.9 = 0.51 4.4/8.9 = 0.49

Difficulty: 2 Medium Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

46) What is the IRR of a project that costs $100,000 and provides cash inflows of $17,000 annually for 6 years? A) 0.57% B) 1.21% C) 5.69% D) 12.10% Answer: A Explanation: Using a financial calculator: n = 6; PV = −$100,000; PMT = $17,000; FV = 0; CPT i = 0.57% Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Apply AACSB: Technology Accessibility: Keyboard Navigation 47) An investment costs $100,000 and provides a cash inflow of $17,000 per year. If the discount rate is 13%, how long must the cash inflows last for it to be an acceptable investment? A) 24 years B) 6 years C) 10 years D) 12 years Answer: D Explanation: NPV = 0 = −$100,000 + $17,000[(1 / 0.13) − 1 / 0.13(1.13)n]; n = 12 years Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

48) If a project costs $72,000 and returns $18,500 per year for 5 years, what is its IRR? A) 8.98% B) 7.39% C) 8.50% D) 7.67% Answer: A Explanation: Using a financial calculator: n = 5; PV = −$72,000; PMT = $18,500; FV = 0; CPT i = 8.98% Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Apply AACSB: Technology Accessibility: Keyboard Navigation 49) If the IRR for a project is 15%, then the project's NPV would be: A) negative at a discount rate of 10%. B) positive at a discount rate of 20%. C) negative at a discount rate of 20%. D) positive at a discount rate of 15%. Answer: C Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 50) As long as the NPV of a project declines smoothly with increases in the discount rate, the project is acceptable if its: A) internal rate of return is positive. B) payback period is greater than one. C) rate of return exceeds the cost of capital. D) cash inflows equal the initial cost. Answer: C Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19

51) A project can have as many different internal rates of return as it has: A) cash inflows. B) cash outflows. C) periods of cash flow. D) changes in the sign of the cash flows. Answer: D Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) What is the NPV for the following project cash flows at a discount rate of 15%? C0 = −$1,000, C1 = $700, C2 = $700. A) ($308.70) B) ($138.00) C) $138.00 D) $308.70 Answer: C Explanation: NPV = −$1,000 + $700[(1 / 0.15) − 1 / 0.15(1.15)2] = $138.00 Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 53) What is the IRR of a project with the following cash flows: C0 = −$200, C1 = $ 110, C2 = $121? A) Zero B) 10% C) 18% D) 5% Answer: B Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Analyze AACSB: Technology Accessibility: Keyboard Navigation 20

54) A project costing $20,000 generates cash inflows of $9,000 annually for the first 3 years, followed by cash outflows of $1,000 annually for 2 years. At most, this project has different IRR(s). A) one B) two C) three D) five Answer: B Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) How many IRRs are possible for the following set of cash flows? CF0 = −$1,000, C1 = $500, C2 = −$300, C3 = $1,000, C4 = $200. A) One B) Two C) Three D) Four Answer: C Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

56) Given a particular set of project cash flows, which one of the following statements must be correct? A) There can be only one NPV for the project. B) There can be only one IRR for the project. C) There can be more than one IRR for the project. D) There can be up to two profitability indexes for any project. Answer: C Difficulty: 3 Hard Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) When projects are mutually exclusive, you should choose the project with the: A) longer life. B) larger initial size. C) highest IRR. D) highest NPV. Answer: D Difficulty: 2 Medium Topic: Mutually exclusive projects Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) When managers select correctly from among mutually exclusive projects, they: A) may give up rate of return for NPV. B) may give up NPV for rate of return. C) have a tendency to select the largest project. D) focus on the payback method to avoid conflicting signals. Answer: A Difficulty: 2 Medium Topic: Mutually exclusive projects Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) When evaluating mutually exclusive projects, remember: A) the project with the higher IRR may have the higher NPV at one discount rate and a lower NPV at another. B) cash flows cannot be discounted when considering mutually exclusive projects. C) mutually exclusive projects produce negative IRR values. D) mutually exclusive projects always have multiple IRRs. Answer: A Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) Two mutually exclusive projects have the same IRR. When will you be indifferent between them? A) When the IRR is equal to the cost of capital. B) Always if they have the same IRR. C) When the IRR is less than the cost of capital. D) When there is only one change in the sign of the cash flows. Answer: A Difficulty: 3 Hard Topic: Mutually exclusive projects Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

61) When managers cannot determine whether to invest now or wait until costs decrease later, the rule should be to: A) postpone until costs reach their lowest level. B) invest now to maximize the NPV. C) postpone until the opportunity cost reaches its lowest level. D) invest at the date that provides the highest NPV today. Answer: D Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 62) You are analyzing a project that is equivalent to borrowing money. This project's: A) NPV graph rises as discount rates decrease. B) initial cash flow is an outflow of funds. C) value increases when the cost of capital increases. D) acceptance requires its IRR to exceed the cost of capital. Answer: C Difficulty: 3 Hard Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) If two machines produce the same product but have different lives, you should choose the machine with the: A) highest IRR. B) longest life. C) lowest equivalent annual cost. D) highest NPV, discounted at the opportunity cost of capital. Answer: C Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) Which mutually exclusive project would you select, if both are priced at $1,000 and your required return is 15%: Project A with three annual cash flows of $1,000; or Project B, with 3 years of zero cash flow followed by 3 years of $1,500 annually? A) Project A B) Project B C) You are indifferent since the NPVs are equal. D) Neither project should be selected. Answer: A Explanation: Project A Project B

0 -1000 -1000

NPV A @ 15% NPV B @ 15%

1 1000 0

2 1000 0

3 1000 0

1500

$ $

1,283.23 1,251.89

Difficulty: 3 Hard Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

65) What is the possible cost of capital rationing? A) The firm may have excess fixed assets. B) The firm is likely to take too many risky projects. C) The firm may miss out on positive NPV opportunities D) The firm may have too high a cost of capital. Answer: C Difficulty: 1 Easy Topic: Capital rationing Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) Soft capital rationing: A) is costly to shareholders. B) is used to evaluate mutually exclusive projects. C) should be costless to the shareholders of the firm. D) solves the problem of investment timing. Answer: C Difficulty: 2 Medium Topic: Capital rationing Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) Soft capital rationing is imposed upon a firm by imposed by . A) management; the capital market. B) the capital market; management. C) the government; the capital market. D) the capital market; the government.

, while hard capital rationing is

Answer: A Difficulty: 1 Easy Topic: Capital rationing Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Remember AACSB: Analytical Thinking Accessibility: Keyboard Navigation

68) If a project has a cost of $50,000 and a profitability index of 0.45, then: A) it has a negative NPV. B) its NPV could be positive or negative depending on the cost of capital. C) its cash flow is $100,000. D) it has a positive NPV. Answer: D Difficulty: 2 Medium Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 69) In simple cases when hard capital rationing exists, projects may be evaluated by: A) the payback period. B) mutually exclusive IRRs. C) a profitability index. D) the modified internal rate of return. Answer: C Difficulty: 2 Medium Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) Use of a profitability index to evaluate mutually exclusive projects in the absence of capital rationing: A) will provide the same rankings as an NPV criterion. B) will maximize NPV, but not IRR. C) can result in misguided selections. D) is technically impossible. Answer: C Difficulty: 2 Medium Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

71) The profitability index selects projects based on the: A) highest net discounted value at time zero. B) highest internal rate of return. C) largest dollar investment per rate of return. D) largest return per dollar invested. Answer: D Difficulty: 2 Medium Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 72) Which of the following investment criteria takes the time value of money into consideration? A) Net present value only B) Profitability index and net present value only C) Internal rate of return and net present value only D) Profitability index, internal rate of return, and net present value Answer: D Difficulty: 1 Easy Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) When calculating a project's payback period, cash flows are: A) discounted at the opportunity cost of capital. B) discounted at the internal rate of return. C) discounted at the risk-free rate of return. D) not discounted at all. Answer: D Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

74) What is the profitability index for a project costing $40,000 and returning $15,000 annually for 4 years at an opportunity cost of capital of 12%? A) 0.139 B) 0.320 C) 0.500 D) 0.861 Answer: A Explanation: PI = {−$40,000 + $15,000[(1 / 0.12) − 1 / 0.12(1.12)4]} / $40,000 = 0.139 Difficulty: 2 Medium Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 75) Which of the following statements is true for a project with a $20,000 initial cost, cash inflows of $6,667 per year for 6 years, and a discount rate of 15%? A) Its payback period is 3 years. B) Its NPV is $2,094. C) Its IRR is 17.85%. D) Its profitability index is 0.104. Answer: A Explanation: Payback = $20,000 / $6,667 = 3 years NPV = −$20,000 + $6,667[(1 / 0.15) − 1 / 0.15(1.15)6] = $5,231 PI = $5,231 / $20,000 = 0.262 IRR = 24.3% Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

76) The "gold standard" of investment criteria refers to the: A) net present value rule. B) internal rate of return rule. C) payback rule. D) profitability index rule. Answer: A Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 77) Which of the following investment decision rules tends to improperly reject long-lived projects? A) Net present value B) Internal rate of return C) Payback period D) Profitability index Answer: C Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 78) The ratio of net present value to initial investment is known as the: A) net present value. B) internal rate of return. C) payback period. D) profitability index. Answer: D Difficulty: 1 Easy Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

79) For mutually exclusive projects, the IRR can be used to select the best project: A) by calculating the modified internal rate of return. B) by calculating the IRR based on incremental cash flows. C) by using the discount rate to calculate the IRR. D) never. IRR cannot be utilized for mutually exclusive projects. Answer: B Difficulty: 2 Medium Topic: Mutually exclusive projects Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 80) The opportunity cost of capital is equal to: A) the discount rate that makes the project NPV equal zero. B) the return that shareholders could expect by investing their money in the financial markets. C) a project's internal rate of return. D) the average rate of return for a firm's projects. Answer: B Difficulty: 1 Easy Topic: Capital budgeting Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 81) Occasionally projects may have positive initial cash flows. Such projects: A) are like lending money. B) are like borrowing money. C) have no IRR. D) their IRR increases as the cost of capital increases. Answer: B Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

82) A project with an IRR that is less than the opportunity cost of capital should be: A) accepted for all projects. B) accepted only for projects with a positive initial cash flow. C) accepted only for projects with a negative initial cash flow. D) rejected for all projects. Answer: B Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) If a project's expected rate of return exceeds its opportunity cost of capital, one would expect: A) the profitability index to be negative. B) the opportunity cost of capital to be too low. C) the project to have a positive NPV. D) the NPV to be zero. Answer: C Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) Which one of the following should be assumed about a project that requires a $100,000 investment at time zero, then returns $20,000 annually for 5 years? A) The NPV is negative. B) The NPV is zero. C) The profitability index is 1.0. D) The IRR is negative. Answer: A Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) If two projects offer the same positive NPV, then they: A) also have the same IRR. B) have the same payback period. C) are mutually exclusive projects. D) add the same amount of value to the firm. Answer: D Difficulty: 2 Medium Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) What is the minimum cash flow that could be received at the end of year 3 to make the following project "acceptable"? Initial cost = $100,000; cash flows at end of years 1 and 2 = $35,000; opportunity cost of capital = 10%. A) $29,494 B) $30,000 C) $39,256 D) $52,250 Answer: D Explanation: NPV = 0 − $100,000 + ($35,000 / 1.1) + $35,000 / 1.12 + $x / 1.13; x = $52,250 A cash flow of $52,250 received in year 3, and discounted at 10%, would increase the NPV to zero. Difficulty: 3 Hard Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

87) According to the NPV rule, all projects should be accepted if NPV is positive when discounted at the: A) internal rate of return. B) opportunity cost of capital. C) risk-free interest rate. D) accounting rate of return. Answer: B Difficulty: 1 Easy Topic: Net present value Learning Objective: 08-01 Calculate the net present value of a project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) If a project's IRR is 13% and the project provides annual cash flows of $15,000 for 4 years, how much did the project cost? A) $44,617.07 B) $52,208.18 C) $41,909.29 D) $49,082.11 Answer: A Explanation: PV = $15,000 (1 / 0.13) − [1 / 0.13(1.13)4] = $44,617.07 Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

89) A project's payback period is determined to be 4 years. If it is later discovered that additional cash flows will be generated in years 5 and 6, then the project's payback period will: A) be reduced. B) be increased. C) be unchanged. D) change but the discount rate must be known to determine the nature of the change. Answer: C Difficulty: 2 Medium Topic: Payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) A polisher costs $10,000 and will cost $20,000 a year to operate and maintain. If the discount rate is 10% and the polisher will last for 5 years, what is the equivalent annual cost of the tool? A) $17,163.04 B) $22,187.84 C) $22,637.98 D) $19,411.15 Answer: C Explanation: PV = −$10,000 + −$20,000[(1 / 0.1) − 1 / 0.1(1.1)5] = −$85,815.74 The equivalent annual cost is the payment with the same present value. So, using a financial calculator: n = 5; i = 10%; PV = −$85,815.74; FV = 0; CPT PMT = $22,637.98 Difficulty: 3 Hard Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Analyze AACSB: Technology Accessibility: Keyboard Navigation

91) Selecting the project(s) with the highest NPV(s) is not the correct decision rule when: A) there is capital rationing. B) there are mutually exclusive projects. C) projects are long-lived. D) projects are independent. Answer: A Difficulty: 2 Medium Topic: Capital rationing Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 92) The investment timing problem arises when: A) cash flows may occur at the beginning or end of each time period. B) there is a choice between using the payback or NPV rules. C) the project has a positive initial cash flow. D) investment can occur now or at some future point. Answer: D Difficulty: 1 Easy Topic: Capital budgeting Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

93) A company owns a tract of timber that will keep growing for a number of years. It calculates that the timber's value less the cost of harvesting is currently $50,000 and that this figure will grow by 10% in the next year and by 5% in the following year. If the cost of capital is 8%, when should the company harvest the timber? A) today. B) year 1. C) year 2. D) harvest a third of the timber each year. Answer: B Explanation: If harvested in year 1, the timber will have an NPV in year 1 of $50,000 × 1.10 = $55,000, and an NPV today of $55,000 / 1.08 = $50,926 If harvested in year 2, it will have an NPV is year 2 of $55,000 × 1.05 = $57,750 and an NPV today of $57,750 / 1.082 = $49,511 Difficulty: 2 Medium Topic: Capital budgeting Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) To justify postponing a project for one year, the NPV needs to increase over that year by a rate that is equal to or greater than: A) the project's IRR. B) the risk-free rate. C) the cost of capital. D) zero. Answer: C Difficulty: 2 Medium Topic: Capital budgeting Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

95) What happens to the equivalent annual cost of a project as the opportunity cost of capital decreases? A) It increases. B) It decreases. C) It is not affected. D) It depends on whether or not the projects are mutually exclusive. Answer: B Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 96) What is the equivalent annual cost for a project that requires a $40,000 investment at time zero, and a $10,000 annual expense during each of the next 4 years, if the opportunity cost of capital is 10%? A) $20,000.00 B) $21,356.95 C) $22,618.83 D) $25,237.66 Answer: C Explanation: NPV = −$40,000 − $10,000[(1 / 0.1) − 1 / 0.1(1.1)4] = −$71,698.65 The EAC is the payment that has the same NPV given 4 years and a 10% discount rate. So, using a financial calculator: n = 4; i = 10%; PV = −$71,698.65; FV = 0; CPT PMT = $22,618.83 Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

97) A currently used machine costs $10,000 annually to run. What is the maximum that should be paid to replace the machine with one that will last 3 years and cost only $4,000 annually to run? The opportunity cost of capital is 12%. A) $15,209.84 B) $9,607.33 C) $14,410.99 D) $10,338.56 Answer: C Explanation: NPV = [−$10,000 − (−$4,000)][(1 / 0.12) − 1 / 0.12(1.12)3] = $14,410.99 Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 98) Because of its age, your car costs $4,000 annually in maintenance expense. You could replace it with a newer vehicle costing $8,000. Both vehicles would be expected to last 4 more years, at which point they will be valueless. If your opportunity cost is 8%, by how much must maintenance expense decrease on the newer vehicle to justify its purchase? A) $1,625.40 B) $1,584.63 C) $1,469.08 D) $1,409.54 Answer: B Explanation: $8,000 = PMT [(1 / 0.08) − 1 / 0.08(1.08)4]; PMT = $2,415.37 Maintenance expense decrease required = $4,000 − 2,415.37 = $1,584.63 Difficulty: 3 Hard Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

99) Projects A and B are mutually exclusive lending projects. Project A has an IRR of 20% while Project B has an IRR of 30%. You would be more likely to choose B unless: A) Project B has a longer life than Project A. B) Project A has more risk than Project B. C) Project A is twice the size of Project B. D) Project B has a larger cash inflow in Year 1 than Project A. Answer: C Difficulty: 2 Medium Topic: Mutually exclusive projects Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 100) What is the decision rule in the case of sign changes that produce multiple IRRs for a project? A) Select the lowest IRR to be conservative B) Select the highest IRR to maximize the benefits C) Any or all of the IRRs are justified to use D) Calculate the modified internal rate of return. Answer: D Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

101) If a project has a payback period of 5 years and a cost of capital of 10%, then the discounted payback will: A) exceed 5 years. B) be less than 5 years. C) decrease if the cost of capital increases. D) decrease if the payback period increases due to revised cash flows. Answer: A Difficulty: 2 Medium Topic: Discounted payback Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 102) You can continue to use your less efficient machine at a cost of $8,000 annually. Alternatively, you can purchase a more efficient machine for $12,000 plus $5,000 annual maintenance. If the new machine lasts 5 years and the cost of capital is 15%, you should: A) buy the new machine and save $600 in equivalent annual costs. B) buy the new machine and save $388 in equivalent annual costs. C) keep the old machine and save $388 in equivalent annual costs. D) keep the old machine and save $580 in equivalent annual costs. Answer: D Explanation: NPV = −$12,000 − $5,000[(1 / 0.15) − 1 / 0.15(1.15)5] = −$28,760.78 Using a financial calculator: N = 5; I = 15%; PV = −$28,760.78; FV = 0; CPT PMT = $8,579.79 Change in annual cost = $8,579.79 − 8,000 = $579.79 Difficulty: 2 Medium Topic: Equivalent annual costs Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure, (b) how to choose between projects with unequal lives, and (c) when to replace equipment. Bloom's: Analyze AACSB: Technology Accessibility: Keyboard Navigation

103) A firm is considering a project with the following cash flows: Time 0 = +$20,000, Years 15 = −$4,500. Should the project be accepted if the cost of capital is 10%? A) Yes; The IRR of the project is 4.06%. B) Yes; The IRR of the project is 12.5%. C) No; The IRR of the project is 4.06%. D) No; The IRR of the project is 12.5%. Answer: A Explanation: Using a financial calculator: n = 5; PV = $20,000; PMT = −$4,500; FV = 0; CPT i = 4.06% Given the cash flow signs, it resembles borrowing at 4.06% and, therefore, it is acceptable if this is less than the cost of capital. Difficulty: 2 Medium Topic: Internal rate of return Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Bloom's: Analyze AACSB: Technology Accessibility: Keyboard Navigation 104) A firm plans to use the profitability index to select between two mutually exclusive investments. If no capital rationing has been imposed, which project should be selected? A) Select the project with the higher profitability index B) Select the project with the lower profitability index C) Without capital rationing, both projects can be selected D) Without capital rationing, the NPV method must be used instead Answer: D Difficulty: 2 Medium Topic: Profitability index Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 1) Capital budgeting analysis focuses on cash flow as opposed to profits. Answer: TRUE Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows. Answer: FALSE Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) Sunk costs influence capital budgeting decisions only when the sunk costs exceed future cash inflows. Answer: FALSE Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 4) Opportunity costs are evaluated for investment decisions at their historical cost. Answer: FALSE Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

5) The method of financing a project affects the determination of its cash flows for capital budgeting purposes. Answer: FALSE Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) In project analysis, allocations of overhead should be limited to those that represent additional expense. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) A reduction in working capital increases cash flows. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8) The present value of the total depreciation tax shield will be higher when an asset uses bonus depreciation than when depreciated straight-line. Answer: TRUE Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

9) If a firm sells an asset for more than its value in the IRS's books, the resulting net cash flow will be less than the sales price. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) When a firm makes an investment in working capital, the cash is usually recovered later. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) Discounting real cash flows with real interest rates provides an overly optimistic idea of a project's value. Answer: FALSE Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12) Sunk costs remain the same whether or not you accept the project. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

13) Sunk costs do not affect the net present value of a project. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) Investments in working capital, just like investments in plant and equipment, result in cash inflows. Answer: FALSE Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) An asset amortized using bonus depreciation will have depreciation expense in 6 different years. Answer: FALSE Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16) A project will always generate extra overhead costs. Answer: FALSE Difficulty: 2 Medium Topic: Fixed and variable costs Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

17) Discounting real cash flows at a nominal rate is a serious mistake. Answer: TRUE Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) Suppose you finance a project partly with debt. You should neither subtract the debt proceeds from the project's required investment, nor would you recognize the interest and principal payments on the debt as cash outflows. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) When you finance a project partly with debt, you should still view the project as if it were all equity-financed, treating all cash outflows required for the project as coming from stockholders, and all cash inflows as going to them. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20) As a project comes to its end, there is a disinvestment in working capital, which also generates positive cash flow as inventories are sold off and accounts receivable are collected. Answer: TRUE Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

21) The total depreciation tax shield equals the product of depreciation and the tax rate. Answer: TRUE Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) Cash flow from operations = (revenues − cash expenses) × (1 − tax rate) + (depreciation × tax rate). Answer: TRUE Difficulty: 2 Medium Topic: Operating cash flow Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) Corporate income statements are designed primarily to show: A) cash flows during a period. B) account balances at the end of a period. C) performance during a period. D) market values of assets and liabilities. Answer: C Difficulty: 1 Easy Topic: Income statement Learning Objective: 09-02 Calculate the cash flows of a project from standard financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

24) Projects that have negative NPVs should be: A) depreciated over a longer time period. B) charged less in overhead costs. C) discounted using lower rates. D) rejected or abandoned. Answer: D Difficulty: 1 Easy Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) If the adoption of a new product will reduce the sales of an existing product, then the project cash flows should: A) reflect only the sales of the new product. B) include only the reduction amount. C) be reduced by the cash that would have been generated by those sales. D) be adjusted upward by the reduction amount. Answer: C Difficulty: 2 Medium Topic: Pro forma statements Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) Which one of these represents a cash outflow for a project? A) A sunk cost B) Increase in accounts receivable C) Depreciation D) Accrued expenses Answer: B Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

27) Bonus depreciation allows an increase: A) in total depreciation over the asset's life. B) in depreciation in the first year only. C) in real but not nominal depreciation expense. D) in the asset's depreciable cost basis. Answer: B Difficulty: 1 Easy Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) The rationale for not including sunk costs in capital budgeting decisions is that they: A) are usually small in magnitude. B) revert at the end of the investment. C) have no incremental effect on project cash flows. D) reduce the project's net present value. Answer: C Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) You are considering the introduction of a new product that will require an investment in new machinery. Which one of these will lower the net present value of that project? A) A reduction in the firm's total variable costs due to the purchase of the new machine B) A loss of sales of existing products due to the introduction of the new product C) The increase in annual depreciation resulting from the asset purchase D) The sale of the machine after it is fully depreciated Answer: B Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

30) When is it appropriate to include sunk costs in the evaluation of a project? A) Whenever they are relatively large B) If they improve the project's NPV C) If they are considered to be overhead costs D) Never Answer: D Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) A firm invests in a 7-year project that requires the purchase of a $135,000 machine tool. This will be depreciated using 100% bonus depreciation in the first year and will have no salvage value. When will this equipment affect the project's tax payments? A) Every year for 5 years B) At the time of purchase only C) It will have no impact D) Every year for 7 years Answer: B Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 32) The opportunity cost of an asset: A) should be depreciated annually. B) should be included in the project cash flows. C) is typically ignored in capital budgeting. D) is important only for parcels of land. Answer: B Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

33) Which one of the following is least likely to influence the opportunity cost of an asset? A) Its current market value B) Alternative uses for the asset C) The current demand for the asset D) Its current book value Answer: D Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) Assume your firm has an unused machine that originally cost $75,000, has a book value of $20,000, and a market value of $25,000. Ignoring taxes, what is the opportunity cost of using this machine? A) $75,000 B) $25,000 C) $20,000 D) $5,000 Answer: B Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35) Which one of the following changes in working capital is least likely if sales increase? A) An increase in inventories B) An increase in accounts payable C) A decrease in accounts receivable D) An increase in notes payable Answer: C Difficulty: 1 Easy Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

36) A proposed project requires an initial investment of $8,500 in current assets, 75% of which will be financed with accounts payable. The project will have: A) an initial cash outflow of $8,500 at time zero for net working capital. B) a cash outflow for net working capital at the end of the project. C) a cash inflow at the end of the project from net working capital. D) a cash outflow for net working capital every year of the project's life. Answer: C Difficulty: 1 Easy Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) Under bonus depreciation: A) all assets are depreciated over 5 years. B) depreciable percentages decline throughout the asset's class life. C) straight-line depreciation percentages are doubled. D) assets are fully expenses when purchased. Answer: D Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 38) Bonus depreciation: A) allows for more total depreciation over the asset's life. B) decreases the depreciation tax shield. C) increases the depreciation tax shield. D) allows for assets to be depreciated more rapidly. Answer: D Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Remember AACSB: Analytical Thinking Accessibility: Keyboard Navigation

39) In which of the following cases will a cash investment in net working capital be most likely? A) Inventory levels will be reduced when the project is introduced. B) All sales related to the project will be cash sales to a subsidiary. C) The project will increase inventory more than accounts payable. D) The project will require additional inventory which will be financed by a supplier. Answer: C Difficulty: 1 Easy Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) What is the effect on a firm's net working capital if a new project requires a $30,000 increase in inventory, a $10,000 increase in accounts receivable, a $35,000 expenditure on machinery, and a $20,000 increase in accounts payable? A) −$5,000 B) $10,000 C) $20,000 D) $55,000 Answer: C Explanation: Change in NWC = $30,000 + 10,000 − 20,000 = $20,000 Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

41) A project is expected to increase inventory by $17,000, increase accounts payable by $10,000, and decrease accounts receivable by $1,000. What is the project's cash flow from net working capital at time zero? A) −$8,000 B) $8,000 C) −$6,000 D) $6,000 Answer: C Explanation: Cash flow0 = −$17,000 + 10,000 + 1,000 = −$6,000 Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 42) Net working capital is expected to increase by $25,000 in year 5 of a project. If this extra working capital is recovered when the project ends in year 6, what is the effect on the project's net present value, if the cost of capital is 15%? A) NPV will not be affected because the $25,000 will all be recouped. B) NPV will increase by $12,429.42. C) NPV will decrease by $25,000. D) NPV will decrease by $1,621.23. Answer: D Explanation: ΔNPV = −$25,000 / 1.155 + 25,000 / 1.156 = $1,621.23 Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

43) Investments in working capital: A) are simply accounting entries and do not affect NPV. B) do not matter because the cash is generally recovered when the project ends. C) increase NPV because they make the project more valuable. D) reduce project NPV. Answer: D Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) Changes in net working capital can occur at: A) the beginning of a project. B) the end of a project. C) any time during the life of a project. D) the beginning of any accounting period. Answer: C Difficulty: 1 Easy Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Remember AACSB: Analytical Thinking Accessibility: Keyboard Navigation 45) What effect is likely at the end of the life of a project that required a $20,000 investment in net working capital? A) The $20,000 must now be paid by the firm. B) The firm receives a $20,000 cash inflow. C) Taxable income is reduced by $20,000. D) No effects are expected because the $20,000 is now a sunk cost. Answer: B Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

46) Allocations of overheads should not affect a project's incremental cash flows unless the: A) project actually changes the total amount of overhead expenses. B) overhead will not be recovered at the end of the project. C) overhead is not currently fully allocated to existing projects. D) accountant is required to allocate costs to this project. Answer: A Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 47) The NPV of an investment proposal becomes negative solely as a result of allocating a portion of the corporation president's salary. It is most likely the case that: A) the project should be accepted. B) rejecting the project is the correct decision. C) the allocation should be postponed until the project is accepted. D) the salary should be considered an opportunity cost of the project. Answer: A Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) The correct method to handle overhead costs in capital budgeting is to: A) allocate a portion to each project. B) allocate them to projects with the highest NPVs. C) ignore all except incremental amounts. D) ignore them in all cases. Answer: C Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

49) Which one of the following would not be expected to affect the decision of whether to undertake an investment? A) Income tax rates B) Estimates of future inflation rates C) Sales reductions in other products caused by this investment D) Cost of the feasibility study that was conducted for this project Answer: D Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 50) Which one of the following methods will provide a correct analysis for capital budgeting purposes? A) Discounting real cash flows with real rates. B) Discounting real cash flows with nominal rates. C) Discounting nominal cash flows with real rates. D) Discounting nominal cash flows with either real or nominal rates. Answer: A Difficulty: 1 Easy Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) The likely effect of discounting nominal cash flows with real interest rates will be to: A) make an investment's NPV appear more attractive. B) make an investment's NPV appear less attractive. C) correctly calculate an investment's NPV if inflation is expected. D) correctly calculate an investment's NPV, regardless of expected inflation. Answer: A Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

52) Your forecast shows $500,000 annually in sales for each of the next 3 years. If your second and third year predictions have failed to incorporate the 3% expected annual inflation, how far off in total dollar sales is your 3-year forecast? A) $45,450 B) $60,900 C) $52,550 D) $76,250 Answer: A Explanation: Difference = $500,000 + ($500,000 × 1.03) + ($500,000 × 1.032) − ($500,000 × 3) = $45,450 Difficulty: 2 Medium Topic: Sales forecasts Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 53) Which one of the following would be more apt to make an unacceptable project appear acceptable? A) Discounting real cash flows with real rates B) Discounting nominal cash flows with real rates C) Discounting real cash flows with nominal rates D) Discounting nominal cash flows with nominal rates Answer: B Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) Capital budgeting proposals should be evaluated as if the project were financed: A) entirely by debt. B) entirely by equity. C) half by debt and half by equity. D) with the highest cost source of funds, to be safe. Answer: B Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17

55) When calculating cash flow from operations, one should: A) subtract depreciation since it represents the cost of replacing worn-out equipment. B) deduct the depreciation tax shield from after-tax profit. C) use after-tax profit and ignore depreciation. D) add depreciation to after-tax profit. Answer: D Difficulty: 2 Medium Topic: Operating cash flow Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) The recovery of an additional investment in working capital is likely to: A) occur at the end of a project's life. B) occur at the beginning of a project's life. C) occur whenever the project first shows a profit. D) be a sunk cost. Answer: A Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) In what manner does depreciation expense affect investment projects? A) It reduces cash flows by the amount of the depreciation expense. B) It increases cash flows by the amount of the depreciation expense. C) It reduces taxable income by the amount of the depreciation expense. D) It reduces taxes by the amount of the depreciation expense. Answer: C Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

58) Given a positive discount rate, which one of the following changes would increase the NPV of a project? A) Increasing the firm's opportunity cost of capital. B) Reducing the amount of working capital that is needed. C) Spreading the total cash inflows over a longer time interval. D) Increasing the project's estimated expenses. Answer: B Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 59) What is the annual depreciation tax shield for a profitable firm in the 21% tax bracket with $100,000 of annual depreciation expense? A) $10,500 B) $21,000 C) $35,000 D) $65,000 Answer: B Explanation: Depreciation tax shield = $100,000 × 0.21 = $21,000 Difficulty: 1 Easy Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

60) What is the amount of the annual depreciation tax shield for a firm with $200,000 in net income, $75,000 in depreciation expense, and a 21% tax rate? A) $15,750 B) $43,750 C) $70,000 D) $75,000 Answer: A Explanation: Depreciation tax shield = $75,000 × 0.21 = $15,750 Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 61) What is the operating cash flow for a firm with $500,000 profit before tax, $100,000 depreciation expense, and a 21% tax rate? A) $260,000 B) $325,000 C) $360,000 D) $495,000 Answer: D Explanation: OCF = [$500,000 × (1 − 0.21)] + $100,000 = $495,000 Difficulty: 2 Medium Topic: Operating cash flow Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

62) A tax shield is equal to the reduction in a firm's: A) total tax liability resulting from a tax deductible expense. B) taxable income resulting from depreciation. C) taxable income resulting from a decrease in long-term debt. D) net income caused by depreciation. Answer: A Difficulty: 1 Easy Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 63) Which one of the following categories would be least likely to require annual adjustments in a capital budgeting analysis due to the effects of inflation? A) Sales B) Expenses C) Working capital D) Depreciation expense Answer: D Difficulty: 1 Easy Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) Why is bonus depreciation often favored for the corporation's set of tax books? A) It increases the total depreciation tax shield over the project's life. B) It reduces the total amount of taxes paid over the project's life. C) It increases net accounting profits over the project's life. D) It allows the depreciation tax savings to be realized earlier. Answer: D Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

65) A firm plans to invest $50,000 in R&D that will be depreciated straight-line over a 5-years. What is the present value of the resulting depreciation tax shield if the tax rate is 21% and the discount rate is 10%? A) $6,866.67 B) $7,960.65 C) $10,500.00 D) $39,500.00 Answer: B Explanation: Annual depreciation tax shield = $50,000 / 5 × 0.21 = $2,100 PV of tax shield = $2,100 {(1 / 0.1) − [1 / 0.1(1.1)5]} = $7,960.65 Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 66) The present value of the depreciation tax shield at any given discount rate is: A) equal for all depreciation methods. B) higher with bonus depreciation than with straight-line depreciation. C) higher for the 7-year recovery period than for the 5-year recovery period class. D) likely to increase annually due to inflation. Answer: B Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

67) When the real rate of interest is less than the nominal rate of interest, then: A) disinflation must be occurring. B) investment returns cannot increase the purchasing power of an investment. C) nominal cash flows should be discounted with real rates. D) the rate of inflation must be positive. Answer: D Difficulty: 1 Easy Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 68) When a depreciable asset is ultimately sold, the sales price is: A) fully taxable. B) nontaxable. C) nontaxable only if accelerated depreciation was used. D) taxable to the extent that the sales price exceeds book value. Answer: D Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 69) Which one of the following statements regarding depreciation is correct? A) The depreciation tax shield adjusts annually with the level of inflation. B) The real amount of annual depreciation is fixed, thus the higher the rate of inflation, the higher the depreciation tax shield. C) Tax law allows immediate expensing to be used for tax purposes for certain assets. D) Bonus Depreciation can be used for accounting purposes but not for tax purposes. Answer: C Difficulty: 1 Easy Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

70) The statement "We've got too much invested in that project to pull out now" possibly illustrates the need to: A) switch to an accelerated method of depreciation. B) recognize sunk costs. C) reduce net working capital assigned to the project. D) reduce discount rates to improve NPV. Answer: B Difficulty: 1 Easy Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 71) What is the undiscounted cash flow in the final year of an investment, assuming $10,000 after-tax cash flows from operations, $1,000 from the sale of a fully depreciated machine, a $2,000 investment in working capital, and a 21% tax rate? A) $8,450 B) $12,600 C) $12,790 D) $14,000 Answer: C Explanation: Cash flowFinal = $10,000 + $2,000 + $1,000 × (1 − 0.21) = $12,790 Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

72) At a 13% cost of capital, a project's NPV is $100,000 if you invest today. By what amount must the initial cost of the project decrease before you would wish to wait 2 years before investing? Assume all else is held constant. A) $21,685 B) $26,000 C) $27,690 D) $29,380 Answer: C Explanation: Required decrease = $100,000 × (1.13)2 − $100,000 = $27,690 Difficulty: 3 Hard Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 73) Which of the following correctly adjusts for depreciation when calculating a project's operating cash flow? A) (revenues − cash expenses) × (1 − tax rate) + (tax rate × depreciation). B) pretax profit + depreciation tax shield. C) after-tax profit − depreciation. D) ignore depreciation since it is not a cash flow. Answer: A Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

74) A new inventory system will immediately reduce inventory levels by $100,000. If this reduction is permanent and the cost of capital is 13%, how does the net working capital change affect company value? A) Company value increases by $100,000. B) NPV increases by $13,000. C) Company value will not change. D) Company value increases by $769,231. Answer: A Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 75) The opportunity cost of a resource should be considered in project analysis, unless: A) negative cash flows result from its use. B) the resource was purchased in a prior time period. C) the resource has been fully depreciated. D) the resource has no identifiable market value or alternative use within the firm. Answer: D Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) A new project requires an increase in both current assets and current liabilities of $125,000 each. What is the overall impact on the net working capital investment? A) An increase of zero B) An increase of $125,000 C) An increase of $250,000 D) An increase of $62,500, when averaged over the life of the project Answer: A Difficulty: 1 Easy Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26

77) The primary difficulty in the allocation of overhead costs to prospective projects is that the: A) allocation will reduce the project's NPV. B) discount rate is unknown. C) costs may not represent an incremental expense. D) expenses may have been previously allocated. Answer: C Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 78) If inflation is forecast to increase, which of the company's following cash flows is most likely to change? A) The depreciation tax shield. B) Labor costs. C) Costs of raw materials purchased on a fixed price contract. D) Interest payments on its long-term debt. Answer: B Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

79) A project costs $12,800 and is expected to provide a real cash inflow of $10,000 at the end of each of years 1 through 5. Calculate the net present value of this project if inflation is expected tobe 4% in each year and the firm employs a nominal discount rate of 10.76%. A) $33,522.30 B) $28,756.79 C) $33,294.07 D) $26,311.15 Answer: B Explanation: Real rate = 1.1076 / 1.04 − 1 = 0.065 NPV = −$12,800 + $10,000{(1 / 0.065) − [1 / 0.065(1.065)5]} = $28,756.79 Difficulty: 3 Hard Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 80) An investment today of $25,000 promises to return $10,000 annually for the next 3 years. What is the real rate of return on this investment if inflation averages 6% annually during the period? A) 3.49% B) 9.78% C) 4.84% D) 6.38% Answer: A Explanation: Using a financial calculator: n = 3, PV = −$25,000, PMT = $10,000, FV = $0, CPT i/Y = 9.701% Real return = 1.09701 / 1.06 − 1 = 0.0349, or 3.49% Difficulty: 3 Hard Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

81) What nominal annual return is required on an investment for an investor to experience a 12% gain in purchasing power? Assume inflation is 4%. A) 7.69% B) 9.29% C) 12.00% D) 16.48% Answer: D Explanation: Nominal rate = 1.12 × 1.04 − 1 = 0.1648, or 16.48% Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 82) What is the NPV of a 6-year project that costs $100,000, has annual revenues of $50,000 and costs of $15,000? Assume the investment can be depreciated for tax purposes straight-line over 6 years, the corporate tax rate is 21%, and the discount rate is 14%. A) −$15,560.04 B) $21,131.99 C) $3,411.14 D) $14,782.09 Answer: B Explanation: Annual cash flow = (revenues − costs) × (1 − tax rate) + (tax rate × depreciation) = (50,000 − 15,000) × (1 − 0.21) + (0.21 × 100,000 / 6) = $31,150 NPV = −$100,000 + $31,150 × [1 / 0.14 −1 / (0.14 × 1.146] = $21,131.99 Difficulty: 3 Hard Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

83) An investment of $120,000 can be depreciated for tax purposes straight line over 6 years. The corporate tax rate is 21%. When calculating cash flow: A) the company should deduct a depreciation tax shield of $4,200 a year from after-tax (revenues less cash expenses) B) the company should add a depreciation tax shield of $4,200 a year to after-tax (revenues less cash expenses) C) the company should add a depreciation tax shield of $20,000 a year to after-tax (revenues less cash expenses) D) no adjustment should be made for depreciation since it is not a cash expense. Answer: B Difficulty: 2 Medium Topic: Operating cash flow Learning Objective: 09-02 Calculate the cash flows of a project from standard financial statements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) A project that increased sales was accompanied by a $50,000 increase in inventory, a $20,000 increase in accounts receivable, and a $25,000 increase in accounts payable. Assuming these amounts remain constant, by how much has net working capital increased? A) $5,000 B) $25,000 C) $30,000 D) $45,000 Answer: D Explanation: ΔNWC = $50,000 + 20,000 − 25,000 = $45,000 Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

85) Which of the following costs probably should not be allocated to the investment needed for a new project? A) Project's required increase in accounts receivable B) New warehouse, built for this project C) A portion of the vice president's salary D) Labor expense for employees involved in the project Answer: C Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) A parcel of corporate land was recently chosen as the new plant site. What cost allocation should the land receive, based on the following: original cost of $200,000, highest market value during time of ownership of $300,000, net book value of $200,000, a recent offer to purchase for $250,000? A) $200,000 B) $250,000 C) $275,000 D) $300,000 Answer: B Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) Which of the following is true of the depreciation tax shield? A) It increases annually with the rate of inflation. B) It decreases annually in nominal terms. C) It is not altered by inflation. D) The real value of the depreciation is fixed. Answer: C Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31

88) Assuming an asset has been fully depreciated, which one of the following statements is correct? A) Its market value is zero. B) Its book value is zero. C) Its book value is the current market value. D) It has neither a book value nor a market value. Answer: B Difficulty: 1 Easy Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) New projects can have multiple effects on a firm. Which one of the following appears to be a positive indirect effect? A) Additional working capital will be required at the start of the project. B) The sales force will need to be increased over the life of the project. C) Sales of replacement parts are expected in the future. D) The cost of employee benefits will increase due to new hires. Answer: C Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) New projects or products can provide positive indirect effects as well as negative effects. Which one of the following appears to be a negative indirect effect? A) The new machine required for the project uses less electricity than the existing machine. B) Orders for your complementary products are expected to increase. C) Customer orders of supplies for the firm's existing products are expected to decrease. D) Variable costs are expected to decrease since the firm can order larger quantities. Answer: C Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

91) Lew's Metals has a machine sitting idle in its warehouse. The machine originally cost $213,000, has a current book value of $32,300, has a scrap metal value of $13,000, and a market value of $46,900. The machine is totally paid for. What value should be placed on this machine if it is used for a new project? A) $0 B) $13,000 C) $32,300 D) $46,900 Answer: D Difficulty: 1 Easy Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 92) A project requires an additional commitment of $100,000 in net working capital in each of years 1 to 4. These extra investments can be recovered in year 5 when the project comes to an end. What is the effect on NPV? A) NPV is reduced by $100,000. B) NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for 4 years. C) NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for each of years 1 to 4 minus the discounted value of the $400,000 that is recovered in year 5. D) No opportunity cost is involved. Answer: C Difficulty: 3 Hard Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

93) The additional inventory investment that is often required for new projects is partially offset by: A) switching to accelerated depreciation methods. B) reducing accounts receivable. C) decreasing equipment purchases. D) increasing accounts payable. Answer: D Difficulty: 2 Medium Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) What rate of nominal growth is expected in sales if they are currently $1,000,000 and are expected to reach $1,600,000 in 5 years? Assume an inflation rate of 3.5%. A) 3.20% B) 9.86% C) 12.00% D) 26.49% Answer: B Explanation: ($1,600,000 / $1,000,000)1/5 − 1 = 9.86% Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 95) What is the effect of using bonus depreciation rather than straight-line depreciation? A) It increases the NPV. B) The total amount of depreciation is increased. C) It allows asset book values to increase with market values. D) It increases gross fixed assets. Answer: A Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34

96) A firm invests $10 million in a new stamping machine. It depreciates it straight line for tax purposes over 5 years. The tax rate is 21%, inflation is 4% a year, and the discount rate is 8%. What is the PV of the depreciation tax shield? A) $600,000. B) $1,676.938. C) $2,579,497. D) $3,000,000. Answer: B Explanation: Annual depreciation tax shield = 0.21 × $10 million / 5 =$420,000 PV shield = =$420,000{1 / 0.08 − 1 / (0.08 × 1.085)] = $1,676,938 Difficulty: 2 Medium Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Capital budgeting projects typically assume that all cash flows transpire at the end of the year. The reason for this is that: A) less tax liability results from this practice. B) balance sheets are prepared at the end of the year. C) it simplifies the analysis and the resulting errors are usually small compared with the errors in forecasting future cash flows. D) most corporations collect their cash at the end of the year. Answer: C Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

98) Which one of the following is not accurate in depicting the cash flows from operations for an all-equity firm? A) (revenues − cash expenses)(1 − tax rate) + (depreciation × tax rate) B) (revenues − expenses − taxes) C) (net profit + depreciation) D) (revenues − cash expenses − taxes) Answer: B Difficulty: 2 Medium Topic: Operating cash flow Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 99) Which of the following typically results from using straight-line depreciation rather than bonus depreciation in the set of books for shareholders? A) Net income appears higher during the early periods of depreciation. B) Less money is paid to the Internal Revenue Service over an asset's life. C) Financial managers have more funds from operations available over the asset's life. D) Cash flow from operations will be higher in the second year of the asset's life. Answer: A Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 100) When you evaluate a proposed project you should: A) allocate a percentage of current overhead costs to the project. B) include all indirect effects. C) include sunk costs. D) ignore opportunity costs. Answer: B Difficulty: 2 Medium Topic: Cash flows Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

101) Which one of the following formulas is incorrect? A) Operating cash flow = revenues − cash expenses − taxes B) Operating cash flow = net profit + depreciation C) Depreciation tax shield = depreciation × (1 − tax rate) D) Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (depreciation × tax rate) Answer: C Difficulty: 2 Medium Topic: Depreciation Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 102) Which one of these statements is incorrect? A) Real cash flows must be discounted at a real discount rate. B) (1 + real rate of interest) = (1 + nominal rate of interest) / (1 + inflation rate) C) The actual real rate of interest almost equals "nominal rate of interest − inflation rate." D) Inflation rate = nominal rate / real rate − 1 Answer: D Difficulty: 1 Easy Topic: Nominal and real rates Learning Objective: 09-01 Identify the cash flows from a proposed new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 103) Which of the following statements regarding investment in working capital is incorrect? A) An investment in working capital, unlike an investment in plant and equipment, represents a positive cash flow when the investment is made. B) Net working capital cash flow is measured by the change in working capital, not the level of working capital. C) Net working capital may change during the life of a project. D) Working capital is generally recovered at the end of a project. Answer: A Difficulty: 1 Easy Topic: Net working capital Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 10 Project Analysis 1) A capital budget shows a proposed list of investments. Answer: TRUE Difficulty: 1 Easy Topic: Capital budgeting Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) The strategic planning portion of the capital budgeting process is essentially a "bottom-up" process. Answer: FALSE Difficulty: 2 Medium Topic: Capital budgeting Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) Competitive advantage is an important element of many successful capital budgeting proposals. Answer: TRUE Difficulty: 1 Easy Topic: Capital budgeting Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

4) While sensitivity analysis is forward-looking, scenario analysis attempts to reconstruct and analyze the past. Answer: FALSE Difficulty: 2 Medium Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) The level of sales that produces a zero project NPV is referred to as the accounting break-even point. Answer: FALSE Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) The NPV break-even level of sales will be higher than the accounting break-even level. Answer: TRUE Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) The degree of operating leverage (DOL) shows the relationship between sales and profits. Answer: TRUE Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

8) Operating leverage increases with fixed cost. Answer: TRUE Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) If a large proportion of a firm's costs is fixed, a shortfall in sales will have a magnified effect on the firm's profits. Answer: TRUE Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) The greater the DOL, the greater the protection against operating losses during economic downturns. Answer: FALSE Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) A firm that employs largely agency staff is likely to have higher operating leverage than one that employs its staff on long-term contracts. Answer: FALSE Difficulty: 1 Easy Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3

12) The option to abandon a project becomes more valuable as the possible outcomes become more varied. Answer: TRUE Difficulty: 2 Medium Topic: Real options Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) Conflicts of interest between shareholders and managers may result in the sacrifice of attractive capital budgeting proposals. Answer: TRUE Difficulty: 1 Easy Topic: Agency costs and problems Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Bloom's: Remember AACSB: Ethics Accessibility: Keyboard Navigation 14) Sensitivity analysis takes into consideration the interrelationship of variables. Answer: FALSE Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Scenario analysis allows managers to look at different and sometimes inconsistent combinations of variables. Answer: FALSE Difficulty: 2 Medium Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 4

16) "What-if" questions ask what will happen to a project in various circumstances. Answer: TRUE Difficulty: 1 Easy Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) What-if analysis is not crucial to capital budgeting. Answer: FALSE Difficulty: 1 Easy Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) What-if analysis can help identify the inputs that are most worth refining before you commit to a project. Answer: TRUE Difficulty: 1 Easy Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) The inputs that are most worth refining before you commit to a project are the ones that have the greatest potential to alter project NPV. Answer: TRUE Difficulty: 1 Easy Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

20) Scenario analysis allows managers to look at different but consistent combinations of interrelated variables. Answer: TRUE Difficulty: 1 Easy Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) A project that breaks even in accounting terms will surely have a negative NPV. Answer: TRUE Difficulty: 1 Easy Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) A project that simply breaks even on an accounting basis gives you your money back but does not cover the opportunity cost of the capital tied up in the project. Answer: TRUE Difficulty: 1 Easy Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) Managers that accept projects that only break even on an accounting basis are helping their shareholders. Answer: FALSE Difficulty: 1 Easy Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6

24) The time value of money causes accounting break-even sales volume to be higher than NPV break-even sales. Answer: FALSE Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) What level of management is responsible for originating capital budgeting proposals? A) Senior management B) Divisional management C) Lower management D) All levels of management Answer: D Difficulty: 1 Easy Topic: Capital budgeting Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) The capital budget should be consistent with the firm's: A) historical growth in sales. B) strategic plans. C) current level of debt. D) dividend policy. Answer: B Difficulty: 1 Easy Topic: Capital budgeting Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

27) Which one of the following would not be included as a traditional capital budgeting project? A) Machine replacement proposals B) Salary adjustment proposals C) New product proposals D) Plant expansion proposals Answer: B Difficulty: 1 Easy Topic: Capital budgeting Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) Which company is likely to have high operating leverage? A) A company with high fixed costs. B) A company with high variable costs. C) A company with low fixed costs. D) A company financed largely by debt Answer: A Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 29) Which one of the following capital budgeting proposals is most apt to be associated with a conflict of interests? A) The proposal with the highest NPV B) The proposal with the longest payback period C) The proposal with the highest IRR and quickest payback D) The proposal to solve pollution problems cited by the EPA Answer: C Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Bloom's: Apply AACSB: Ethics Accessibility: Keyboard Navigation

30) Analysis indicates that a project's level of success is primarily dependent upon the firm controlling the variable costs. What type of analysis was conducted? A) Sensitivity analysis B) Break-even analysis C) Ratio analysis D) Real option analysis Answer: A Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) Which of the following project analysis techniques does not allow for alteration of multiple variables simultaneously? A) Sensitivity analysis B) Scenario Analysis C) Simulation Analysis D) Monte Carlo Analysis Answer: A Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 32) Soft capital rationing may be beneficial to a firm if it: A) reduces a firm's taxes. B) weeds out proposals with NPVs that have been overstated. C) allows managers to select their favorite projects. D) lowers the cost of capital. Answer: B Difficulty: 2 Medium Topic: Capital budgeting Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9

33) The purpose of sensitivity analysis is to show: A) the optimal level of capital expenditures. B) how price changes affect break-even volume. C) seasonal variation in product demand. D) how variables in a project affect profitability. Answer: D Difficulty: 1 Easy Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) Decision trees are most useful when valuing which type of real option? A) Abandonment B) Expand C) Flexible facilities D) Timing Answer: A Difficulty: 2 Medium Topic: Decision trees Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 35) Sensitivity analysis evaluates projects by: A) forecasting changes in interest rates that would increase financing costs. B) recording profitability changes while changing one variable at a time. C) ensuring that the project sponsor has the proper incentives. D) testing for interrelated variables. Answer: B Difficulty: 1 Easy Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

36) What is the change in the NPV of a one-year project if fixed costs are increased from $400 to $600, assuming the firm is profitable, has a 21% tax rate, and a 12% cost of capital? A) −$200.00 B) −$178.57 C) −$152.00 D) −$141.07 Answer: D Explanation: ΔNPV = (−$600 + 400)(1 − 0.21) / 1.12 = −$141.07 Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 37) What happens to the NPV of a two-year project if sales less costs are increased in each year from $1,000 to $1,500? Assume the firm has a 21% tax rate, and a 15% cost of capital. A) NPV increases by $812.85. B) NPV increases by $642.16. C) NPV increases by $500.00. D) NPV increases by $282.61. Answer: B Explanation: ΔNPV = 500(1 − 0.21) / 1.15 + 500(1 − 0.21) / 1.152 = $642.16 Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

38) Which one of the following appears to be a more likely result from using sensitivity analysis? A) Agreement on the appropriate discount rate B) Determination of whether to finance with debt or equity C) Isolation of the pivotal factor in project profitability D) Selection of the best capital budgeting project Answer: C Difficulty: 1 Easy Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) If a 20% reduction in a project's forecast sales would still result in a positive NPV, then sensitivity analysis would suggest: A) that there is little point in further market research. B) that a more detailed sales forecast is required. C) that the initial sales forecasts were inflated. D) that more of the company's overhead costs can be allocated to this product. Answer: A Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

40) If sensitivity analysis concludes that the largest impact on profits would come from changes in the sales level, then: A) fixed costs should be traded for variable costs. B) variable costs should be traded for fixed costs. C) the project should not be undertaken. D) additional marketing analysis may be beneficial before proceeding. Answer: D Difficulty: 1 Easy Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 41) Which one of the following statements is correct concerning sensitivity analysis? A) It ignores interrelationships between variables. B) Several variables are allowed to change concurrently. C) It considers all feasible variable combinations. D) It can guarantee a project's success. Answer: A Difficulty: 1 Easy Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) Sensitivity analysis: A) makes most sense when variables are interrelated. B) gives an idea of the combined effect of pessimistic outcomes. C) allows the manager to weight the various outcomes to provide a better estimate of NPV. D) forces the manager to identify the underlying factors. Answer: D Difficulty: 2 Medium Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

43) Which one of the following techniques may be more appropriate to analyze projects with interrelated variables? A) Sensitivity analysis B) Scenario analysis C) Break-even analysis D) DOL analysis Answer: B Difficulty: 1 Easy Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) Which one of the following descriptions is representative of scenario analysis? A) One variable at a time is allowed to change. B) It isolates the unknowns that belong in the model. C) Different combinations of variables are analyzed. D) It represents the "top-down" approach. Answer: C Difficulty: 1 Easy Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) Which statement is not correct? A) project proposers tend to be overconfident about the likely success of the project. B) project proposers often exaggerate the likely profitability in order to gain acceptance. C) overconfidence and enthusiasm can result in increased effort. D) most project proposals are based on very conservative forecasts. Answer: D Difficulty: 1 Easy Topic: Simulation analysis Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

46) Assume a 5-year project has a base-case NPV of $213,000, a tax rate of 21%, and a cost of capital of 14%. What will be the worst-case NPV if the annual after-tax cash flows are reduced in that scenario by $35,000 for each of the 5 years? A) −$92,842.17 B) −$120,157.83 C) $92,842.17 D) $120,157.83 Answer: C Explanation: NPV = $213,000 + (−$35,000 {(1 / 0.14) − [1 / 0.14(1.145)]}) = $92,842.17 Difficulty: 2 Medium Topic: Scenario analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 47) Which one of the following variables would you suspect to be least significant in a sensitivity analysis of a fast-food establishment? A) Sales B) Depreciation C) Labor cost D) Food cost Answer: B Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

48) A firm has fixed costs of $1.2 million and depreciation of $1 million. Variable costs are 64% of sales. What is the accounting break-even level of sales? A) $5.23 million B) $3.44 million C) $6.11 million D) $4.87 million Answer: C Explanation: Profit margin = 1 − 0.64 = 0.36 Accounting B / E = ($1.2m + 1m) / 0.36 = $6.11 million Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 49) Weston's has variable costs that average 68% of sales. If fixed costs increase by $1, what will be the increase in the break-even level of revenues? A) An increase of $0.68 B) An increase of $1.00 C) An increase of $1.471 D) An increase of $3.125 Answer: D Explanation: ΔBreak-even revenues = $1 / (1 − 0.68) = $3.125 Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

50) The accounting break-even level of sales represents the point where: A) fixed costs are covered. B) variable costs are covered. C) fixed costs and variable costs are covered. D) sales are equal to the sum of fixed costs, variable costs, and depreciation. Answer: D Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) The Corner Market has fixed costs of $1,600, depreciation of $1,200, a tax rate of 21%, and a cost of capital of 12%. Variable costs represent 67% of sales. What minimum level of sales must the market obtain to avoid a net loss on its income statement? A) $8,484.85 B) $6,666.67 C) $7,033.33 D) $7,867.67 Answer: A Explanation: Accounting B / E = ($1,600 + 1,200) / (1 − 0.67) = $8,484.85 Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

52) Calculate the accounting break-even level of sales assuming $865,000 of fixed costs, $400,000 depreciation expense, and a variable costs-to-sales ratio of 65%. A) $2,769,230.77 B) $3,614,285.71 C) $4,237,769.23 D) $1,946.153.85 Answer: B Explanation: Accounting B / E = ($865,000 + 400,000) / (1 − 0.65) = $3,614,285.71 Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 53) What effect will a reduction in the cost of capital have on the accounting break-even level of revenues? A) It raises the break-even level. B) It reduces the break-even level. C) It has no effect on the break-even level. D) This cannot be determined without knowing the length of the investment horizon. Answer: C Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

54) Break-even revenues on an accounting basis typically indicate a: A) negative NPV. B) positive NPV. C) high degree of operating leverage. D) downturn in the business cycle. Answer: A Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) The accounting break-even level of revenues represents the point at which the project has: A) zero pretax profit. B) zero net present value. C) covered all opportunity costs. D) covered the fixed and variable costs but not the depreciation. Answer: A Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) Which one of the following changes might turn a negative NPV project into a positive NPV project? A) A decrease in the estimated annual sales B) An increase in the discount rate C) An increase in the initial investment D) A decrease in the fixed costs Answer: D Difficulty: 1 Easy Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

57) If project sales exceed the accounting break-even point, but the project has a negative EVA, then the project has a: A) positive NPV but earns less than the discount rate. B) negative NPV but earns more than the discount rate. C) net loss on the income statement. D) net profit but negative NPV. Answer: D Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) A company has $3,000 per year in depreciation over a 6 year period. Due to tax code changes, the company can switch to bonus depreciation and expense the entire investment immediately. What is the increase in PV of cash flows given a 21% corporate tax rate and a discount rate of 9%? Assume the bonus depreciation is taken at the end of year 1. A) $586.32 B) $641.76 C) $717.44 D) $865.69 Answer: B Explanation: Old tax savings per year = $3,000 × 0.21 = $630 PV of tax savings using a financial calculator: Pmt = 630, FV = 0, n = 6, i = 9, solve for PV = $2,826.13 PV of tax savings with bonus depreciation = ($3,000 × 6 × 0.21)/1.09 = $3,467.89 Increased savings = $3,467.89 − $2,826.13 = $641.76 Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) Calculate the ratio of variable costs to sales for a firm with a $3 million accounting breakeven revenue point, $1.2 million fixed costs, and $450,000 depreciation. A) 40% B) 45% C) 55% D) 60% Answer: B Explanation: Accounting B / E = $3m = ($1.2m + 0.45m) / x; x = 0.55 Variable costs to sales = 1 − 0.55 = 0.45, or 45% Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 60) What is the maximum percentage of variable costs to sales that a firm could have and still break even with $5 million in revenues, $1 million in fixed costs, and $500,000 of depreciation? A) 30% B) 70% C) 80% D) 90% Answer: B Explanation: Accounting B / E = $5m = ($1m + 0.5m) / x; x = 0.30 Variable costs to sales = 1 − 0.30 = 0.70, or 70% Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

61) A firm with 60% of sales going to variable costs, $1.5 million fixed costs, and $500,000 depreciation and sales of $3 million. How does the current level of sales compare to the accounting break-even sales level? A) Current sales are $2 million below the break-even level. B) Current sales are $333,333 below the break-even level. C) Current sales are $800,000 below the break-even level. D) Current sales exceed the break-even level by $360,000. Answer: A Explanation: Accounting B / E = ($1.5m + 0.5m) / (1 − 0.60) = $5m; Current sales are $2 million below the break-even level. Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 62) A 6-year project has a zero NPV with sales of $5 million and a discount rate of 8%. The annual cash inflows are equal to 10% of sales minus $300,000. What was the initial investment in the project assuming that none of the investment is recoverable when the project ends? A) $416,667 B) $924,576 C) $1,016,678 D) $2,311,450 Answer: B Explanation: Investment = [($5m × 0.10) − $300,000]{(1 / 0.08) − [1 / 0.08(1.086)]} = $924,576 Difficulty: 3 Hard Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

63) A pro football team has a NPV of $200 million. There is a 70% chance the team will get a new stadium within 1 year and the value of the team will increase to $350 million. To keep the team from moving, a rich local benefactor has offered to buy the team for $200 million today. Given a 12% discount rate what is the most the current owner should be willing to offer the benefactor to keep the offer on the table until the end of the year? A) $50 mil B) $72 mil C) $137 mil D) $150 mil Answer: B Explanation: Value of team with offer = (0.70 × $350 + $200 × 0.30) / (1.12) = $272 million Value of team without offer = $200 million Value of offer to buy the team = $272 − 200 = $72 million Difficulty: 3 Hard Topic: Decision trees Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 64) Calculate the NPV break-even level of sales for a project requiring an investment of $3 million and providing annual cash flows equal to 15% of sales less $250,000. None of the initial investment is recoverable. Assume the project will generate these cash flows for 10 years and the discount rate is 10%. A) $3,254,890 B) $3,504,890 C) $4,921,575 D) $1,686,667 Answer: C Explanation: $3m = [(Sales × 0.15) − $250,000]{(1 / 0.10) − [1 / 0.10(1.10)10]}; Sales = $4,921,575 Difficulty: 3 Hard Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

65) If the level of sales is less than that calculated as the NPV break-even level, then the: A) project will break even in accounting terms. B) project's EVA will be greater than zero but less than the opportunity cost of capital. C) project will have a negative EVA. D) discount rate should be reduced. Answer: C Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) One difference between an NPV break-even level of sales and an accounting break-even level of sales is the: A) consideration of the opportunity cost of capital. B) consideration of interest expense. C) allowance of the sales level to vary in response to changes in demand. D) inclusion of income taxes. Answer: A Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) A project that has zero economic value added: A) has a positive NPV. B) has an NPV of zero. C) has a negative NPV. D) is at the accounting break-even point. Answer: B Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

68) Which one of these projects would you always reject? A) High operating leverage, sales projected at the accounting break-even level, and no option to abandon or expand. B) High operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand. C) Low operating leverage, sales projected at the accounting break-even level, and an option to abandon or expand. D) Low operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand. Answer: A Difficulty: 3 Hard Topic: Project analysis and evaluation Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 69) Fixed costs including depreciation have increased at Leverage Inc., from $4 million to $5.3 million. Suppose that the company now breaks even on an accounting basis with sales of $20 million. What must be the break-even variable cost as a percentage of sales? A) 69.2% B) 65.8% C) 73.5% D) 76.7% Answer: C Explanation: Accounting B / E = $20m = $5.3m / (1 − x); x = 0.735, or 73.5% Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

70) Fixed costs: A) are a constant percentage of sales revenues. B) vary with the level of depreciation expense. C) are constant regardless of the level of output. D) are inversely related to the level of output. Answer: C Difficulty: 1 Easy Topic: Fixed and variable costs Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 71) A firm with high operating leverage is expected to: A) have high variable costs. B) have low fixed costs. C) have a high degree of profitability. D) perform particularly well when sales are high. Answer: D Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 72) If the firm's degree of operating leverage is 4.5, what percentage change in sales will result in a 3% rise in profits? A) 0.33% B) 0.67% C) 3.03% D) 1.50% Answer: B Explanation: ΔSales = 3% / 4.5 = 0.67% Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 26

73) If the firm's degree of operating leverage is 3.8, what percentage change in sales will result in a 13.8% fall in profits? A) 0.28% B) −2.75% C) −3.63% D) 10.00% Answer: C Explanation: ΔSales = −13.8% / 3.8 = −3.63% Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 74) If the proportion of fixed costs increases: A) DOL falls. B) DOL rises. C) the NPV breakeven level of sales declines. D) the NPV of the cash flows declines. Answer: B Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

75) What happens to a firm with high operating leverage when the overall level of sales is very high? A) The firm is likely to have higher levels of fixed costs. B) The firm is likely to enjoy high profits. C) The firm will not break even in accounting terms. D) The firm will have a reduced level of depreciation. Answer: B Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) For a firm with a DOL of 3.5, an increase in sales of 6% will: A) increase pretax profits by 3.5%. B) decrease pretax profits by 3.5%. C) increase pretax profits by 21.0%. D) increase pretax profits by 1.71%. Answer: C Explanation: ΔProfits = 6% × 3.5 = 21% Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

77) A firm with $800,000 of fixed costs including $200,000 of depreciation is expected to produce $225,000 in profits. What is its DOL? A) 3.56 B) 3.67 C) 4.56 D) 4.67 Answer: C Explanation: DOL = 1 + [$800,000 / $225,000] = 4.56 Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 78) If a firm's DOL is 3.6 with a profit of $2,000,000 and depreciation of $500,000, what are its other fixed costs? A) $5,250,000 B) $4,700,000 C) $5,520,000 D) $5,800,000 Answer: B Explanation: DOL = 3.6 = 1 + (FC + $500,000) / $2,000,000; FC = $4,700,000 Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

79) A firm with a DOL of 4.5 generates pretax profits of $1 million. If depreciation expense is $600,000, what are its other fixed costs? A) $1.1 million B) $2.1 million C) $2.9 million D) $3.9 million Answer: C Explanation: DOL= 4.5 = 1 + (FC + $600,000) / $1,000,000; FC = $2,900,000 Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 80) If a firm doubled its level of fixed costs but maintained its operating leverage, then one explanation may be that: A) depreciation expense increased to offset the increase. B) sales revenue also doubled and the proportion of variable costs did not change. C) sales revenues declined and the proportion of variable costs doubled. D) pretax profits decreased. Answer: B Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

81) A project offers a 30% probability of a payoff after one year of $2 million and a 70% chance of a payoff of $1 million. What is the maximum you would invest in this project today if the discount rate is 10%? A) $818,181.82 B) $1,181,818.18 C) $1,300,000.00 D) $1,430,000.00 Answer: B Explanation: NPV = 0 = −Inv + [(0.30 × $2m) + (0.70 × $1m)] / 1.1; Inv = $1,181,818.18 Difficulty: 2 Medium Topic: Decision trees Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 82) Decision trees: A) are an alternative to NPV analysis. B) recognize that managers may need to react to unexpected future events. C) are a way to adjust the discount rate to allow for uncertainty. D) lay out the different steps in preparing the capital budget. Answer: B Difficulty: 2 Medium Topic: Decision trees Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

83) If MacCaugh's pilot project is successful, it will be able to build a plant with an NPV of $2 million in 1 year's time. Otherwise the pilot investment will be valueless. If the discount rate is 20% and the chances of success are 50%, how much can MacCaugh afford to spend on the pilot project? A) $1 million. B) $2 million. C) $1.667 million. D) $833,333. Answer: D Explanation: NPV = 0 = C0 + 0.5 × $2 million / 1.2 C0 = −$833,333 Difficulty: 2 Medium Topic: Decision trees Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) The branches on a decision tree A) illustrate possible combinations of fixed and variable costs. B) are a convenient way to illustrate the results of a sensitivity analysis. C) show possible project break-even points. D) show possible management decisions and possible uncertain consequences. Answer: D Difficulty: 2 Medium Topic: Decision trees Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

85) The option for a firm to expand future production has most value when: A) future production will be profitable. B) the outlook for the business is very assured. C) the future is very uncertain. D) today's production costs are lower than in the future. Answer: C Difficulty: 2 Medium Topic: Real options Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) The option to abandon a project inexpensively has particular value when: A) the equipment has a ready second-hand value. B) you can be confident about future profits. C) the project looks to have a very large NPV. D) has a low degree of operating leverage. Answer: A Difficulty: 2 Medium Topic: Real options Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) The option to switch between using oil or natural gas in a power station is: A) an option to expand. B) an option to abandon. C) a production flexibility option. D) a timing option. Answer: C Difficulty: 2 Medium Topic: Real options Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

88) A firm acquires a patent to produce a new enhanced type of transcripter. What is the real option? A) abandonment option. B) timing option. C) option to change raw material inputs. D) expansion option. Answer: D Difficulty: 1 Easy Topic: Real options Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 89) A firm has a tract of timber. The future growth rate of the trees and the price of lumber are uncertain. The firm: A) has an expansion option. B) has an option to vary the production technology. C) should harvest the timber immediately if NPV is positive. D) has a timing option. Answer: D Difficulty: 2 Medium Topic: Real options Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

90) Recognizing that it may be in managers' best interests to be overly optimistic when proposing projects, how might firms effectively control this impulse? A) Employ capital rationing B) Require that all proposals be initiated from the lowest possible management level C) Fire managers if any of their proposals fail to produce the expected results D) Fund all project proposals Answer: A Difficulty: 2 Medium Topic: Capital rationing Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) One of the problems inherent in sensitivity analysis is that: A) it suggests when it may be useful to spend money to get a better estimate of sales or costs. B) most projects are equally sensitive to all variables. C) it ignores any interrelationships between variables. D) the cost of conducting the analysis is excessive. Answer: C Difficulty: 2 Medium Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 92) Which of the following correctly describes sensitivity analysis? A) recalculation of project NPV by changing several inputs to new but consistent values. B) measures the degree to which fixed costs magnify the effect on profits of a shortfall in sales. C) analysis of how project NPV changes if different assumptions are made about key variables. D) measures the future level of sales at which NPV equals zero. Answer: C Difficulty: 1 Easy Topic: Sensitivity analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

93) The accounting break-even point for a project is that level of sales where: A) sales revenue equals variable costs. B) sales revenue equals variable plus fixed costs. C) the operating cash flow equals zero. D) profit equals zero. Answer: D Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) The greater the ratio of variable costs to sales, the: A) more each additional sale contributes to the coverage of fixed costs. B) lower the level of profitability. C) more units that must be sold to cover fixed charges. D) lower the benefit of conducting a sensitivity analysis. Answer: C Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 95) When the level of fixed costs is decreased, the break-even level of revenues: A) will automatically decrease. B) will automatically increase. C) may or may not change, depending on variable costs. D) will remain unchanged as long as depreciation remains constant. Answer: C Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

96) A manufacturer contemplates a change in technology that would reduce fixed costs from $800,000 to $600,000, and reduce depreciation expense from $125,000 to $100,000. However, the ratio of variable costs to sales would increase from 68% to 80%. What would be the change in the break-even level of revenues? A) Increase of $609,375 B) Increase of $574,750 C) Decrease of $211,250 D) Decrease of $341,675 Answer: A Explanation: Accounting B / ECurrent = ($800,000 + 125,000) / (1 − 0.68) = $2,890,625 Accounting B / EProposed = ($600,000 + 100,000) / (1 − 0.80) = $3,500,000 ΔAccounting B / E = $3,500,000 − 2,890,625 = $609,375 Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 97) In a graphic depiction of accounting break-even analysis, the greater the slope of the total cost line, the higher the: A) level of fixed costs. B) level of total revenue. C) number of units sold. D) percentage of variable costs to sales. Answer: D Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

98) What is the economic break-even level of sales for a project costing $4,000,000 and generating annual cash flows equal to 0.30 × sales − $450,000? Assume the project willlast 10 years and require a discount rate of 12%. A) $2,093,654 B) $2,359,047 C) $3,859,789 D) $13,783,333 Answer: C Explanation: NPV = 0 = −$4,000,000 + [(0.30 × Sales) − $450,000] {(1 / 0.12) − [1 / 0.12(1.1210)]}; Sales = $3,859,789 Difficulty: 3 Hard Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 99) The opportunity to abandon a project loses some of its value when: A) fixed costs are high. B) markets are extremely competitive. C) the future is relatively certain. D) secondary markets exist and are active. Answer: C Difficulty: 2 Medium Topic: Real options Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

100) Which one of the following sets of conditions represents the more suitable investment? A) Total revenues cover fixed and variable costs. B) An investment breaks even in an accounting sense. C) An investment breaks even in an economic sense. D) Total revenues exceed the costs of goods sold. Answer: C Difficulty: 1 Easy Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 101) Positive NPV projects exist because: A) analysts select high discount rates. B) most projects are unique and innovative. C) cash-flow projections are extended into the future. D) firms hold competitive advantages. Answer: D Difficulty: 1 Easy Topic: Project analysis and evaluation Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 102) How much depreciation expense exists in a firm that has a break-even level of revenues of $2 million, fixed costs of $400,000, and a 60% ratio of variable costs to sales? A) $144,000 B) $266,667 C) $400,000 D) $666,667 Answer: C Explanation: $2,000,000 = ($400,000 + depreciation) / (1 − 0.60); Depreciation = $400,000 Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 39

103) The accounting break-even point for a firm is a function of its: A) net cash flows and depreciation expense. B) fixed costs and gross profit on each sale. C) variable costs and tax rate. D) revenues and fixed costs. Answer: B Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 104) What is the level of profits for a firm in which DOL = 5 and fixed costs including depreciation = $300,000? A) $60,000 B) $75,000 C) $1,200,000 D) $1,500,000 Answer: B Explanation: DOL = 5 = 1 + ($300,000 / profits); Profits = $75,000 Difficulty: 2 Medium Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

105) The DOL measures the percentage change in . A) fixed costs; sales B) profits; fixed costs C) profits; sales D) operating leverage; fixed costs

given a percentage change in

Answer: C Difficulty: 1 Easy Topic: Operating leverage Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 106) The economic break-even point of a project can be found by: A) setting the discount rate equal to the DOL. B) solving for the annual sales that will equate total revenue with total cost. C) solving for the annual sales that will give the project an NPV of zero. D) solving for the level of sales that will give the project an IRR of zero. Answer: C Difficulty: 2 Medium Topic: Break-even analysis Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 107) Firms that lack competitive advantages will: A) have difficulty finding positive NPV projects for investment. B) be forced to capture larger market shares to be profitable. C) avoid the need to conduct sensitivity analyses. D) be forced to operate with a high degree of operating leverage. Answer: A Difficulty: 2 Medium Topic: Project analysis and evaluation Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital 1) A market index is used to measure performance of a broad-based portfolio of stocks. Answer: TRUE Difficulty: 1 Easy Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Stock market indexes are found in many countries outside the United States. Answer: TRUE Difficulty: 1 Easy Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) Long-term bonds are the only portfolio of securities found to be riskier than common stocks. Answer: FALSE Difficulty: 2 Medium Topic: Historical performance Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

4) For investment horizons greater than 20 years, long-term bonds traditionally have outperformed common stocks. Answer: FALSE Difficulty: 2 Medium Topic: Historical performance Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) The S&P 500 accounts for most of the total market value of stocks traded in the United States. Answer: TRUE Difficulty: 2 Medium Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) The expected return on an investment includes compensation for both the time value of money and the risks assumed. Answer: TRUE Difficulty: 2 Medium Topic: Expected (required) return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) If one portfolio's variance exceeds that of another portfolio, its standard deviation will also be greater than that of the other portfolio. Answer: TRUE Difficulty: 2 Medium Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 2

8) The market risk premium is the difference between the return on common stocks and the riskfree interest rate. Answer: TRUE Difficulty: 1 Easy Topic: Risk Premium Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 9) Market risk can be eliminated in a stock portfolio through diversification. Answer: FALSE Difficulty: 2 Medium Topic: Systematic and unsystematic risk Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) Macro risks are faced by all common stock investors. Answer: TRUE Difficulty: 1 Easy Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 11) The risk that remains in a well-diversified stock portfolio is known as specific risk. Answer: FALSE Difficulty: 2 Medium Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

12) Cyclical stocks tend to perform well when other stocks are performing well also. Answer: TRUE Difficulty: 2 Medium Topic: Asset classes Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) Average returns on high-risk assets are higher than those on low-risk assets. Answer: TRUE Difficulty: 2 Medium Topic: Risks and returns Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) The historical record fails to show that investors have received a risk premium for holding risky assets. Answer: FALSE Difficulty: 2 Medium Topic: Historical performance Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Many investors who bought shares in the general stock market index in October 2007 saw the value of their investment decline over the next one-and-a-half years. Answer: TRUE Difficulty: 1 Easy Topic: Historical performance Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

16) Every additional stock added to a portfolio reduces the portfolio's level of risk by an equal amount. Answer: FALSE Difficulty: 1 Easy Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) The expected return on an investment provides compensation to investors both for waiting and for worrying. Answer: TRUE Difficulty: 2 Medium Topic: Expected (required) return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) One estimate of the market risk premium is provided by the difference between the average historical return on common stocks and the risk-free interest rate. Answer: TRUE Difficulty: 2 Medium Topic: Risk Premium Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) When using historical data to estimate the market risk premium, it is important to focus on recent experience. Answer: FALSE Difficulty: 1 Easy Topic: Historical performance Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 5

20) The mathematical measurement for volatility in the stock market is standard deviation. Answer: TRUE Difficulty: 1 Easy Topic: Debt issues Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) A share of stock currently sells for $60, pays an annual dividend of $4.00, and earned a rate of return of 20% over the past year. What did this stock sell for one year ago? A) $42.00 B) $46.15 C) $48.46 D) $53.33 Answer: D Explanation: 0.20 = ($60 + 4 − P) / P; P = $53.33 Difficulty: 2 Medium Topic: Total return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 22) Sue purchased a stock for $25 a share, held it for one year, received a $1.34 dividend, and sold the stock for $26.45. What nominal rate of return did she earn? A) 11.16% B) 14.23% C) 12.09% D) 10.55% Answer: A Explanation: R = ($26.45 + 1.34 − 25) / $25 = 0.1116, or 11.16% Difficulty: 2 Medium Topic: Total return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

23) What is the percentage return on a stock that was purchased for $48.40, paid a $1.67 dividend, and was then sold after one year for $46.20? A) −2.50% B) −1.10% C) 0.23% D) −0.33% Answer: B Explanation: R = ($46.20 + 1.67 − 48.40) / $48.40 = −0.0110, or −1.10% Difficulty: 2 Medium Topic: Total return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 24) What was the percentage return on a non-dividend-paying stock that was purchased for $40.00 and then sold after one year for $39.00? A) −2.50% B) −0.39% C) −0.04% D) −2.56% Answer: A Explanation: R = ($39 − 40) / $40 = −0.0250, or −2.50% Difficulty: 2 Medium Topic: Total return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

25) An investor receives a 15% total return by purchasing a stock for $40 and selling it after one year with a 5% capital gain. How much was received in dividend income during the year? A) $2.00 B) $2.20 C) $4.00 D) $4.40 Answer: C Explanation: Dividend income = (0.15 − 0.05) × $40 = $4.00 Difficulty: 2 Medium Topic: Total return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 26) How is it possible for real rates of return to increase during times when the rate of inflation increases? A) Inflation increased more than the real return. B) Nominal returns actually decreased. C) Nominal returns increased more than inflation. D) Nominal returns increased less than inflation. Answer: C Difficulty: 2 Medium Topic: Nominal and real returns Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

27) What nominal return was received by an investor when inflation averaged 3.46% and the real rate of return was 2.5%? A) 0.96% B) 5.96% C) 6.05% D) 5.47% Answer: C Explanation: R = (1.0346 × 1.025) − 1 = 0.0605, or 6.05% Difficulty: 2 Medium Topic: Fisher effect Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) Real rates of return are typically less than nominal rates of return due to: A) inflation. B) capital gains. C) dividend payments. D) depreciation. Answer: A Difficulty: 1 Easy Topic: Nominal and real returns Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

29) If a share of stock provided a 14.84% nominal rate of return over the previous year while the real rate of return was 6.65%, then the inflation rate was: A) 8.89%. B) 7.68%. C) 8.03%. D) 9.12%. Answer: B Explanation: h = 1.1484 / 1.0665 − 1 = 0.0768, or 7.68% Difficulty: 2 Medium Topic: Fisher effect Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) The actual real rate of return on an investment will be positive as long as the: A) nominal return is positive. B) inflation rate is positive. C) nominal return exceeds the inflation rate. D) inflation rate exceeds the real return. Answer: C Difficulty: 1 Easy Topic: Nominal and real returns Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

31) If inflation is 6%, what real rate of return is earned by an investor in a bond that was purchased for $1,000, has an annual coupon of 8%, and was sold at the end of the year for $960? A) −1.89% B) 1.92% C) −2.66% D) 2.47% Answer: A Explanation: Nominal return = [$960 + (0.08 × $1,000) − $1,000] / $1,000 = 0.04 Real return = 1.04 / 1.06 − 1 = −0.0189, or −1.89% Difficulty: 2 Medium Topic: Fisher effect Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32) The Dow Jones Industrial Average is: A) the most representative of the stock market indexes. B) an index of 500 largest corporate stocks in America. C) an index of 30 major stocks. D) an equally weighted index of all stocks traded on the New York Stock Exchange. Answer: C Difficulty: 1 Easy Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

33) Volatility is likely to be highest in which of the following investments? A) Common stocks B) Preferred stock C) Corporate bonds D) Treasury bonds Answer: A Difficulty: 2 Medium Topic: Historical performance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 34) "Dow up 14. Story at 6:00." This means that: A) the Dow was up 14% during today's trading. B) 14 of the Dow's 30 stocks increased in price today. C) a share of Dow stock went up by $14 today. D) the Dow index increased by 14 points in today's trading. Answer: D Difficulty: 1 Easy Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35) Although several stock indexes are available to inform investors of market changes, the Dow Jones Industrial Average: A) is the broadest-based of the market indexes. B) is the only reliable market index. C) accounts for approximately 90% of U.S. market value. D) is one of the best-known of the U.S. market indexes. Answer: D Difficulty: 1 Easy Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

36) Risks that are peculiar to a single firm: A) are called market risks B) cannot be diversified away C) are called specific risks D) tend to cause stocks to move together Answer: C Difficulty: 2 Medium Topic: Market and specific risk Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) Stock A has 10 million shares outstanding and stock B has 5 million shares outstanding. Both stocks sell for $10 a share. What is their relative weighting if both stocks are represented in the S&P 500? A) They have equal weighting, like all S&P 500 stocks. B) B has twice the weighting, to account for having fewer shares. C) A has twice the weighting, to account for having more shares. D) They are weighted according to their expected performance. Answer: C Difficulty: 2 Medium Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 38) Which one of these is the safest investment? A) Corporate bonds B) Common stock C) U.S. Treasury bills D) Preferred stock Answer: C Difficulty: 2 Medium Topic: Risks and returns Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

39) Although Standard and Poor's Composite Index contains a limited number of U.S. publicly traded stocks, the Index represents: A) all stocks in the industrial sector. B) all stocks priced at $50 a share or more. C) approximately 40% of U.S. stocks traded, in market value. D) approximately 80% of U.S. stocks traded, in market value. Answer: D Difficulty: 2 Medium Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 40) The primary difference between U.S. Treasury bills and U.S. Treasury bonds is that the bills: A) do not have default risk. B) have more price volatility. C) have a shorter maturity at time of issue. D) offer a higher return. Answer: C Difficulty: 1 Easy Topic: Debt issues Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

41) Assume market interest rates have risen substantially in the 5 years since an investor purchased Treasury bonds that were offering a 3% return over their 15-year life. If the investor sells now, he or she is likely to realize a total return that is: A) greater than 3%. B) less than 3%. C) equal to 1%. D) equal to 3%. Answer: B Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) A maturity premium is offered on long-term Treasury bonds due to: A) the risk of changing interest rates. B) the risk of default. C) their specific risk. D) the uncertainty of their maturity date. Answer: A Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

43) The idea that investors on average have earned a higher return from common stocks than from Treasury bills supports the view that: A) investors are irrational. B) there is a relationship between risk and return. C) real rates of return will be lower during periods of price stability. D) stocks should be avoided when inflation is low. Answer: B Difficulty: 2 Medium Topic: Risk and return relationship Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) Which combination of companies is likely to provide the best diversification benefit? A) Ford, Toyota, Nissan, GM B) Facebook, Twitter, Google, Amazon C) Tyson, Sony, Apple, Delta D) Walmart, Target, Home Depot, Lowes Answer: C Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) Which one of the following guarantees is offered to common stock investors? A) Guarantee to receive dividends B) Guarantee to receive capital gains C) Guarantee only to receive a refund of principal D) No guarantees of any form Answer: D Difficulty: 1 Easy Topic: Common stock features Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

46) The wider the dispersion of returns on a stock, the: A) lower the expected rate of return. B) higher the standard deviation. C) lower the real rate of return. D) lower the variance. Answer: B Difficulty: 1 Easy Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 47) The variance of an investment's returns is a measure of the: A) volatility of the rates of return. B) probability of a negative return. C) historic return over long time periods. D) average value of the investment. Answer: A Difficulty: 1 Easy Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) Which one of the following security classes has the highest standard deviation of returns? A) Common stocks B) Long-term Treasury bonds C) Treasury bills D) Corporate bonds Answer: A Difficulty: 1 Easy Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

49) In a year in which common stocks offered an average return of 12% and Treasury bills offered 3%. The risk premium for common stocks was: A) 1%. B) 3%. C) 12%. D) 9%. Answer: D Explanation: Risk premium = 12% − 3% = 9% Difficulty: 2 Medium Topic: Risk Premium Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 50) Over a 20-year period an investment of $1,000 in common stocks returned an average of 11% in nominal terms and 4% in real terms. At the end of the 20 years, the portfolio value was: A) $1,800 in real terms. B) $3,679.19 in real terms. C) $7,870.59 in nominal terms. D) $8,062.31 in nominal terms. Answer: D Explanation: FVNominal = $1,000(1.11)20 = $8,062.31 FVReal = $1,000(1.04)20 = $2,191.12 Difficulty: 2 Medium Topic: Nominal and real returns Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

51) A stock is expected to return 11% in a normal economy, 19% if the economy booms, and lose 8% if the economy moves into a recessionary period. Economists predict a 65% chance of a normal economy, a 25% chance of a boom, and a 10% chance of a recession. What is the expected return on the stock? A) 11.98% B) 12.06% C) 11.10% D) 11.23% Answer: C Explanation: E(R) = (0.65 × 0.11) + (0.25 × 0.19) + (0.10 × −0.08) = 0.1110, or 11.10% Difficulty: 2 Medium Topic: Expected return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 52) When the annual rate of return on U.S. Treasury bills is historically high, investors expect the return on the stock market: A) considerably lower than normal. B) about average. C) also to be high. D) approximately equal to zero. Answer: C Difficulty: 2 Medium Topic: Expected (required) return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) Historical returns (1900-2017) suggest that in a year when Treasury bills offered 3.8% the approximate return on portfolio of common stocks should be in the region of: A) 7.5% B) 9.3% C) 11.5% D) 18.5% Answer: C Explanation: 3.8% + 7.7% (historical risk premium on common stocks) = 11.5% Difficulty: 2 Medium Topic: Expected (required) return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 54) The appropriate opportunity cost of capital is the return that investors give up on alternative investments that: A) possess the same level of risk. B) earn the risk-free rate of return. C) are included in the S&P 500 index. D) earn the average market rate of return. Answer: A Difficulty: 2 Medium Topic: Risks and returns Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

55) An estimation of the opportunity cost of capital for projects that have an "average" level of risk is the expected rate of return on: A) Treasury bills. B) the market portfolio. C) the market portfolio minus the rate of return on Treasury bills. D) Treasury bonds plus a maturity premium. Answer: B Difficulty: 2 Medium Topic: Risks and returns Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) Over the past 3 years an investment returned 18%, −12%, and 15%. What is the variance of returns? A) 231 B) 182 C) 546 D) 961 Answer: B Explanation: Mean = (18% − 12 + 15) / 3 = 7% Variance = {(18 − 7)2 + (−12 − 7)2 + (15 − 7)2} / 3 = 182 Difficulty: 3 Hard Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

57) Over the past 4 years an investment returned 18%, −9%, −12%, and 15%. What is the standard deviation of returns? A) 9.2% B) 10.36% C) 11.2% D) 13.6% Answer: D Explanation: Mean = (18% − 9 − 12 + 15) / 4 = 3% Variance = {[18 − 3]2 + [−9 − 3)2 + [−12 − 3)2 + [15 − 3)]2} / 4 = 184.5 Std dev = 184.50.5 = 13.6% Difficulty: 3 Hard Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 58) The variance of a stock's returns can be calculated as the: A) average value of deviations from the mean. B) average value of squared deviations from the mean. C) square root of the average value of deviations from the mean. D) sum of the deviations from the mean. Answer: B Difficulty: 1 Easy Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) Calculate the variance of returns for Alpha stock with the following historical rates of return: 2015 20% 2016 25% 2017 30% A) 16.67 B) 33.33 C) 50.00 D) 100.00 Answer: A Explanation: Mean = (20% + 25 + 30) / 3 = 25% Variance = {(20 − 25)2 + (25 − 25)2 + (30 − 25)2} / 3 = 16.67 Difficulty: 3 Hard Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 60) What is the standard deviation of returns of a portfolio that produced returns of 10%, 15%, 25%, and 30%? A) 62.5% B) 31.1% C) 7.9% D) 5.2% Answer: C Explanation: Mean = (10% + 15 + 25 + 30) / 4 = 20% Variance = {(10 − 20)2 + (15 − 20)2 + (25 − 20)2 + (30 − 20} / 4 = 62.5 Std dev = 62.50.5 = 7.9% Difficulty: 3 Hard Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

61) What is the variance of returns of a portfolio that produced returns of 20%, 25%, and 30%, respectively? A) 10.00 B) 16.7 C) 15.00 D) 20.00 Answer: B Explanation: Mean = (20% + 25% + 30%) / 3 = 25% Variance = {(20 − 25)2 + (25 − 25)2 + (30 − 25)2} / 3= 16.7 Difficulty: 3 Hard Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 62) If the standard deviation of a portfolio's returns is known to be 30%, then its variance is: A) 5.48. B) 5.48 squared. C) 900.00 squared. D) 900.00 Answer: D Explanation: 302 = 900 Difficulty: 2 Medium Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

63) What is the standard deviation of a portfolio's returns if the mean return is 15%, and the variance of returns is 184? A) 7.83% B) 13.56% C) 41.00% D) 225.00% Answer: B Explanation: Std dev = 1840.5 = 13.6% Difficulty: 2 Medium Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 64) What is the standard deviation of returns for an investment that is equally likely to return 100% as it is to provide a 100% loss? A) 0% B) 50% C) 71% D) 100% Answer: D Explanation: Mean = 0.5 × 100% + 0.5 × −100% = 0% Variance = 0.5 × (100 − 0)2 + 0.5 × (−100 − 0)2 = 10,000 Std dev = 10,0000.5 = 100% Difficulty: 3 Hard Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

65) What is the typical relationship between the standard deviation of an individual common stock and the standard deviation of a diversified portfolio of common stocks? A) The individual stock's standard deviation will be lower. B) The individual stock's standard deviation will be higher. C) The standard deviations should be equal. D) There is no relationship. Answer: B Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) The standard deviations of individual stocks are generally higher than the standard deviation of the market portfolio because the market portfolio: A) offers lower returns. B) has less systematic risk. C) diversifies risk. D) has specific risk. Answer: C Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) The benefits of portfolio diversification are highest when the individual securities within the portfolio have returns that: A) vary directly with the rest of the portfolio. B) vary proportionally with the rest of the portfolio. C) are largely uncorrelated with the rest of the portfolio. D) are perfectly correlated with the market portfolio. Answer: C Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

68) The major benefit of diversification is the: A) increased expected return. B) removal of all negative risk assets from the portfolio. C) reduction in the portfolio's market risk. D) reduction in the portfolio's total risk. Answer: D Difficulty: 1 Easy Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 69) Companies that are exposed to the business cycle: A) tend to have high market risk. B) tend to have low market risk. C) have negligible specific risk. D) are safe investments. Answer: A Difficulty: 2 Medium Topic: Classes of stock Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) A firm is said to be countercyclical if its returns: A) continue to decrease, year after year. B) continue to increase, year after year. C) outperform when most stocks do poorly. D) are negative in real terms. Answer: C Difficulty: 1 Easy Topic: Classes of stock Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

71) Industries that generally perform very well when the entire economy performs well and perform very badly when the economy performs badly are called: A) diversified industries. B) cyclical industries. C) risk-free industries. D) specific-risk industries. Answer: B Difficulty: 1 Easy Topic: Classes of stock Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 72) What is the expected return on a portfolio that will decline in value by 13% in a recession, will increase by 16% in normal times, and will increase by 23% during boom times? Each scenario has an equal likelihood of occurrence. A) 8.67% B) 13.00% C) 13.43% D) 17.33% Answer: A Explanation: E(R) = (−13% + 16 + 23) / 3 = 8.67% Difficulty: 2 Medium Topic: Expected return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

73) The higher the standard deviation of a stock's returns, the: A) lower the level of specific risk. B) lower the expected rate of return. C) higher the accuracy of predictions of the stock's return for any given year. D) wider the dispersion of those returns over time. Answer: D Difficulty: 2 Medium Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) The incremental risk to a portfolio from adding another stock: A) is always greater than the average portfolio risk. B) is always less than the average portfolio risk. C) is always positive. D) may be either positive or negative. Answer: D Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) In general, which stocks should be combined into a portfolio if the goal is the greatest reduction possible in overall portfolio risk? A) Stocks with returns that are positively correlated B) Stocks with returns that are not correlated C) Stocks with returns that have the highest specific risk D) Stocks that have the highest expected returns Answer: B Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

76) Which one of the following concerns is likely to be most important to portfolio investors seeking diversification? A) Total volatility of individual securities B) Standard deviation of individual securities C) Correlation of returns between securities D) Achieving the risk-free rate of return Answer: C Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 77) A stock investor owns a diversified portfolio of 15 stocks. What will be the most likely effect on the portfolio's standard deviation if one more stock is added? A) A slight increase will occur. B) A large increase will occur. C) A slight decrease will occur. D) A large decrease will occur. Answer: C Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 78) As you add more stocks to a portfolio: A) specific risk at first falls, then rises. B) market risk is increasingly diversified away. C) specific risk is increasingly diversified away. D) market risk declines but specific risk rises. Answer: C Difficulty: 1 Easy Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

79) Risks that affect only a single firm are called: A) market risks. B) specific risks. C) systematic risks. D) risk premiums. Answer: B Difficulty: 1 Easy Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 80) Which one of the following risks can be progressively eliminated by adding stocks to a portfolio? A) Systematic risk B) Specific risk C) Market risk D) Inflation rate risk Answer: B Difficulty: 1 Easy Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) Which one of the following risks is most important to a well-diversified investor in common stocks? A) Market risk B) Specific risk C) Unsystematic risk D) Diversifiable risk Answer: A Difficulty: 1 Easy Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31

82) Which one of the following risks would be classified as a specific risk for an auto manufacturer? A) Interest rates B) Delays in launching a new model C) Business cycles D) Foreign exchange rates Answer: B Difficulty: 1 Easy Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) Which statement is correct concerning macro risk exposure? A) All firms face equal macro risk exposure. B) Only portfolios of stocks face macro risk exposure. C) Macro risk exposure affects the cost of capital. D) Macro risk exposure is less important to diversified investors than micro risk exposure. Answer: C Difficulty: 3 Hard Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) Individual stocks are: A) exposed to the same amount of market risk. B) exposed to differing amounts of market risk. C) not exposed to market risk; only the general economy is subject to market risk. D) exposed to differing amounts of market risk but the same amount of specific risk. Answer: B Difficulty: 2 Medium Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) Which one of these is a specific risk? A) Revision to the corporate tax laws. B) Inflation increase of 2.3%. C) Deterioration in the overall economic outlook. D) A fire at the company's main factory. Answer: D Difficulty: 2 Medium Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) Which one of the following statements is incorrect concerning stock indexes? A) Indexes have been developed for foreign stocks. B) Some indexes cover only a specific market sector. C) Most indexes include all of the publicly-traded common stocks. D) Some indexes are equally weighted. Answer: C Difficulty: 1 Easy Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) Periods of market decline are called: A) discount factors. B) bull markets. C) coupons. D) bear markets. Answer: D Difficulty: 1 Easy Topic: Historical performance Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

88) The fact that historical returns on Treasury bonds are less volatile than common stock returns indicates that: A) the variance of Treasury bond returns is zero. B) the standard deviation of Treasury bond returns is negative. C) the real return on Treasury bonds has been negative. D) common stocks should offer a higher return than Treasury bonds. Answer: D Difficulty: 2 Medium Topic: Risks and returns Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) If the toss of a coin comes down heads, you win a dollar. If it comes down tails, you lose fifty cents. How much would you expect to gain after 20 tosses? A) $5.00 B) $7.50 C) $10.00 D) $15.00 Answer: A Explanation: Expected return = 20 × [($1 × 0.5) − (0.50 × 0.5)] = $5.00 Difficulty: 2 Medium Topic: Expected return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

90) A project's expected return is 15%, which represents a 35% return in a boom and a 5% return in a stagnant economy. What is the probability of a boom if these are the only two economic states? A) 18.33% B) 25.00% C) 33.33% D) 50.00% Answer: C Explanation: 15% = 35%(x) + 5%(1 − x); x = 33.33% Difficulty: 2 Medium Topic: Expected return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 91) What is the return to an investor who purchases a stock for $30, receives a $1.50 dividend at the end of the year, and then sells the share for $28.50? A) −5% B) 0% C) 5% D) 10% Answer: B Explanation: R = ($28.50 + 1.50 − 30) / $30 = 0% Difficulty: 2 Medium Topic: Expected return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

92) Stock A has an expected return of 15%; stock B has an expected return of 8%. What is the expected return on a portfolio is comprised of 60% of Stock A and 40% of Stock B? A) 12.2% B) 10.8% C) 9.1% D) 14.4% Answer: A Explanation: Portfolio: 0.6 × 15% + 0.4 × 8% = 12.2% Difficulty: 2 Medium Topic: Expected return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 93) Which one of the following companies is most likely to be exposed to the least amount of macro risk? A) A producer of dog biscuits B) A regional airline C) A major commercial bank D) A machine tool manufacturer Answer: A Difficulty: 2 Medium Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

94) An investor holds a stock for one year. She then receives a dividend of $10 and sells the stock for $120. If her return was 16%, at what price did she buy the stock? A) $103.45 B) $64.80 C) $139.20 D) $112.07 Answer: D Explanation: 1.16 = ($120 + $10) / P; P = $112.07 Difficulty: 2 Medium Topic: Total return Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 95) Which one of the following would you expect to represent the broadest-based index of U.S. stocks? A) Wilshire 5000 B) Dow Jones Industrial Average C) Standard and Poor's Composite D) Financial Times Index Answer: A Difficulty: 1 Easy Topic: Stock market prices and reporting Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

96) Treasury bonds have provided a higher historical return than Treasury bills, which can be attributed to their: A) greater default risk. B) higher level of specific risk. C) greater exposure to interest rate risk. D) illiquidity. Answer: C Difficulty: 1 Easy Topic: Risks and returns Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Averaging the deviations from the mean for a portfolio of securities will: A) compute the standard deviation. B) compute the variance. C) equal zero. D) equal the number of securities in the portfolio. Answer: C Difficulty: 1 Easy Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 98) One common reason for reporting standard deviations of percentage returns rather than variances is that standard deviations: A) are lower. B) are stated in understandable percentages. C) account properly for negative returns. D) take probability estimates into consideration. Answer: B Difficulty: 2 Medium Topic: Standard deviation and variance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 38

99) When viewing the long-term trend of the price volatility of U.S. stocks, it is readily apparent that volatility has: A) continually increased. B) continually decreased. C) increased and decreased but has no specific pattern. D) remained constant for years. Answer: C Difficulty: 2 Medium Topic: Historical performance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 100) If a stock's returns are volatile, then the stock: A) cannot be considered a negative risk asset. B) can still be considered a negative risk asset. C) has macro risk, but no specific risk. D) does not offer diversification potential. Answer: B Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 101) A good way to reduce macro risk in a stock portfolio is to invest in stocks that: A) have only specific risks. B) have diversified away the macro risk. C) have low exposure to business cycles. D) pay guaranteed dividends. Answer: C Difficulty: 2 Medium Topic: Diversification concepts and measures Learning Objective: 11-03 Understand why diversification reduces risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

102) Which one of the following firms is likely to exhibit the least macro risk exposure? A) Construction company B) Airline company C) Gold mining company D) Auto manufacturer Answer: C Difficulty: 1 Easy Topic: Systematic and unsystematic risk Learning Objective: 11-04 Distinguish between specific risk, which can be diversified away, and market risk, which cannot. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 103) Investment risk can best be described as the: A) dispersion of possible returns. B) elimination of macro risk through diversification. C) possibility of changes in the cost of capital. D) level of systematic risk for an undiversified investor. Answer: A Difficulty: 2 Medium Topic: Risks and returns Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 104) Since about 1900, the standard deviation of annual returns on a portfolio of U.S. common stocks has been about: A) −10%. B) 6%. C) 20%. D) 12%. Answer: C Difficulty: 2 Medium Topic: Historical performance Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 12 Risk, Return, and Capital Budgeting 1) The capital asset pricing model (CAPM) assumes that the stock market is dominated by welldiversified investors who are concerned only with market risk. Answer: TRUE Diff: 1 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) The CAPM states that the expected risk premium on any security equals its beta times the market risk premium. Answer: TRUE Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) The security market line displays the relationship between expected return and beta. Answer: TRUE Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

4) The security market line sets a standard for other investments—investors will be willing to hold other investments only if they offer equally good prospects as shown by the points on the line. Answer: TRUE Diff: 2 Topic: Security market line Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) The required risk premium for any given investment is defined by the security market line. Answer: TRUE Diff: 1 Topic: Security market line Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) Empirical evidence suggests that over a long period of time returns are directly related to beta. Answer: TRUE Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) There is little doubt that the CAPM captures everything that is going on in the market. Answer: FALSE Diff: 1 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

8) Beta measures the total risk of an individual security. Answer: FALSE Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) The security market line provides a standard that can be used to make project acceptance/rejection decisions. Answer: TRUE Diff: 1 Topic: Security market line Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) If a low-risk company invests in a high-risk project, those cash flows should be discounted at a high cost of capital. Answer: TRUE Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) The project cost of capital depends on the risk of the company undertaking the project. Answer: FALSE Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

12) Beta measures a stock's sensitivity to market risks. Answer: TRUE Diff: 1 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 13) The project cost of capital depends on how the capital is used. Answer: TRUE Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) Investors expect aggressive stocks to outperform the market in periods of strong economic activity. Answer: TRUE Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Defensive stocks typically provide better returns during periods of economic downturn since they are not very sensitive to market fluctuations. Answer: TRUE Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation

16) Diversification decreases the variability of both specific and market risk. Answer: FALSE Diff: 1 Topic: Diversification concepts and measures Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) Market risk premium is defined as the difference between the market rate of return and the risk-free interest rate. Answer: TRUE Diff: 1 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) According to the CAPM, a stock's expected return is positively related to its beta. Answer: TRUE Diff: 1 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) The CAPM is a theory of the relationship between risk and return that states that the expected risk premium on any security equals its beta times the market return. Answer: FALSE Diff: 1 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

20) The stocks of gold-mining companies commonly have above-average volatility but relatively low betas. Answer: TRUE Diff: 2 Topic: Systematic and unsystematic risk Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) According to the capital asset pricing model, the expected rates of return for all projects lie on the security market line. Answer: FALSE Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) As a project's beta increases, the project's opportunity cost of capital increases. Answer: TRUE Diff: 1 Topic: Security market line Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) A project should be accepted if its return plots below the security market line. Answer: FALSE Diff: 2 Topic: Security market line Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

24) The security market line shows how the expected rate of return depends on beta. Answer: TRUE Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) The required risk premium for any investment is given by the security market line. Answer: TRUE Diff: 1 Topic: Security market line Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) Project cost of capital and company cost of capital are synonymous terms. Answer: FALSE Diff: 2 Topic: Cost of capital-general Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 27) The project cost of capital depends on the use to which that capital is put. Therefore, it depends on both the risk of the project and also on the risk of the company. Answer: FALSE Diff: 2 Topic: Cost of capital-general Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

28) If a company with a low credit rating invests in a low-risk project, it should discount the cash flows at a relatively high cost of capital. Answer: FALSE Diff: 2 Topic: Cost of capital-general Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) If a project has a risk of a bad outcome, the company should always set a higher discount rate to compensate. Answer: FALSE Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) A stock return that sits above the security market line is considered a good risk adjusted investment. Answer: TRUE Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

31) The slope of the security market line for an index mutual fund should be steeper than that of the S&P 500 index. Answer: FALSE Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 32) The expected return on a security includes a reward for: A) market risk and specific risk. B) specific risk. C) diversification and portfolio risk. D) time value of money and market risk. Answer: D Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33) If a security plots below the security market line, it is: A) ignoring all of the security's specific risk. B) underpriced, a situation that should be temporary. C) offering too little return to justify its risk. D) a defensive security, which expects to offer lower returns. Answer: C Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

34) Macro events only are reflected in the performance of the market portfolio because: A) the market portfolio contains only risk-free securities. B) only macro events are tracked by economists. C) the specific risks have been diversified away. D) the firm-specific events would be too numerous to quantify. Answer: C Diff: 2 Topic: Diversification concepts and measures Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35) In practice, the market portfolio is often represented by: A) a portfolio of U.S. Treasury securities. B) a diversified stock market index. C) an investor's mutual fund portfolio. D) the historic record of stock market returns. Answer: B Diff: 1 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) A stock's beta measures the: A) average return on the stock. B) sensitivity of the stock's returns to those of the market portfolio. C) difference between the return on the stock and the return on the market portfolio. D) market risk premium on the stock. Answer: B Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

37) In theory, the "market portfolio" should contain: A) the securities of the S&P 500. B) the securities of the Dow. C) the securities of the S&P 500 and Treasury bills. D) all risky assets. Answer: D Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 38) When the overall market is up by 10%, investors with portfolios of defensive stocks will probably have: A) negative portfolio returns less than 10%. B) negative portfolio returns greater than 10%. C) positive portfolio returns less than 10%. D) positive portfolio returns greater than 10%. Answer: C Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) When the overall market experiences a decline of 8%, investors with portfolios of aggressive stocks will probably experience portfolio: A) losses of less than 8%. B) losses greater than 8%. C) gains of less than 8%. D) gains greater than 8%. Answer: B Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11

40) A stock has a beta of 1.5, the market risk premium is 6% and the risk-free rate is 2%. What is the lowest return the company should accept on a new investment? A) 7.50% B) 10.50% C) 12.50% D) 15.25% Answer: C Explanation: E(R) = 2% + 1.50(7%) = 12.50% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 41) A stock with a beta greater than 1.0 would be termed: A) an aggressive stock, expected to increase more than the market increases. B) a defensive stock, expected to decrease more than the market increases. C) an aggressive stock, expected to decrease more than the market increases. D) a defensive stock, expected to increase more than the market decreases. Answer: A Diff: 1 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) The average of the betas for all stocks is: A) greater than 1.0; most stocks are aggressive. B) less than 1.0; most stocks are defensive. C) unknown; betas are continually changing. D) exactly 1.0; these stocks represent the market. Answer: D Diff: 1 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

43) The slope of the line fitted to a plot of a stock's returns versus the market's returns measures the: A) security market line. B) beta of the stock. C) market risk premium. D) capital asset pricing model. Answer: B Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2%, then its beta equals: A) 1.04 B) 1.24 C) 1.33 D) 1.40 Answer: C Explanation: β = 1.6% / 1.2% = 1.33 Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 45) If the slope of the line measuring a stock's returns against the market's returns is positive, then the stock: A) has a beta greater than 1.0. B) has no specific risk. C) has a positive beta. D) plots above the security market line. Answer: C Diff: 1 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

46) If the line measuring a stock's historic returns against the market's historic returns has a slope greater than 1.0, then the: A) stock is currently underpriced. B) market risk premium is increasing. C) stock has a significant amount of specific risk. D) stock has a beta exceeding 1.0. Answer: D Diff: 1 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 47) A mutual fund returns 14%. If the risk free rate is 2% and the beta of the fund is 1.60, what is the implied market risk premium? A) 6.50% B) 7.50% C) 8.50% D) 9.50% Answer: B Explanation: 14% = 2% + 1.60 (MRP) MRP = 7.50% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

48) What is the most likely explanation for a +20.0% return on a stock with a beta of 1.0 in a month when the market returned +10.0%? A) The stock is aggressive. B) The market is undervalued. C) Favorable firm-specific news was reported. D) The beta is really less than 1.0. Answer: C Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 49) If a stock's beta is 0.8 during a period when the market portfolio was down by 10%, then, a priori, we could expect this individual stock to: A) lose more than 10%. B) lose, but less than 10%. C) gain more than 10%. D) gain, but less than 10%. Answer: B Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Reflective Thinking Accessibility: Keyboard Navigation 50) A stock's total risk depends on the stock's A) beta; specific risk B) beta; market risk C) specific risk; firm-specific risk D) aggressive risk; defensive risk

and

Answer: A Diff: 2 Topic: Stock returns and yields Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

51) Estimate a stock's beta based on the following information: Month 1 = Stock + 1.5%, Market + 1.1%; Month 2 = Stock + 2.0%, Market + 1.4%; Month 3 = Stock − 2.5%, Market − 2.0%. A) Greater than 1.0 B) Less than 1.0 C) Equal to 1.0 D) Indeterminate Answer: A Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) If you were willing to bet that the overall stock market was heading up on a sustained basis, it would be more profitable to invest in: A) high beta stocks. B) low beta stocks. C) stocks with large amounts of specific risk. D) stocks that plot above the security market line. Answer: A Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73? A) 1.0 B) 1.17 C) 1.22 D) 1.25 Answer: D Explanation: βPortfolio = 0.25 × 0.9 + 0.4 × 1.05 + 0.35 × 1.73 = 1.25 Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 54) You want to construct a portfolio containing equal amounts of U.S. Treasury bills and two stocks. If the beta of the first stock is 1.23 and the beta of the portfolio is 1.0, what does the beta of the second stock have to be? A) 0.77 B) 1.23 C) 0.23 D) 1.77 Answer: D Explanation: 1 = (0 + 1.23 + βB) / 3; βB = 1.77 Diff: 3 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

55) An investor wishes to invest equal amounts in three stocks and to achieve a portfolio beta of 1.2. If stock A has a beta of 0.9 and stock B has a beta of 1.1, what must be the beta of stock C? A) 0.7 B) 1.6 C) 1.2 D) 1.8 Answer: B Explanation: 1.2 = (0.9 + 1.1 + βC) / 3; βC = 1.6 Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 56) What is the standard deviation of the market portfolio if the standard deviation of a welldiversified portfolio with a beta of 1.25 equals 20%? A) 16.00% B) 18.75% C) 25.00% D) 32.50% Answer: A Explanation: Portfolio σ = beta × market portfolio σ 20% = 1.25 × σm σm = 16% Diff: 2 Topic: Standard deviation and variance Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

57) What is the beta of a U.S. Treasury bill? A) 1.0 B) −1.0 C) 0 D) Unknown Answer: C Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) One of the easiest methods of diversifying away firm-specific risks is to: A) buy only stocks with a beta of 1.0. B) build a portfolio with 40 to 55 individual stocks. C) purchase the shares of an index fund. D) purchase stocks that plot above the security market line. Answer: C Diff: 2 Topic: Diversification concepts and measures Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 59) A scatter in the plot of a stock's returns versus the returns on the market reflects the: A) high beta of the stock. B) specific risk of the stock. C) changes in market risk premium over time. D) current underpricing of the stock. Answer: B Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

60) A project has a beta of 1.24, the risk-free rate is 3.8%, and the market rate of return is 9.2%. What is the project's expected rate of return? A) 15.21% B) 11.41% C) 10.50% D) 14.61% Answer: C Explanation: E(R) = 3.8% + 1.24(9.2% − 3.8) = 10.50% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 61) Which of the following statements about the CAPM is FALSE? A) A discount rate for capital budgeting valuation can be derived from the CAPM. B) The CAPM offers risk adjusted returns. C) Risk is measured by the CAPM. D) CAPM is used to determine the opportunity cost of an investment. Answer: C Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

62) A project has a beta of 0.97, the risk-free rate is 4.1%, and the market risk premium is 8.1%. What is the project's expected rate of return? A) 7.98% B) 11.96% C) 8.35% D) 11.83% Answer: B Explanation: E(R) = 4.1% + 0.97(8.1%) = 11.96% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 63) Which one of the following statements is correct when Treasury bills yield 3.5% and the market risk premium is 9.5%? A) The S&P 500 would be expected to return 4.50%. B) The S&P 500 would be expected to return 5.50%. C) The S&P 500 would be expected to return 19.68%. D) The S&P 500 would be expected to return 13.00%. Answer: D Explanation: E(R) = 3.5% + 1(9.5%) = 13% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

64) If a well-diversified portfolio of stocks has an expected return of 15% when the expected return on the market portfolio is 10%, then A) Treasury bills are offering a 7% yield. B) The portfolio beta is greater than 1.0. C) The portfolio beta equals 1.67. D) The investor's portfolio contains many defensive stocks. Answer: B Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 65) The market rate of return is 12.5% and the risk-free rate is 3.1%. What will be the change in a stock's expected rate of return if its beta increases from 1.2 to 1.4? A) 1.88% B) 2.5% C) 18.8% D) 25.0% Answer: A Explanation: ΔE(R) = (1.4 − 1.2)(12.5% − 3.1%) = 1.88% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

66) If a stock with a beta of 1.4 is expected to return 18% when Treasury bills yield 6%, what is the expected return on the market portfolio? A) 8.67% B) 10.84% C) 12.02% D) 14.57% Answer: D Explanation: 18% = 6% + 1.4(rm − 6%); rm = 14.57% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 67) When Treasury bills yield 3% and the expected return on the market is 12%, then the risk premium on an asset is equal to: A) 3%. B) 12%. C) 9% times the asset's beta. D) 9% plus the risk-free rate. Answer: C Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

68) Calculate the risk premium on stock C given the following information: risk-free rate = 5%, market return = 13%, stock C's beta = 1.3. A) 8.0% B) 10.4% C) 15.4% D) 16.9% Answer: B Explanation: RPC = 1.3(13% − 5) = 10.4% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 69) If the interest rate on Treasury bills is 4% and the market risk premium is 9%, then a stock with a beta of 1.5 would be expected to return: A) 11.0%. B) 13.0%. C) 17.5%. D) 19.5%. Answer: C Explanation: E(R) = 4% + 1.5(9%) = 17.5% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

70) An investor expects a return of 18% on his portfolio with a beta of 1.25. If the expected market risk premium increases from 8% to 10%, what return should he now expect on the portfolio? A) 20.0% B) 20.5% C) 22.5% D) 26.0% Answer: B Explanation: E(R) = 18% + 1.25(10% − 8%) = 20.5% Diff: 2 Topic: Portfolio return Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 71) An investor expects a return of 14.7% on her portfolio with a beta of 1.13. If the expected market risk premium decreases from 8% to 7%, what return should she now expect on the portfolio? A) 13.57% B) 13.89% C) 14.67% D) 15.87% Answer: A Explanation: E(R) = 14.7% + 1.13(7% − 8%) = 13.57% Diff: 2 Topic: Portfolio return Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

72) What rate of return should an investor expect for a stock that has a beta of 0.8 when the market is expected to yield 14% and Treasury bills offer 6%? A) 9.2% B) 11.2% C) 12.4% D) 12.8% Answer: C Explanation: E(R) = 6% + 0.8(14% − 6) = 12.4% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 73) You believe that Alpha stock which has a beta of 1.32 will return 16.0% this coming year. The market is expected to return 11.4% and T-bills return 3.8%. According to CAPM, which one of these statements is correct given this information? A) The stock is currently underpriced. B) The stock plots below the security market line. C) The risk premium on the stock is too low given the stock's beta. D) The stock plots to the left of the market on a security market line graph. Answer: A Explanation: E(R) = 3.8% + 1.32(11.4% − 3.8) = 13.83% < 16% Diff: 3 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

74) Why should stock market investors ignore specific risks when calculating required rates of return? A) There is no method for quantifying specific risks. B) Specific can be diversified away. C) Specific risks are compensated by the risk-free rate. D) Beta includes a component to compensate for specific risk. Answer: B Diff: 1 Topic: Diversification concepts and measures Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio beta is: A) 0.70. B) 1.05. C) 1.40. D) 2.10. Answer: B Explanation: βPortfolio = 0.5 × 1.4 + 0.5 × 0.7 = 1.05 Diff: 1 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

76) A portfolio consists of an index mutual fund which represents the overall market and Treasury bills. The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk premium is 7.6%. What is your best estimate of the portfolio expected rate of return? A) 8.39% B) 7.76% C) 10.80% D) 9.02% Answer: B Explanation: E(R)Portfolio = (1 − 0.6)(3.2%) + (0.6)[3.2% + 1(7.6%)] = 7.76% Diff: 2 Topic: Portfolio return Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 77) What is the beta of a security with an expected return of 12% if Treasury bills yield 6% and the market risk premium is 8%? A) 0.50 B) 0.75 C) 0.90 D) 1.50 Answer: B Explanation: E(R) = 12% = 6% + β(8%); β = 0.75 Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

78) The slope of the security market line equals: A) one. B) beta. C) the market risk premium. D) the expected return on the market portfolio. Answer: C Diff: 1 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 79) A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the market rate of return is 10.6%? A) 2.825% B) 3.250% C) 3.275% D) 3.415% Answer: C Explanation: E(R) = 13.53% = rf + 1.4(10.6% − rf); rf = 3.275% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

80) The market portfolio has an expected return of 18% and the risk-free rate is 6%. An investor borrows $100 at the risk-free rate and invests this and a further $100 of his own in the market portfolio. What is his expected return? A) 18.6% B) 19.6% C) 21.6% D) 30.0% Answer: D Explanation: βPortfolio = (2 × βmarket) + (−1 × βloan) = (2 × 1) + 0 = 2 Expected return = 6% + 2(18% − 6) = 30% Diff: 3 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 81) If Stock A has a higher expected return than Stock B, which of the following statements is most likely? A) Stock A has more specific risk. B) Stock B plots below the security market line. C) Stock B is a cyclical stock. D) Stock A has a higher beta. Answer: D Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

82) A stock's risk premium is equal to the: A) expected market return times beta. B) Treasury bill yield plus the expected market return. C) risk-free rate plus the expected market risk premium. D) expected market risk premium times beta. Answer: D Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) Investing borrowed funds in a stock portfolio will generally: A) increase the beta of the portfolio. B) decrease the volatility of the portfolio. C) decrease the expected return on the portfolio. D) increase the market risk premium. Answer: A Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) A stock is expected to pay a year-end dividend of $8 and then to sell at a price of $109. The risk-free interest rate is 4%, the expected market return is 12% and the stock has a beta of 0.8. What is the stock price today? A) $102.99. B) $98.73. C) $105.98. D) $109.00. Answer: C Explanation: r = 4% + 0.8(12% − 4%) = 10.4%. P = ($8 + $109) / 1.104 = $105.98. Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31

85) Which one of these statements is correct? A) Betas can be measured exactly. B) If a stock has a very low beta, it is likely to have a high beta in the future. C) The expected future risk premium is easy to accurately determine. D) CAPM is widely used as a means of estimating expected returns. Answer: D Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) What happens to the expected portfolio return if the portfolio beta increases from 1.0 to 1.5, the risk-free rate decreases from 5 to 4%, and the market risk premium increases from 8 to 9%? A) It increases from 12 to 14.0%. B) It increases from 13 to 17.5%. C) It increases from 12 to 12.5%. D) It increases from 13 to 13.5%. Answer: B Explanation: rp = 5% + 1(8) = 13%; rp = 4% + 1.5(9) = 17.5% Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

87) What would you recommend to an investor who is considering an investment that plots below the security market line? A) Invest; The expected return is high relative to the risk. B) Don't invest; The risk is high relative to the expected return. C) Invest; All stocks revert to the SML over time. D) Don't invest; All stocks below the SML are low-growth stocks. Answer: B Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Investment projects that plot above the security market line have: A) a positive NPV. B) a negative NPV. C) a zero NPV. D) an excessively high discount rate. Answer: A Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if: A) it results in a negative NPV for the proposal. B) the project has a different degree of risk from the company. C) the company has specific risk. D) the company expects to earn more than the risk-free rate. Answer: B Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33

90) A proposed investment must earn at least as much as the acceptable. A) company cost of capital B) risk-free rate C) market risk premium D) project cost of capital

if it is to be deemed

Answer: D Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) A project with higher than average risk offers an expected return of 14%. Which statement is correct if the company's opportunity cost of capital is 12% and the project's opportunity cost of capital is 15%? A) Project NPV is positive; it should be accepted. B) Project NPV is negative; it should be rejected. C) Project NPV is positive but it should be rejected. D) Project NPV is negative but it should be accepted. Answer: B Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

92) The project cost of capital is: A) equal to the company cost of capital. B) less than the company cost of capital. C) greater than the company cost of capital because the project has specific risk. D) not necessarily related to the company cost of capital. Answer: D Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 93) The minimum acceptable expected rate of return on a project is the: A) project cost of capital. B) company cost of capital. C) risk-free rate of return. D) project beta times the market risk premium. Answer: A Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) If changing discount rates from the company cost of capital to the project cost of capital changes NPV from negative to positive, then the project should use the: A) company cost of capital and be accepted. B) company cost of capital and be rejected. C) project cost of capital and be accepted. D) project cost of capital and be rejected. Answer: C Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

95) Which one of the following statements best explains the fact that cyclical firms tend to have high betas? A) Their earnings are particularly sensitive to the state of the economy. B) Their stocks are overpriced. C) Their earnings are less diversifiable. D) Their profit margins are small. Answer: A Diff: 1 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 96) What type of risk is properly reflected in a project's discount rate? A) Market risk B) Specific risk C) Total risk D) Diversifiable risk Answer: A Diff: 2 Topic: Systematic and unsystematic risk Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Last month a stock with a beta of 1.0 lost 20% while the S&P 500 had a 10% gain. Given this, it is most likely that the: A) stock's beta has been calculated incorrectly. B) S&P 500 cannot represent the overall market. C) firm released some negative information about itself. D) the market index had an exceptionally good month. Answer: C Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

98) The slope of the fitted line that shows the relationship between a stock's return and the market's return is the: A) market's beta. B) stock's beta. C) market risk premium. D) stock's standard deviation. Answer: B Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 99) Which one of the following is most likely correct for a diversified stock portfolio that exhibits a higher standard deviation than the market index? A) The portfolio contains aggressive stocks with a beta greater than 1.0 B) The portfolio plots below the security market line. C) The portfolio's beta is less than 1.0. D) The portfolio contains a significant amount of specific risk. Answer: A Diff: 2 Topic: Standard deviation and variance Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

100) An investor divides her portfolio into three equal parts, with one part in Treasury bills, one part in a market index, and one part in a mutual fund with beta of 1.50. What is the beta of the investor's overall portfolio? A) 0.83 B) 1.00 C) 1.17 D) 1.25 Answer: A Explanation: βPortfolio = (0 + 1 + 1.5) / 3 = 0.83 Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 101) If the market portfolio is expected to return 16%, then a portfolio that is expected to return 13%: A) plots above the security market line. B) plots to the right of the market on an SML graph. C) is not diversified. D) has a beta that is less than 1.0. Answer: D Diff: 2 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

102) The basic tenet of the CAPM is that a stock's expected risk premium should be: A) greater than the expected market return. B) proportionate to the market return. C) proportionate to the stock's beta. D) greater than the risk-free rate of return. Answer: C Diff: 1 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 103) If the company cost of capital is 20% and a proposed project's cost of capital is 15%, then discounting the projects' cash flows at 20% would: A) determine where the project plots in relation to the security market line. B) make the project look more attractive than it should be. C) be correct from a theoretical perspective. D) be incorrect and could cause the project to be erroneously rejected. Answer: D Diff: 2 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 104) Over the long run value stocks have: A) had low ratios of book value to market value. B) performed exactly as predicted by CAPM. C) provided a higher return than growth stocks. D) consistently underperformed. Answer: C Diff: 2 Topic: Historical performance Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

105) If a project could have a bad outcome: A) the discount rate should be increased. B) expected cash flows should be adjusted downward to reflect this possibility. C) the beta should be increased. D) the market risk premium should be revised downward. Answer: B Diff: 3 Topic: Project analysis and evaluation Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 106) A project costs $3 million, and is expected to generate $1 million in cash flows for the next 4. If the opportunity cost of capital is 15%, the project's return would plot: A) above the security market line. B) below the security market line. C) on the security market line. D) on the security market line, with a beta of 1.0. Answer: B Explanation: The project's IRR = 12.6%. Therefore, the return on the project will plot below the SML. Diff: 3 Topic: Security market line Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

107) An investor prefers to invest in companies that have high operating leverage. How can this be accomplished if the investor also requires a portfolio beta of 1.0? A) Invest 50% in cyclical stocks and 50% in firms with high operating leverage B) Invest 50% in a market index fund and 50% in firms with high operating leverage C) Finance part of the portfolio with borrowing D) Invest a portion of the portfolio in U.S. Treasury securities Answer: D Diff: 3 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 108) Which one of the following portfolios might be expected to exhibit less specific risk? A) Five random stocks; portfolio beta = 0.8 B) Three random stocks; portfolio beta = 1.2 C) Ten random stocks; portfolio beta = 1.0 D) Twelve random stocks; portfolio beta unknown Answer: D Diff: 2 Topic: Diversification concepts and measures Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 109) If the plot of a portfolio's returns against returns on the market index produces a tight pattern, then the portfolio: A) appears to be well diversified. B) has a beta of 0. C) has very little systematic risk. D) has a risk premium lower than the market. Answer: A Diff: 2 Topic: Beta Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

110) If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury bills, then the investor should expect to receive: A) the risk-free rate plus 75% of the expected return on the market. B) the risk-free rate plus 75% of the expected market risk premium. C) 75% of the expected return on the market. D) 25% of the risk-free rate plus 75% of the expected market risk premium. Answer: B Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 111) Which statement is correct? A) the superior performance of value stocks is exactly what the CAPM would predict. B) the CAPM predicts that investors are concerned only with the risk that cannot be diversified away. C) few financial managers in practice use the CAPM to estimate the cost of capital. D) the CAPM is a model of actual returns whereas the cost of capital is concerned with expected returns. Answer: B Diff: 2 Topic: Capital asset pricing model Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 13 The Weighted-Average Cost of Capital and Company Valuation 1) Capital structure refers to a firm's mix of long-term debt and equity financing. Answer: TRUE Difficulty: 1 Easy Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) The company cost of capital is the expected rate of return that investors demand from the company's assets and operations. Answer: TRUE Difficulty: 2 Medium Topic: Cost of capital-general Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) The company cost of capital is the minimum acceptable rate of return for any project the firm undertakes. Answer: FALSE Difficulty: 2 Medium Topic: Divisional and project costs of capital Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 4) The weighted-average cost of capital is the expected rate of return on a portfolio of all the firm's securities, adjusted for the tax savings on interest payments. Answer: TRUE Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 1

5) If a project has a zero NPV when the expected cash flows are discounted at the weightedaverage cost of capital, then the project's cash flows are just sufficient to give debtholders and shareholders the return they require. Answer: TRUE Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) A firm's cost of capital should be computed using the book weights of each financing source. Answer: FALSE Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) There are two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, because higher levels of debt increase the required rate of return to equity. Answer: TRUE Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8) The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders. Answer: TRUE Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

9) If the firm decreases its debt ratio, both the debt and the equity will become riskier. The debtholders and equityholders will require a higher return to compensate for the increased risk. Answer: FALSE Difficulty: 2 Medium Topic: Cost of capital-general Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) A firm's weighted-average cost of capital will generally increase if the firm lowers its debtequity ratio. Answer: TRUE Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) Preferred stock should be ignored when computing a firm's weighted-average cost of capital. Answer: FALSE Difficulty: 1 Easy Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 12) Both the capital asset pricing model and the dividend discount model can be used to determine the cost of equity financing. Answer: TRUE Difficulty: 1 Easy Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

13) The cost of equity will generally increase for risky firms when the risk-free rate of return increases. Answer: TRUE Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) Interest tax shields are available to the firm on debt and preferred stock but not on common equity. Answer: FALSE Difficulty: 2 Medium Topic: Cost of preferred stock Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) New projects should be undertaken by firms only if they have the same risk as existing assets. Answer: FALSE Difficulty: 2 Medium Topic: Divisional and project costs of capital Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16) Projects that have a zero NPV when the cash flows are discounted at the WACC will provide just sufficient returns to creditors and shareholders. Answer: TRUE Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Understand AACSB: Analytical Thinking Accessibility: Keyboard Navigation

17) As a firm increases its debt ratio, debtholders are likely to demand higher rates of return. Answer: TRUE Difficulty: 1 Easy Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) An increase in a firm's debt ratio will have no effect on the required rate of return for equity holders. Answer: FALSE Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) A firm's cost of capital should be used as the discount rate for every new project the firm considers. Answer: FALSE Difficulty: 2 Medium Topic: Divisional and project costs of capital Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20) The mix of a company's short-term financing is referred to as its capital structure. Answer: FALSE Difficulty: 1 Easy Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

21) To a company, the cost of interest payments on its bonds is reduced by the amount of tax savings generated by that interest. Answer: TRUE Difficulty: 1 Easy Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) The interest tax shield generated by a project's actual equity financing is accounted for by using the after-tax cost of equity in the WACC. Answer: FALSE Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) Assuming a project has the same risk and financing as the firm, it will have a positive NPV if its rate of return is greater than the firm's WACC. Answer: TRUE Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) For healthy firms, the expected return on their bonds is close to their yield to maturity. Answer: TRUE Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

25) One way to estimate the expected return on bonds is to find the yield to maturity on recentlyissued bonds with similar characteristics and risks. Answer: TRUE Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an acceptable return to its security holders. Answer: TRUE Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) When using the WACC as a discount rate, it is often adjusted upward for riskier projects and downward for safer projects. Answer: TRUE Difficulty: 1 Easy Topic: Divisional and project costs of capital Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) All things being equal, a decrease in the corporate tax rate will cause the company to be financed with more debt. Answer: FALSE Difficulty: 2 Medium Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

29) A change in the company's capital structure will change the amount of taxes paid but will not change the WACC. Answer: FALSE Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) A drop in the corporate tax rate from 35% to 21% will cause the WACC for companies to go up. Answer: TRUE Difficulty: 2 Medium Topic: Cost of capital-general Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 31) Capital structure decisions refer to the: A) dividend yield of the firm's stock. B) blend of equity and debt used by the firm. C) capital gains available on the firm's stock. D) maturity date for the firm's securities. Answer: B Difficulty: 1 Easy Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

32) What is the debt ratio of a firm that has outstanding $15 million in bonds and equity with a market value of $35 million? A) 15% B) 30% C) 35% D) 43% Answer: B Explanation: Debt ratio = $15m / ($15m + 35m) = 0.30, or 30% Difficulty: 2 Medium Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 33) To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's: A) weighted-average cost of capital. B) pre-tax cost of debt. C) after-tax cost of debt. D) cost of equity. Answer: A Difficulty: 2 Medium Topic: Firm valuation Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

34) The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax cost of debt, 15% cost of equity, and a 21% tax rate is: A) 9.36%. B) 9.94%. C) 10.45%. D) 13.80%. Answer: A Explanation: WACC = [0.65 × 0.08 × (1 − 0.21)] + (0.35 × 0.15) = 0.0936, or 9.36% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 35) The weighted-average cost of capital for a firm with a 40/60 debt/equity split, 8% cost of debt, 15% cost of equity, and a 21% tax rate is: A) 12.20%. B) 8.63%. C) 11.53%. D) 13.80%. Answer: C Explanation: WACC = [0.40 × 0.08 × (1 − 0.21)] + (0.60 × 0.15) = 0.1153, or 11.53% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 36) Why is debt financing said to include a tax shield for the company? A) Taxes are reduced by the amount of the debt. B) Taxes are reduced by the amount of the interest. C) Taxable income is reduced by the amount of the debt. D) Taxable income is reduced by the amount of the interest. Answer: D Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

37) If the after-tax cost of debt is 10%, what is the pretax cost for a firm in the 21% tax bracket? A) 5.85% B) 10.15% C) 12.66% D) 18.71% Answer: C Explanation: After-tax cost of debt = 0.10 / (1 − 0.21) = 0.1266, or 12.66% Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 38) What is a firm's weighted-average cost of capital for a firm that is financed 45% by debt? The debt has a 10% required return and the equity has a 17% required return. The tax rate is 21%. A) 13.85% B) 12.91% C) 13.50% D) 9.00% Answer: B Explanation: WACC = 0.45 × [10% × (1 − 0.21)] + 0.55 × 17% = 12.91% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

39) What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity, and has a 21% tax rate? A) 9.6% B) 12.0% C) 14.7% D) 16.0% Answer: C Explanation: WACC = [0.5 × 0.12 × (1 − 0.21)] + (0.5 × 0.20) = 0.1474, or 14.74% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 40) Company X has 2 million shares of common stock outstanding with a book value of $2 per share. The stock trades for $3 per share. It also has $2 million in face value of debt that trades at 90% of face value. What is the debt ratio that should be used to calculate WACC? A) 13.91% B) 23.08% C) 31.03% D) 27.67% Answer: B Explanation: Debt ratio = (0.90 × $2m) / [(2m × $3) + (0.90 × $2m)] = 0.2308, or 23.08% Difficulty: 2 Medium Topic: Capital structure weights Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

41) If the tax rate is 21%, what is the cost of preferred stock that sells for $10 per share and pays a $1.20 dividend? A) 4.20% B) 7.80% C) 8.33% D) 12.00% Answer: D Explanation: Cost of preferred = $1.20 / $10.00 = 0.12, or 12% Difficulty: 2 Medium Topic: Cost of preferred stock Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 42) A firm is financed 55% by common stock, 10% by preferred stock and 35% by debt. The required return is 15% on the common, 10% on the preferred, and 8% on the debt. If the tax rate is 21% what is the WACC? A) 10.72% B) 11.46% C) 11.70% D) 12.05% Answer: B Explanation: WACC = (0.55 × 0.15) + (0.1 × 0.1) + [0.35 × 0.08 × (1 − 0.21)] = 0.1146, or 11.46% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

43) For a firm with EBIT of $10 million, paying $6 million per year in interest expense, a drop in the corporate tax rate from 35% to 21% will have what impact on their interest tax shield? A) $0.84 million higher B) $0.84 million lower C) $0.56 million higher D) $0.56 million lower Answer: D Explanation: Tax shield change = (10 − 6) × 0.35 − (10 − 6) × 0.21 = 0.56 Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) A project requires an investment of $10 million and offers an annual after-tax cash flow of $1,250,000 indefinitely. If the firm's WACC is 12.5% and the project is riskier than the firm's average projects, should it be accepted? A) Yes, since the project's NPV is positive. B) Yes, since a zero NPV indicates marginal acceptability. C) No, since the project's NPV is zero. D) No, since the project's NPV is negative. Answer: D Explanation: NPV at WACC = −$10m + $1.25m / 0.125 = $0; However, the 12.5% rate does not reflect the projects' greater risk; thus the project's NPV is negative. Difficulty: 2 Medium Topic: Divisional and project costs of capital Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

45) How much will a firm need in cash flow before tax and interest to satisfy debtholders and equity holders if the tax rate is 21%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds requiring an 8% return? A) $1,392,000 B) $1,488,000 C) $2,000,000 D) $2,800,000 Answer: C Difficulty: 3 Hard Topic: Cost of capital-general Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 46) How much will a firm need in cash flow before tax and interest to satisfy debtholders and equity holders if the tax rate is 21%, there is $15.8 million in common stock requiring a 10% return, and $6 million in bonds requiring a 6% return? A) $1,392,000 B) $1,488,000 C) $2,360,000 D) $2,480,000 Answer: C Difficulty: 3 Hard Topic: Cash flows Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 47) Which one of the following statements is incorrect? A) The equity component of WACC reflects the return expected by the company's shareholders. B) Market values should be used in calculating WACC. C) Preferred equity is a separate component of WACC. D) There is a tax shield on the equity dividends paid. Answer: D Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

48) What will be the effect of using the book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued? A) The debt-to-value ratio will be overstated. B) The debt-to-value ratio will be understated. C) There will be no effect on WACC decisions. D) It cannot be determined without knowing interest rates. Answer: B Explanation: Assume for example that the market value of equity is $5 million, the book value of debt is $2 million, and the value of the firm is $7 million. In the example, the debt-to-value ratio is 0.286. However, if the market value of debt is $2.5 million due to decreased interest rates, the value of the firm is $7.5 million and the debt-to-value ratio is 0.333. The key is that the numerator of the ratio changes proportionately more than the denominator. Difficulty: 2 Medium Topic: Capital structure weights Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 49) A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39. There are 5,000 shares of preferred stock with a book value of $22 and a market value of $26. There is a $400,000 face value bond issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the firm's WACC? A) 7.25% B) 13.74% C) 11.48% D) 15.09% Answer: B Explanation: Weight of preferred = (5,000 × $26) / [(12,000 × $39) + (5,000 × $26) + ($400,000 × 0.87)] = 0.1374, or 13.74% Difficulty: 2 Medium Topic: Capital structure weights Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

50) What would you estimate as the cost of equity if a stock sells for $40, pays a $4.25 dividend, and is expected to grow at a constant rate of 5%? A) 17.46% B) 14.52% C) 12.69% D) 15.63% Answer: D Explanation: E(R) = $4.25 / $40 + 0.05 = 0.1563, or 15.63% Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 51) What is the expected growth rate in dividends for a firm in which shareholders require an 18% rate of return and the dividend yield is 10%? A) 1.8% B) 5.2% C) 8.0% D) 28.0% Answer: C Explanation: g = 18% − 10% = 8% Difficulty: 1 Easy Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

52) What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54 per share and a book value of $50 per share? A) $2.92 B) $4.50 C) $4.68 D) $4.86 Answer: D Explanation: 9% = dividend / $54; Dividend = $4.86 Difficulty: 2 Medium Topic: Cost of preferred stock Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 53) If a firm earns the WACC on its assets, then: A) equityholders will be satisfied, but bondholders will not. B) bondholders will be satisfied, but equityholders will not. C) all investors will earn their minimum required rate of return. D) the firm is investing in only positive NPV projects. Answer: C Difficulty: 1 Easy Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) As debt is added to the capital structure, the: A) WACC will continually decline. B) WACC will continually increase. C) cost of debt can be expected to rise. D) WACC will be unaffected. Answer: C Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

55) An implicit cost of increasing the proportion of debt in a firm's capital structure is that: A) the firm's asset beta will increase. B) shareholders will demand a higher rate of return. C) the tax shield will not apply to the added debt. D) the cost of equity will decrease. Answer: B Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) A firm is considering a project that will generate perpetual cash flows of $50,000 per year beginning next year. The project has the same risk as the firm's overall operations. If the firm's WACC is 12%, and its debt-to-equity ratio is 1.33, what is the most it could pay for the project and still earn its required rate of return? A) $313,283 B) $375,094 C) $416,667 D) $554,167 Answer: C Explanation: PV = $50,000 / 0.12 = $416,667 Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 57) A firm's WACC: A) is the proper discount rate for every project the firm undertakes. B) is used to value all of the firm's existing projects. C) is a benchmark discount rate that may be adjusted for the riskiness of each project. D) is for informational value only and should never be used as a discount rate. Answer: C Difficulty: 1 Easy Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19

58) Other things equal, which of the following will decrease the WACC of a firm that has both debt and equity in its capital structure? A) An increase in the stock's beta B) An increase in the expected market return C) An increase in the tax rate D) An increase in the yield on preferred stock Answer: C Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 59) Calculate a firm's WACC given that the total value of the firm is $2 million, $600,000 of which is debt, the pre-tax cost of debt is 10%, and the cost of equity is 15%. The firm pays no taxes. A) 9.0% B) 11.5% C) 13.5% D) 14.4% Answer: C Explanation: WACC = 0.10($600,000 / $2m) + 0.15[($2m − 600,000) / $2m] = 0.135, or 13.5% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

60) A firm has a debt-to-equity ratio of 1/4. The WACC is 18.6%, and the pretax cost of debt is 9.4%. What is the cost of common equity if the tax rate is 21%? A) 19.90% B) 20.90% C) 21.48% D) 22.73% Answer: C Explanation: D/V = 0.2 and E/V = 0.8; 18.6 = 0.2(9.4)(1 − 0.21) + 0.8(re); re = 21.48% Difficulty: 3 Hard Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 61) For a company that pays no corporate taxes, its WACC will be equal to: A) the expected return on its assets. B) the expected return on its debt. C) the total value of its assets. D) the expected return on its equity. Answer: A Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

62) A firm is 40% financed by debt with a yield-to-maturity of 8.5%. The equity has a beta of 1.3, the market risk premium is 8.4% and the risk-free rate is 3.8%. What is the firm's WACC if the tax rate is 21%? A) 10.74% B) 11.52% C) 11.91% D) 12.38% Answer: B Explanation: re = 3.8% + 1.3(8.4%) = 14.72% WACC = (1 − 0.40)(0.1472) + 0.40(.085)(1 − 0.21) = 0.1152, or 11.52% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 63) If a firm has twice as much equity as debt in its capital structure, then the firm is financed with: A) 75.0% debt. B) 66.7% equity. C) 40.0% debt. D) 33.3% equity. Answer: B Difficulty: 2 Medium Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

64) If a firm has three times as much equity as debt in its capital structure, then the firm is financed with: A) 25.0% debt. B) 90.0% equity. C) 40.0% debt. D) 33.3% debt. Answer: A Difficulty: 2 Medium Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 65) If a company's WACC is less than the required return on equity, then the firm: A) is financed with more than 50% debt. B) is perceived to be safe. C) has debt in its capital structure. D) is all equity financed. Answer: C Difficulty: 2 Medium Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) The company cost of capital is the return that is expected on a portfolio of the company's: A) existing securities. B) equity securities. C) debt securities. D) proposed securities. Answer: A Difficulty: 1 Easy Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

67) A firm has just paid its annual dividend of $5.64 a share. Thereafter the dividend is expected to increase at a rate of 2% a year. If the firm's stock currently sells for $60 a share, what is the cost of equity? A) 11.59% B) 14.33% C) 11.40% D) 9.40% Answer: A Explanation: re = ($5.64 × 1.02) / $60 + 0.02 = 0.11588, or 11.59% Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 68) What is the WACC for a firm financed with 30% debt if the debt investors require a return of 12.5% and equity investors require a 16% return? The corporate tax rate is 21%. A) 11.8% B) 13.3% C) 14.2% D) 14.8% Answer: C Explanation: WACC = 0.3(0.79 × 12.5) + (1 − 0.3)(16) = 0.142, or 14.2% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

69) Which one of the following changes would tend to increase the WACC for a tax-paying firm? A) Decrease the proportion of equity financing B) Increase the market value of the debt C) Decrease the proportion of debt financing D) Decrease the market value of the equity Answer: C Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) A firm is considering expanding its current operations and has estimated the internal rate of return on that expansion to be 12.2%. The firm's WACC is 11.8%. Given this, you know that the: A) project will have a lower debt-equity ratio than the firm's current operations. B) appropriate discount rate for the project is between 11.8% and 12.2%. C) project has slightly more risk than the firm's current operations. D) expansion should be undertaken as it has a positive net present value. Answer: D Explanation: Since the project is an expansion project, the risk-level of the project is equal to the risk-level of the current firm. Thus, the project NPV will be positive since the IRR exceeds the required return. Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

71) A firm has 12,500 shares of stock outstanding that sell for $42 each. The book value of equity is $400,000. The firm has also issued $250,000 face value of debt that is currently quoted at 101.2. What value should be used as the weight of equity when computing WACC? A) 67.48% B) 72.09% C) 61.54% D) 69.74% Answer: A Explanation: We = (12,500 × $42) / [(12,500 × $42) + 1.012($250,000)] = 0.6748, or 67.48% Difficulty: 2 Medium Topic: Capital structure weights Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 72) A tax-paying firm is currently financed with 50% debt and 50% equity. The after-tax cost of debt is 6% and the cost of equity is 12%. If the firm issues some 8% preferred stock at par, then the firm's WACC will: A) increase. B) decrease. C) either increase or decrease depending upon the amount of stock issued. D) not be affected. Answer: B Explanation: Current WACC = 0.50(0.06) + 0.50(0.12) = 0.09, or 9%; Including some preferred stock at a cost of 8%, will lower the firm's WACC. Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

73) Assume a firm's debt is selling at face value. What is the firm's cost of debt if the debt has a coupon rate of 7.5% and the tax rate is 21%? A) 4.88% B) 4.97% C) 5.21% D) 5.93% Answer: D Explanation: Rd = 7.5%(1 − 0.21) = 5.93% Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 74) What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt is 7%, the tax rate is 21%, and the required return on equity is 18%? A) 54.00% B) 63.64% C) 70.26% D) 77.78% Answer: B Explanation: 14% = (1 − x)(7%) + (x)18%; x = 63.64% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

75) What proportion of a firm is equity financed if the WACC is 14%, the before-tax cost of debt is 10.77%, the tax rate is 21%, and the required return on equity is 18%? A) 54.00% B) 57.86% C) 70.26% D) 77.78% Answer: B Explanation: 0.14 = (1 − x)(10.77%)(1 − 0.21) + x(18%); x = 57.86% Difficulty: 3 Hard Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 76) A firm has a debt-to-value ratio of 40%, a cost of equity of 14%, and an after-tax cost of debt of 5.5%. It plans to launch a new product that will produce cash flows of $398,000 next year and $211,000 in year 2. If this project is about as risky as the firm's existing assets, what is the present value of the project? A) $458,008 B) $481,707 C) $500,614 D) $532,349 Answer: D Explanation: WACC = 0.4(5.5%) + (1 − 0.4)(14%) = 10.6% PV = $398,000 / 1.106 + $211,000 / 1.1062 = $532,349 Difficulty: 3 Hard Topic: Firm valuation Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

77) Al's Market plans to close after 3 more years. The firm expects to have free cash flows of $148,000 next year, $128,000 in Year 2, and $65,000 in Year 3 after incurring the costs of closing. The firm's cost of equity is 15.5% and its after-tax cost of debt is 6.2%. What is the present value of the firm if its debt to value ratio is 30%? A) $312,020 B) $248,915 C) $277,467 D) $301,004 Answer: C Explanation: WACC = 0.3(6.2%) + (1 − 0.3)(15.5%) = 12.71% PV = $148,000 / 1.1271 + $128,000 / 1.12712 + $65,000 / 1.12713 = $277,467 Difficulty: 3 Hard Topic: Firm valuation Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 78) A proposed project has a positive NPV if it is financed entirely by equity. If the project can sensibly be financed partly by debt and the firm pays tax, will the project remain acceptable? A) Yes, using debt will increase the NPV. B) No, using debt will decrease the NPV. C) The project may now become unacceptable. D) There will be no change in the project's NPV. Answer: A Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

79) What is the after-tax cost of preferred stock that pays a 12% dividend and sells at par if the firm's tax rate is 21%? A) 7.8% B) 8.5% C) 12.0% D) 16.2% Answer: C Explanation: There is no adjustment for taxes on preferred stock. Therefore, after-tax cost = pretax cost. Difficulty: 1 Easy Topic: Cost of preferred stock Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 80) What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if their respective costs are 6% after tax, 12%, and 18%? The firm's tax rate is 21%. A) 9.48% B) 11.16% C) 12.00% D) 15.60% Answer: C Explanation: WACC = (0.4 × 6%) + (0.2 × 12%) + (0.4 × 18%) = 12.00% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

81) What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if their respective costs are 9.23% before tax, 12%, and 18%? The firm's tax rate is 21%. A) 9.48% B) 11.16% C) 12.52% D) 15.60% Answer: C Explanation: WACC = [0.4 × ((1 − 0.21) × 9.23%)] + (0.2 × 12%) + (0.4 × 18%) = 12.52% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 82) A project will generate a $1 million net cash flow annually in perpetuity. If the project costs $7 million, what is the break-even WACC? A) 13.33% B) 12.08% C) 14.29% D) 16.67% Answer: C Explanation: $7m = $1m / WACC; WACC = 14.29% Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

83) Which one of the following changes offers the greatest chance of changing a project's NPV from negative to positive? A) Substituting preferred stock for debt B) Selling the debt at less than par value C) Reducing the risk of the project D) Reducing the maturity of the debt Answer: C Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) What decision should be made on a project with above-average market risk? A) Accept if the cash flows discounted at the WACC have a positive NPV. B) Discount the cash flows at the IRR and accept if NPV is positive. C) Accept if the IRR is greater than the WACC. D) Use a higher discount rate than the WACC to reflect the project's risk and accept if NPV is positive at this higher discount rate. Answer: D Difficulty: 2 Medium Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) If equity investors require a 20% rate of return, what is the maximum acceptable amount of equity financing for a project with cash flows of $2 million a year in perpetuity before tax and interest? The project supports debt of $3 million with a 10% coupon, and the tax rate is 21%. A) $5.87 million B) $6.72 million C) $8.5 million D) $9.03 million Answer: B Explanation: Maximum equity = $1,343,000 / 0.20 = $6,715,000, or $6.72 million Difficulty: 3 Hard Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 86) For purposes of computing the WACC, if the book value of equity exceeds the market value of equity, then: A) the book value of equity should be used. B) the book value of equity less retained earnings should be used. C) the market value of equity should be used. D) the market value of equity less retained earnings should be used. Answer: C Difficulty: 2 Medium Topic: Capital structure weights Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

87) How much cash flow before tax and interest is necessary to support a project if $2 million is used to pay interest, the tax rate is 21%, and equity investors require annual income of $4 million? A) $7.06 million B) $7.86 million C) $8.15 million D) $8.85 million Answer: A Difficulty: 3 Hard Topic: Project evaluation Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn't-the appropriate discount rate for a new project. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 88) What equity proportion should be used when calculating WACC for a firm with $50 million in debt selling at 85% of par, $50 million in book value of equity, and $65 million in market value of equity? A) 50.00% B) 54.18% C) 56.55% D) 60.47% Answer: D Explanation: We = $65m / [($50m × 0.85) + $65m] = 0.6047, or 60.47% Difficulty: 2 Medium Topic: Capital structure weights Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

89) According to CAPM estimates, what is the cost of equity for a firm with a beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%? A) 19.5% B) 21.0% C) 22.5% D) 24.0% Answer: A Explanation: Re = 6% + 1.5(15% − 6) = 19.5% Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 90) What return on equity do investors expect for a firm with a $55 share price, an expected dividend of $4.60, a beta of 0.9, and a constant growth rate of 3.5%? A) 9.87% B) 12.48% C) 13.95% D) 11.86% Answer: D Explanation: Re = $4.60 / $55 + 0.035 = 0.1186, or 11.86% Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 91) Changing the capital structure by adding debt will: A) reduce the return that shareholders require. B) reduce default risk. C) increase debtholder risk. D) reduce the cost of debt. Answer: C Difficulty: 2 Medium Topic: Capital structure Learning Objective: 13-03 Measure a company's capital structure. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35

92) The company cost of capital: A) measures the return that investors require from the company. B) depends on current profits and cash flows. C) is measured using security book values. D) depends on historical profits and cash flows. Answer: A Difficulty: 2 Medium Topic: Cost of capital-general Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 93) XYZ Company issues common stock at a price of $25 a share. The firm expects to pay a dividend of $2.20 a share next year. If the dividend is expected to grow at 2.5% annually, what is XYZ's cost of common equity? A) 6.3% B) 11.3% C) 13.7% D) 8.9% Answer: B Explanation: re = $1.20 / $25 + 0.025 = 0.113, or 11.3% Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 94) Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk free rate is 5% and the return on the market is 13.6%. A) 11.54% B) 13.08% C) 16.18% D) 18.02% Answer: C Explanation: rr = 0.05 + 1.3(0.136 − 0.05) = 0.1618, or 16.18% Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 36

95) Plasti-tech Inc. is financed 60% with equity and 40% with debt. Currently, its debt has a pretax interest rate of 12%. Plasti-tech's common stock trades at $15.00 per share and its most recent dividend was $1.00. Future dividends are expected grow by 4%. If the tax rate is 21%, what is Plasti-tech's WACC? A) 7.39% B) 9.57% C) 10.35% D) 11.20% Answer: C Explanation: re = [($1 × 1.04) / $15] + 0.04 = 0.1093, or 10.93% WACC = 0.4[0.12(1 − 0.21)] + 0.6(0.1035) = 0.1035, or 10.35% Difficulty: 3 Hard Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 96) The capital structure for the CR Corporation includes bonds valued at $5,500 and common stock valued at $11,000. If CR has an after-tax cost of debt of 6%, and a cost of common stock of 16%, what is its WACC? A) 9.33% B) 12.67% C) 13.33% D) 14.67% Answer: B Explanation: WACC = [($5,500 / $16,500) × 6%] + [($11,000 / $16,500) × 16%] = 12.67% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 13-01 Calculate the weighted average cost of capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

97) What is the yield to maturity on Dotte Inc.'s bonds if its after-tax cost of debt is 10% and its tax rate is 21%? A) 6.50% B) 12.66% C) 15.38% D) 16.42% Answer: B Explanation: 0.10 = rd(1 − 0.21); rd = 12.66% Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 98) Increasing debt financing will do all of the following except: A) cause investors to demand a higher interest rate on debt. B) increase the risk to the firm's common stockholders. C) cause stockholders to demand a higher return. D) decrease the firm's cost of common equity. Answer: D Difficulty: 2 Medium Topic: Cost of equity Learning Objective: 13-04 Estimate the expected returns on a firm's securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

99) Suppose an analyst estimates that free cash flow will be $2.43 million in year 5. What is the present value of this free cash flow if the company cost of capital is 12%, the WACC is 10%, and the equity cost of capital is 15%? A) $2,113,043 B) $1,208,139 C) $1,508,839 D) $1,378,847 Answer: C Explanation: PV = $2.43m / 1.105 = $1,508,839 Difficulty: 2 Medium Topic: Firm valuation Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 100) WACC can be used to determine the value of a firm by discounting the firm's: A) after-tax net profits. B) pretax profits. C) cash inflows. D) free cash flows. Answer: D Difficulty: 1 Easy Topic: Firm valuation Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 14 Introduction to Corporate Financing 1) Only a portion of the board of directors are up for election in any given year when a firm has a classified board. Answer: TRUE Difficulty: 2 Medium Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Shares of stock that have been issued and subsequently repurchased by the issuer are known as treasury stock. Answer: TRUE Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) The price at which new shares are sold to investors almost always exceeds par value. The difference is entered into the company's accounts as additional paid-in capital, or capital surplus. Answer: TRUE Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

4) Firms tend to issue more debt when internal funds are low. Answer: TRUE Difficulty: 1 Easy Topic: Debt Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 5) In proxy contests, outsiders compete with the firm's existing management and directors for control of the corporation. Answer: TRUE Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) Historically, internally generated cash covers less than half of the non-financial firms' capital requirements in the U.S. Answer: FALSE Difficulty: 1 Easy Topic: External financing need Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 7) The gap between internally generated cash and the cash that the company needs is called the financial deficit. Answer: TRUE Difficulty: 1 Easy Topic: External financing need Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2

8) Ford Motor Company and Google have issued two classes of shares with different voting rights to allow their firms to obtain fresh capital without giving up their management's controlling rights. Answer: TRUE Difficulty: 2 Medium Topic: Classes of stock Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 9) Suppose a firm needs fresh capital, but its management does not want to give up its controlling interest. The existing shares could be labeled Class A, and then Class B shares with limited voting rights could be issued to outside investors. Answer: TRUE Difficulty: 1 Easy Topic: Classes of stock Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) If an incompetent management team controls a large block of votes, it may use these votes to stay in control. Answer: TRUE Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

11) Companies sometimes sell the cash flows from a bundle of loans. Such bonds are known as asset-backed bonds. Answer: TRUE Difficulty: 1 Easy Topic: Bond types Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12) Firms have the right to resell any Treasury stock they own. Answer: TRUE Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) Different classes of stock often have different voting rights. Answer: TRUE Difficulty: 1 Easy Topic: Classes of stock Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) If shareholders do not like the policies that management pursues, they can vote in a different board of directors. Answer: TRUE Difficulty: 2 Medium Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

15) A majority of a firm's directors must be independent of the firm's management. Answer: TRUE Difficulty: 2 Medium Topic: Ethics, governance, and regulation Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16) Corporate investors are indifferent between investing in common and preferred shares. Answer: FALSE Difficulty: 2 Medium Topic: Preferred stock features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) If you are concerned with maintaining the market value of your preferred stock, you should purchase floating-rate preferred shares. Answer: TRUE Difficulty: 1 Easy Topic: Preferred stock features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) A convertible bond generally has a higher market value than a comparable non-convertible bond. Answer: TRUE Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

19) A corporation cannot default on funded debt. Answer: FALSE Difficulty: 2 Medium Topic: Bond types Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20) Dividends represent an important component of a firm's net book value. Answer: FALSE Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) The price at which new shares are issued is referred to as the par value of the stock. Answer: FALSE Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) A capital surplus is created when the selling price of new shares is greater than the par value. Answer: TRUE Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

23) Declassification of a firm's board tends to increase the market value of the firm's stock. Answer: TRUE Difficulty: 2 Medium Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) The term "senior debt" refers only to debt that was issued in the more distant past. Answer: FALSE Difficulty: 1 Easy Topic: Preferred stock features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 25) In a bankruptcy situation, funded debt will be repaid while unfunded debt will not. Answer: FALSE Difficulty: 2 Medium Topic: Bankruptcy Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) Holders of callable bonds know that the company will wish to buy the issue back if interest rates fall, and therefore the price of the bond will not rise above the call price. Answer: TRUE Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

27) Callable bonds may be repurchased by the issuing firm before maturity at the specified call price. Answer: TRUE Difficulty: 1 Easy Topic: Bond features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) The call provision of callable bonds comes at the expense of bond holders, for it limits their capital gain potential. Answer: TRUE Difficulty: 2 Medium Topic: Bond yields and returns Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) Bonds with the callable feature tend to sell at lower prices than bonds without such a feature. Answer: TRUE Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) A eurobond is defined as any bond that is denominated in euros. Answer: FALSE Difficulty: 1 Easy Topic: Bond types Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

31) For most firms, the majority of their funding is from external sources. Answer: FALSE Difficulty: 2 Medium Topic: External financing need Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 32) Privately placed debt must be held until maturity and can never be resold. Answer: FALSE Difficulty: 1 Easy Topic: Private placements and leveraged buyouts Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 33) When firms retain cash, they are generating funds internally thereby decreasing the amount of external funds needed. Answer: TRUE Difficulty: 1 Easy Topic: External financing need Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) As a group, individual investors are the largest holder of US company bonds. Answer: FALSE Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

35) The par value of stock is determined by the stock market. Answer: FALSE Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 36) When faced with a financial deficit, companies will usually first turn to issuing new shares. Answer: FALSE Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 37) Floating-rate bonds appeal to investors who are worried about fluctuations in interest rates. Answer: TRUE Difficulty: 2 Medium Topic: Bond types Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 38) A stock's par value is the: A) maturity value of the stock. B) price at which each share is recorded. C) price at which an investor could sell the stock. D) price received by the firm when the stock was issued. Answer: B Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10

39) Additional paid-in capital refers to: A) a firm's retained earnings. B) a firm's treasury stock. C) the difference between the issue price and the par value. D) funds borrowed from a bank or bondholders. Answer: C Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) Which one of the following equity concepts would you expect to be least important to a financial analyst? A) Par value per share B) Additional paid-in capital C) Retained earnings D) Net common equity Answer: A Difficulty: 1 Easy Topic: Financial statement analysis Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 41) Any capital surplus shown by a firm on its balance sheet results from: A) not paying out all net income as dividends. B) repurchasing shares for treasury stock. C) issuing stock at a price higher than par value. D) retained earnings. Answer: C Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

42) How much will be recorded as a firm's additional paid-in capital if the firm issues 1 million shares that have a $5 par value for $15 per share? A) $0 B) $5 million C) $10 million D) $15 million Answer: C Explanation: Additional paid-in capital = 1m($15 − 5) = $10m Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 43) If a corporation issues 1,000 shares of $1 par value stock for $10 per share, then retained earnings will: A) increase by $1,000. B) increase by $9,000. C) decrease by $9,000. D) remain unchanged. Answer: D Explanation: Issuing new shares does not affect retained earnings. Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

44) Assume a firm with 5,000 shares outstanding earns $10 per share and has a 30% plowback ratio. In this case retained earnings will: A) increase by $15,000. B) increase by $50,000. C) decrease by $15,000. D) decrease by $50,000. Answer: A Explanation: Change in retained earnings = 5,000 × $10 × 0.30 = $15,000 Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 45) What is the book value per share of equity for a firm with $1 million in net common equity, $50,000 in authorized share capital, 25,000 shares issued, and 20,000 shares outstanding? A) $38.00 B) $40.00 C) $47.50 D) $50.00 Answer: D Explanation: Book value per share = $1m / 20,000 = $50 Difficulty: 2 Medium Topic: Per-share valuations Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

46) Assume a corporation has cumulative voting and there are two directors up for election. What is the maximum number of votes a shareholder who owns 100 shares can cast for Candidate Jones if there are a total of 5 candidates? A) 20 B) 40 C) 100 D) 200 Answer: D Explanation: Maximum votes = 100 × 2 = 200 votes Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 47) Assume a corporation has cumulative voting and there are two directors up for election. What is the minimum number of votes a shareholder who owns 100 shares can cast for Candidate Jones if there are a total of 5 candidates? A) 0 B) 20 C) 40 D) 100 Answer: A Explanation: Minimum votes = 0 Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

48) In which voting process are outsiders more likely to win seats on the board of directors? A) Cumulative voting B) Majority voting C) Minority voting D) Staggered voting Answer: A Difficulty: 2 Medium Topic: Ethics, governance, and regulation Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 49) A proxy contest is typically one in which: A) the Board attempts to gain control from the shareholders. B) management attempts to gain control from the Directors. C) outsiders attempt to gain control from management. D) the Board attempts to gain control from the Directors. Answer: C Difficulty: 2 Medium Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 50) A corporation's net worth is composed of the: A) book value of common equity plus par value of debt. B) par value plus additional paid-in capital. C) retained earnings less treasury stock. D) book value of common equity plus preferred stock. Answer: D Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

51) Preferred stock dividends: A) have preference over bond interest payments. B) are guaranteed to be paid at least annually. C) are excluded from the taxable income of their recipients. D) have priority over common stock dividends. Answer: D Difficulty: 2 Medium Topic: Preferred stock features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) If a corporation receives $50,000 in preferred stock dividends, how much tax does it pay on these dividends? The corporate tax rate is 21%. A) $0 B) $3,150 C) $12,250 D) $17,500 Answer: B Explanation: Tax liability = $50,000 × 0.30 × 0.21 = $3,150 Difficulty: 2 Medium Topic: Preferred stock features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 53) Which one of the following statements about floating-rate preferred stock is correct? A) Its dividends increase as interest rates increase. B) Its market price increases at a set rate annually. C) It is the only stock issued without a par value. D) Its dividends are deductible for tax purposes by the paying corporation. Answer: A Difficulty: 2 Medium Topic: Preferred stock features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

54) Funded debt refers to those liabilities that: A) have established a sinking fund for repayment. B) are not callable at the option of the firm. C) are secured by specific collateral. D) have a maturity of more than one year remaining. Answer: D Difficulty: 1 Easy Topic: Debt Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 55) The purpose of a sinking fund is to: A) reduce the par value of stock over time. B) take advantage of the tax break on preferred stock. C) periodically retire debt prior to final maturity. D) allow risky corporations to avoid bankruptcy. Answer: C Difficulty: 1 Easy Topic: Bond features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 56) Warrants: A) allow their holder to purchase shares at the current market price. B) have a guaranteed maturity value. C) grant the option to purchase either stocks or bonds at the holders discretion. D) have an expiration date. Answer: D Difficulty: 2 Medium Topic: Warrants Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

57) Which one of these terms applies to the bundling of a group of loans with the subsequent sale of the cash flows from those loans? A) Convertible bond B) Warrants C) Asset-backed bond D) Preferred bond Answer: C Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) Eurobonds are long-term, corporate liabilities that: A) are issued by European firms. B) must be held inside the United States by foreigners. C) are marketed in many countries. D) are repaid in U.S. dollars. Answer: C Difficulty: 2 Medium Topic: Debt Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 59) Bonds that have been sold only to a limited number of institutional investors are considered: A) secured bonds. B) convertible bonds. C) private placements. D) indexed bonds. Answer: C Difficulty: 1 Easy Topic: Private placements and leveraged buyouts Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

60) Which one of these accounts represents internal funding? A) Retained earnings B) Common stock C) Bonds payable D) Preferred stock Answer: A Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 61) A warrant grants its holder the right to do which one of these prior to a specified date? A) Convert debt into a specified number of shares B) Sell common shares at a predetermined price C) Exchange stock for bonds at a specified price D) Purchase shares at a predetermined price Answer: D Difficulty: 2 Medium Topic: Warrants Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 62) What happens in the case of a bond selling for $1,000 that can be converted to 20 shares of stock that are currently selling for $80 per share? A) The bondholder will lose $100. B) The stock will go down to $50 per share. C) The bond's price will go down to $900. D) The bondholder will choose to convert. Answer: D Explanation: Conversion value = 20 × $80 = $1,600; Bondholders will convert. Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) What happens in the case of a bond selling for $1,000 that can be converted to 20 shares of stock that are currently selling for $45 per share? A) The bondholders will choose to convert. B) The stock will go up to $50 per share. C) The bond's price will go down to $900. D) Bondholders will not convert. Answer: D Explanation: Conversion value = 20 × $45 = $900; bondholders will not convert. Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) Convertible bonds resemble a combination of which two types of securities? A) Investment grade bonds and junk bonds B) Bonds and common stock C) Bonds and warrants D) Bonds and preferred stock Answer: C Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 65) What is the most commonly bundled type of loan in the asset-backed bond category? A) Automobile loans B) Mortgages C) Credit card receivables D) Student loans Answer: B Difficulty: 1 Easy Topic: Bond types Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

66) Which one of the following statements is correct? A) A convertible bondholder is forced to convert no later than a pre-specified time. B) The convertible option on a bond gives the owner the right to buy shares from a company at a pre-determined cash price. C) The owner of a warrant has an option to convert the warrant into convertible bonds. D) The owner of a warrant will benefit if the firm's stock does well. Answer: D Difficulty: 2 Medium Topic: Warrants Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) An investor might prefer floating-rate debt if she thought that: A) interest rates would rise. B) interest rates would decline. C) its bond rating might be lowered. D) its bonds were going to be converted into equity. Answer: A Difficulty: 1 Easy Topic: Bond features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 68) If net equity issues have been negative, A) more shares have been repurchased than newly issued. B) new shares have been sold at less than par value. C) issuing stock has been a negative NPV transaction. D) dividend payments have exceeded net income. Answer: A Difficulty: 2 Medium Topic: Financial statement analysis Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

69) All of the following are true of retained earnings except: A) They are the difference between paid-in capital and the total dividends paid. B) They represent the amount of new capital shareholders have indirectly contributed. C) They are equal to the cumulative earnings less dividends. D) They are the amount of earnings plowed back into the firm. Answer: A Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) Jay's Jams Inc. was just established with an investment of $3 million. Jay expects his company to generate free cash flow of $800,000 a year for the next 10 years. If Jay's cost of capital is 15%, find the market value and book value of his company. A) Market value = $8.0 million; book value = $3.0 million B) Market value = $3.0 million; book value = $4.0 million C) Market value = $4.0 million; book value = $3.0 million D) Market value = $8.0 million; book value = $4.0 million Answer: C Difficulty: 3 Hard Topic: Market and book values Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

71) Wheat's Market just issued 17,500 new shares of common stock at a price of $20 a share. How will this transaction affect the equity accounts on the firm's balance sheet if the par value is $1 per share? A) The common stock account will increase by $350,000. B) The common stock account will decrease by $17,500. C) Paid in surplus will increase by $332,500. D) Paid in surplus will increase by $350,000. Answer: C Explanation: Increase in common stock account = 17,500 × $1 = $17,500 Increase in paid in surplus = 17,500 × ($20 − 1) = $332,500 Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 72) When new shares of stock are sold at a price greater than par value, the excess over par is recorded as: A) capital surplus. B) retained earnings. C) treasury stock. D) authorized capital. Answer: A Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

73) A firm just issued 15,000 new shares of stock with a market price of $14 per share and par value of $2 per share. Which one of these correctly states the resulting change in the equity accounts? A) Capital surplus will increase by $180,000. B) Retained earnings will decrease by $210,000. C) Common stock will increase by $15,000. D) Common stock will increase by $210,000. Answer: A Explanation: Increase in common stock = 15,000 × $2 = $30,000 Increase in capital surplus = 15,000 × ($14 − 2) = $180,000 Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 74) Corporations generally need shareholder approval to do which one of the following? A) Select a new CEO B) Increase the number of authorized shares C) Purchase Treasury stock D) Pay a regular dividend Answer: B Difficulty: 2 Medium Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

75) Which statement correctly describes the company's dividend decision? A) The dividend payment is set by shareholders at the annual general meeting. B) The dividend payment is the sole responsibility of the company's management. C) The dividend payment must be approved by the board of directors. D) The dividend payment is set by the company's bondholders together with the shareholders. Answer: C Difficulty: 2 Medium Topic: Board decisions Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) The value of retained earnings on the corporate balance sheet represents the amount of earnings: A) not paid out in dividends this period. B) that are being held in cash. C) over and above corporate income taxes. D) reinvested in the firm since its inception. Answer: D Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 77) Which one of the following statements is typically correct for a going-concern firm? A) Book value of equity exceeds market value of equity. B) Market value of equity exceeds book value of equity. C) Book value of equity equals market value of equity. D) No typical relationship exists between book and market values of equity. Answer: B Difficulty: 1 Easy Topic: Market and book values Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

78) A company's board of directors is primarily an agent of the company's: A) management. B) employees. C) shareholders. D) management and employees. Answer: C Difficulty: 1 Easy Topic: Agency costs and problems Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 79) The system of electing a board of directors where each director is voted on separately is known as: A) majority voting. B) supermajority voting. C) cumulative voting. D) proxy voting. Answer: A Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

80) A shareholder owning 100 shares of stock is voting for the board of directors who are elected by cumulative voting. How many votes will the shareholder cast for Director "A" if four directors are to be elected and the maximum number of votes are cast for "A"? A) 25 B) 100 C) 200 D) 400 Answer: D Explanation: Maximum votes with cumulative voting = 4 × 100 = 400 Difficulty: 2 Medium Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) One way in which control of a corporation can be removed from the current board of directors is to: A) take away the directors' stock. B) give voting power to management. C) remove the Board's voting power. D) fight a proxy contest. Answer: D Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

82) One common reason for issuing two distinct classes of common stock is to: A) sell different classes to increase profits. B) allow one stock to increase in price while the other class declines. C) restrict voting privileges from some shareholders. D) conserve cash by offering dividends to only one class of stockholders. Answer: C Difficulty: 1 Easy Topic: Classes of stock Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) Which one of the following statements is correct? A) Common stock dividends cannot be paid if preferred stock dividends are in arrears. B) Preferred stock dividends cannot be paid if common stock dividends are in arrears. C) Common and preferred dividends must be paid simultaneously. D) No dividends on the common stock can be paid without specific shareholder approval. Answer: A Difficulty: 1 Easy Topic: Preferred stock features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) What is the after-tax cost to a corporation in the 21% tax bracket of paying $50,000 in preferred stock dividends? A) $17,500 B) $32,500 C) $50,000 D) $76,923 Answer: C Explanation: Dividends are paid out of after-tax income. Difficulty: 2 Medium Topic: Tax effects on dividends and payouts Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) Which one of the following statements is correct about a corporation in the 21% tax bracket that can invest either in a bond paying 8% interest or in the preferred stock of another corporation that pays a 6% dividend? Ignore any differences in risk. A) The preferred stock should be selected because its after-tax yield is 0.17% higher. B) The preferred stock should be selected because its after-tax yield is 1.74% higher. C) The bond should be selected because its after-tax yield is 0.17% lower. D) The bond should be selected because its after-tax yield is 1.74 higher. Answer: D Explanation: Bond after-tax yield = 8%(1 − 0.21) = 6.32% Stock after-tax yield = 6% − (6% × 0.30 × 0.21) = 4.58% Difference = 4.58% − 6.32 = − 1.74%; the preferred stock is the better investment. Difficulty: 2 Medium Topic: Tax effects on dividends and payouts Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 86) What is the rationale for saying that the federal government provides a tax subsidy to corporate debtors? A) Interest and principal payments are tax deductible. B) Interest payments are tax deductible. C) Principal payments are tax deductible. D) Seventy percent of interest payments are tax deductible. Answer: B Difficulty: 1 Easy Topic: Tax effects on dividends and payouts Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

87) Which one of the following statements is correct about a floating interest rate loan if the interest rate is defined as "Prime plus 1 percent"? The interest rate: A) is set to vary at a rate equal to the prime rate plus 1 percent. B) can fluctuate up to a maximum of 1% above the current prime rate over the life of the loan. C) will be fixed at the current prime rate plus 1 percent. D) will vary with the prime rate but changes will only occur in 1 percent intervals. Answer: A Difficulty: 2 Medium Topic: Bond features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Corporations that annually retire a set portion of their long-term debt are said to be using: A) indexed bonds. B) sinking funds. C) convertible debt. D) secured debt. Answer: B Difficulty: 1 Easy Topic: Bond features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) An independent outside director: A) is defined as a company employee who has no management responsibilities outside of the board. B) cannot serve as the board chairman. C) is prohibited from owning shares of the firm. D) can be a shareholder as long as he/she holds no management position in the firm outside of the board. Answer: D Difficulty: 2 Medium Topic: Ethics, governance, and regulation Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

90) If a corporation has more shares issued than outstanding, then: A) the Board of Directors is holding shares. B) there are preferred shares outstanding. C) the corporation has treasury stock. D) unexercised stock warrants exist. Answer: C Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) Which one of the following statements is true with respect to financial and product markets? A) In product markets, companies rarely find investments that yield a positive NPV. B) Financial markets face fast-moving competition. C) Competition in financial markets is not as thorough as in product markets. D) Competition in product markets is more intense than in financial markets. Answer: B Difficulty: 2 Medium Topic: Market efficiency Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 92) A warrant has an exercise price of $40, and the current stock price is $38. An investor holding this option will purchase the stock only if the: A) dividend yield on the stock exceeds 10%. B) stock price falls below $38. C) stock price rises above $40. D) stock price falls to $20 or below. Answer: C Difficulty: 2 Medium Topic: Warrants Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

93) Which one of these statements describes U.S. firms during recent years? A) Firms have rarely relied on debt financing. B) Internal funds have provided less than half of the firms financing needs. C) Firms have repurchased more equity than they have sold. D) Debt is used to fund approximately half of the firms financing needs. Answer: C Difficulty: 2 Medium Topic: Capital structure observations Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) A firm's internally generated funds are calculated by: A) subtracting depreciation from net income. B) adding depreciation to net income. C) adding dividends to net income. D) subtracting dividends from net income plus depreciation. Answer: D Difficulty: 2 Medium Topic: Cash flows Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 95) If 100 million shares of common stock are issued with a par value of $2 and additional paid in capital is $800 million, the total par value of the issued shares is: A) $200 million. B) $600 million. C) $800 million. D) $1 billion. Answer: A Explanation: Total par value = 100m × $2 = $200m Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32

96) A company is about to issue 1,000 new shares of stock at a market price of $33 per share. If the par value per share is $4, the increase in capital surplus from this stock issue will be: A) $33,000. B) $4,000. C) $29,000. D) $32,000. Answer: C Explanation: Increase in capital surplus = 1,000 × ($33 − 4) = $29,000 Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 97) One way that investors contribute capital to the firm is by: A) the company plowing back part of its earnings. B) paying less than par value for the stock. C) letting their warrants expire unexercised. D) increasing the amount of treasury stock. Answer: A Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

98) When a firm issues 50,000 shares with a par value of $5 and a market price of $22 per share, additional paid in capital will: A) decrease by $250,000. B) increase by $250,000. C) increase by $850,000. D) increase by $1,100,000. Answer: C Explanation: Increase in paid in capital = 50,000 × ($22 − 5) = $850,000 Difficulty: 2 Medium Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 99) If the Beta Co. issues $100 million worth of preferred stock, what will happen to its net worth if book value of common equity is $500 million? A) It will increase by $400 million. B) It will decrease by $100 million. C) It will increase to $600 million. D) It will decrease to $400 million. Answer: C Explanation: Book value = $100m + 500m = $600m Difficulty: 1 Easy Topic: Balance Sheet Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

100) Preferred stockholders generally: A) have full voting rights. B) receive a fixed dividend. C) have priority over debt holders if the company goes bankrupt. D) convert to bond holders. Answer: B Difficulty: 2 Medium Topic: Preferred stock features Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 101) All of the following are types of innovative bonds except: A) preferred stock. B) asset-backed bonds. C) collateralized debt obligations (CDOs). D) mortality bonds. Answer: A Difficulty: 2 Medium Topic: Bond types Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 102) The majority of an established firm's capital is generated: A) internally. B) externally. C) through issuance of new shares. D) through funded debt. Answer: A Difficulty: 2 Medium Topic: Capital structure Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

103) Earnings this year for Plasti-tech Inc. were $200,000. It decided to plow back $60,000 and recorded $20,000 of depreciation. Plasti-tech's internally generated funds are: A) $40,000. B) $60,000. C) $80,000. D) $140,000. Answer: C Explanation: Internally generated funds = $60,000 + 20,000 = $80,000 Difficulty: 2 Medium Topic: Cash flows Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 104) With respect to bonds, when interest rates increase typically: A) the coupon rate on existing bonds also increases. B) the coupon rate on existing bonds remains unchanged. C) bond prices also increase. D) bond prices remain constant. Answer: B Difficulty: 2 Medium Topic: Interest rate risk Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 105) How does competition in financial markets compare to the competition that can be found in product markets? A) Financial markets are more competitive. B) Financial markets are less competitive. C) Both markets are similar in competition. D) Financial markets are not competitive, due to regulation. Answer: A Difficulty: 1 Easy Topic: Market efficiency Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36

106) To state that financing at current market terms is a zero-NPV transaction indicates that: A) firms should avoid these methods of financing. B) there is no cost involved in the financing. C) the market has not set financing terms correctly. D) there are no "bargains" when financing at current terms. Answer: D Difficulty: 2 Medium Topic: Market efficiency Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 107) An efficient capital market is one in which: A) all securities that investors desire are offered. B) all transactions are closed within 2 business days. C) current prices reflect all current information. D) the lowest interest rates are offered. Answer: C Difficulty: 1 Easy Topic: Market efficiency Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 108) Which one of the following is least likely to contribute to the positive-NPV investments found in product markets? A) Patented-production processes B) Financing strategies C) Brand-name product recognition D) Lack of competition Answer: B Difficulty: 2 Medium Topic: Market efficiency Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

109) If financial markets were not efficient, it would be easier for firms to: A) finance investments in a zero-NPV transaction. B) finance investments in a positive NPV transaction. C) totally avoid the need for external financing. D) finance investments in a negative NPV transaction. Answer: B Difficulty: 2 Medium Topic: Market efficiency Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 110) The true value of a security is: A) the value of that security at some future date. B) the sum of all future income from that security. C) the amount of funds invested to date in the security. D) the price that incorporates all currently available information. Answer: D Difficulty: 1 Easy Topic: Market efficiency Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 15 How Corporations Raise Venture Capital and Issue Securities 1) Equity capital in young businesses is known as venture capital and it is provided by venture capital firms, wealthy individuals, and investment institutions such as pension funds. Answer: TRUE Difficulty: 1 Easy Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Venture capitalists generally provide sufficient up-front funding in one lump sum to take a new firm to the point where it can go public. Answer: FALSE Difficulty: 1 Easy Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) In many countries it is common even for large businesses to remain privately owned. Answer: TRUE Difficulty: 1 Easy Topic: Forms of business organization Learning Objective: 15-01 Understand how venture capital works. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 4) Underwriters usually play a triple role-first providing the company with procedural and financial advice, then buying the stock, and finally reselling it to the public. Answer: TRUE Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 1

5) Some successful corporations will provide venture capital to new firms with innovative ideas. Answer: TRUE Difficulty: 1 Easy Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) A consequence of the Sarbanes-Oxley Act has been a decreased reporting burden on small public companies and a decrease in the number of companies reverting to private ownership. Answer: FALSE Difficulty: 2 Medium Topic: Financial market regulation Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) When a public company makes a general cash offer of debt or equity, it essentially follows the same procedure used when it first went public. Answer: TRUE Difficulty: 1 Easy Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 8) Shelf registration is a procedure that allows firms to file several registration statements for one issue of the security. Answer: FALSE Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

9) The book building method used by almost all IPOs in the United States is like an auction, since potential buyers indicate how many shares they are prepared to buy at given prices. Answer: TRUE Difficulty: 2 Medium Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) The SEC requires the sale of a private placement to be limited to a small number of knowledgeable investors. Answer: TRUE Difficulty: 1 Easy Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) The advantage of the bookbuilding method is that it allows underwriters to give preference to those investors whose bids are most helpful in setting the issue price and to offer them a reward in the shape of underpricing. Answer: TRUE Difficulty: 1 Easy Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

12) When securities are issued under a firm commitment, the underwriter bears the risk of low demand from investors. Answer: TRUE Difficulty: 2 Medium Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) The SEC reviews the registration statement and determines whether or not an investment in the firm is advisable. Answer: FALSE Difficulty: 1 Easy Topic: Basics of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) Like a general cash offering, a rights issue is an offer to buy shares made to existing and potential shareholders. Answer: FALSE Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

15) In a rights offering, the shares are priced at a substantial discount to current market value, which ensures that the shareholders will either exercise the rights themselves or sell them to other investors. Answer: TRUE Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16) Shelf registration is used more frequently for equity financing than for debt financing. Answer: FALSE Difficulty: 1 Easy Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 17) An average-sized firm should expect the underwriting and administrative costs of going public to be around 7% to 8% of the IPO proceeds. Answer: TRUE Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 18) Issue costs for debt are considerably lower than issue costs for equity securities. Answer: TRUE Difficulty: 1 Easy Topic: Costs of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 19) The evidence indicates that industrial stock prices in the U.S. decrease by approximately 3%, 5

on average, when new equity issues are announced. Answer: TRUE Difficulty: 1 Easy Topic: Costs of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 20) Firms are attracted to the private placement of debt because of the lower average interest rates. Answer: FALSE Difficulty: 2 Medium Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 21) The contract between the underwriter and the issuing company is known as the new issue prospectus. Answer: FALSE Difficulty: 1 Easy Topic: Basics of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 22) IPOs are generally overpriced in order to raise large amounts of cash. Answer: FALSE Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 23) The winner's curse theory assumes that the informed investor receives more of the 6

underpriced IPOs. Answer: TRUE Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 24) Privately placed securities may be difficult to resell. Answer: TRUE Difficulty: 2 Medium Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 25) A rights issue is one in which a public company offers shares only to existing shareholders in order to raise additional cash. Answer: TRUE Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 26) Crowdfunding is primarily used as a means for a publicly-traded company to raise additional capital. Answer: FALSE Difficulty: 2 Medium Topic: Raising capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) A general cash offer is necessary when issuing a private placement.

Answer: FALSE Difficulty: 2 Medium Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) Private placement contracts may be custom tailored for firms with special needs or unique opportunities. Answer: TRUE Difficulty: 1 Easy Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 29) One advantage to private placements is the low cost. Answer: TRUE Difficulty: 2 Medium Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 30) Private placements tend to be made by smaller firms that usually incur the highest costs when issuing public securities. Answer: TRUE Difficulty: 2 Medium Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 31) Money that is offered to finance a new business is known as: A) a general cash offer. 8

B) venture capital. C) a private placement. D) a rights issue. Answer: B Difficulty: 2 Medium Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 32) An investor exercises the right to buy one additional share at $20 for every five shares held. How much should each share be worth after the rights issue if they previously sold for $50 each? A) $35.00 B) $41.67 C) $45.00 D) $46.00 Answer: C Explanation: New price = $20 + (5 × $50) / (1 + 5) = $45.00 Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 33) A firm's first offering of stock to the general public is known as: A) first-stage financing. B) an IPO. C) a general cash offer. D) a seasoned offering. Answer: B Difficulty: 1 Easy Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 34) A secondary offering IPO occurs when: A) new shares are sold to provide the company with additional funds. B) the second public issue of equity becomes available. 9

C) the company's founders or venture capitalists market a portion of their shares. D) not all of the shares in a primary IPO were sold. Answer: C Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35) The most important function of an underwriter is to: A) assess the firm's capital needs. B) approve the prospectus before distribution to the public. C) provide private placement of the firm's debt. D) buy the securities issue from the firm and resell the securities to the public. Answer: D Difficulty: 2 Medium Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) When underwriters issue securities on a best efforts basis, they: A) sell as much of the stock as possible, but with no guarantee. B) submit a bid for purchase, which the issuer compares to other bids. C) buy the entire issue from the firm. D) guarantee that the issuer will be charged the minimum spread. Answer: A Difficulty: 2 Medium Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

37) If an underwriter charges the public $40 per share for a new issue after having promised the issuer $38 per share, the spread per share is: A) $1. B) $2. C) $38. D) $40. Answer: B Explanation: Spread = $40 − 38 = $2 Difficulty: 1 Easy Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 38) When underwriters are unsure of the demand for a new offering, they: A) reduce their spread. B) undertake the issue on a firm commitment basis. C) undertake the issue on a best efforts basis. D) provide shelf registration for the issue. Answer: C Difficulty: 2 Medium Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) A major purpose of the prospectus is to: A) inform investors of the security's rate of return. B) advise investors of the security's potential risks. C) distribute stock warrants to prospective investors. D) list the security's dividend payment dates. Answer: B Difficulty: 1 Easy Topic: Basics of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11

40) Studies have shown that, on average, new security issues are: A) subject to flotation costs of approximately 32%. B) overpriced by the amount of the spread. C) underpriced. D) overpriced to reward venture capitalists. Answer: C Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 41) One reason that underpricing of new issues occurs more frequently than overpricing is that: A) underwriters want to reduce the risk of a firm commitment. B) the demand for a new issue is typically too high. C) underwriters earn low rates of return. D) issuing firms demand that equity be underpriced. Answer: A Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

42) How much will a firm receive in net funding from a firm commitment underwriting of 250,000 shares priced to the public at $40 if a 10% underwriting spread has been added to the price paid by the underwriter? Additionally, the firm pays $600,000 in legal fees. A) $8,400,000 B) $8,460,025 C) $8,490,909 D) $8,545,455 Answer: C Explanation: Net proceeds = [($40 / 1.10) × 250,000] − $600,000 = $8,490,909 Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 43) One reason for an underwriters' syndication is to: A) monitor the actions of the different underwriters. B) reduce the risk of selling a large issue. C) increase the size of the spread. D) avoid the scrutiny of the Securities and Exchange Commission. Answer: B Difficulty: 2 Medium Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

44) Who bears the bulk of the cost of underpricing an IPO? A) The underwriters B) The investors who purchase IPO shares C) All of the after-IPO shareholders D) The pre-IPO shareholders Answer: D Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) An IPO was offered to the public at $18 a share with the issuing firm receiving $16.50 of that amount. The issuer incurred $750,000 in legal and administrative costs. At the end of the first trading day, the stock was priced at $22.40 a share. What was the total dollar cost, including both direct and indirect costs, of issuing the securities if 225,000 shares were offered? A) $1,687,500 B) $1,540,000 C) $2,077,500 D) $1,087,500 Answer: C Explanation: Total cost = [($22.40 − 16.50) × 225,000] + $750,000 = $2,077,500 Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

46) The consent of a corporation's stockholders must be received prior to any: A) issue of new securities. B) selection of an underwriter. C) increase in authorized capital. D) private placement of securities. Answer: C Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 47) When securities are issued under a rights issue: A) existing shareholders have the opportunity to expand their holdings. B) shares are offered to the public at a discount. C) the existing shares will increase in price. D) current shareholders have the right to resell their stock to the issuer. Answer: A Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

48) What would you expect to be the market price of stock after a sold-out rights issue, if each existing shareholder purchases one new share at $60 for each three that he or she currently holds, and the current share price is $100? A) $75 B) $80 C) $85 D) $90 Answer: D Explanation: New price = [$60 + (3 × $100)] / (1 + 3) = $90 Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 49) What was the market price of a share of stock before a rights issue, if one share of new stock could be purchased at $100 for every four shares that were previously owned? The stock price after the successful rights issue was $200. A) $220 B) $225 C) $240 D) $250 Answer: B Explanation: $200 = [$100 + (4 × POld)] / (1 + 4); POld = $225 Difficulty: 3 Hard Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

50) Which one of these terms applies to a public company offering new shares to the general public? A) Rights offer B) Initial public offering C) Venture capital offer D) General cash offer Answer: D Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) Shelf registration was enacted to allow: A) the Department of Justice to prosecute those guilty of insider trading. B) the prospectus to be distributed after the sale of securities begins. C) underwriters to join together in syndication. D) a joint filing for multiple issues of a single security. Answer: D Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) Which one of the following would not be included among the benefits of shelf registration? A) Reduction of lead time for security issuance B) No additional registration necessary for 5 years C) Issuer can take advantage of favorable conditions D) Issuer can search for best underwriting terms Answer: B Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) The enactment of shelf registration is likely to have increased: A) the cost of issuing new securities. B) the interests of venture capitalists. C) competition among underwriters. D) the underpricing of securities. Answer: C Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) If a corporation's management, with its superior knowledge of proposed investments, considers a security issue to be underpriced, it may react by: A) forgoing the security issuance and investment. B) lowering the price of the existing shares to equal the new shares. C) increasing the number of shares to be sold. D) adopting shelf registration, which automatically raises the issue price. Answer: A Difficulty: 3 Hard Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) If a new stock offering were overpriced and could be sold, then the: A) existing shareholders would benefit. B) new investors would gain at the expense of the existing shareholders. C) firm could avoid the underwriting spread. D) firm could avoid the SEC filing. Answer: A Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

56) Issue costs for equity are higher than those for debt for all of the following reasons except: A) equity issues have higher administrative costs. B) underwriting stock is riskier than underwriting bonds. C) equity issues involve significantly more time to sell. D) equity issues have no economies of scale. Answer: D Difficulty: 1 Easy Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) A firm has just issued $250 million of equity which caused its stock price to drop by 3%. Calculate the loss in value of the firm's equity given that its market value of equity was $1 billion before the new issue. A) $7.5 million B) $30.0 million C) $33.3 million D) $37.5 million Answer: B Explanation: Loss in value = 0.03 × $1 billion = $30 million Difficulty: 1 Easy Topic: Costs of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

58) Companies offering smaller security issues may prefer to issue them through a: A) private placement because lower rates of return can be offered. B) private placement because it is cheaper than a public issue. C) public issue because it is cheaper than a private placement. D) public issue because more exposure will be achieved. Answer: B Difficulty: 2 Medium Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 59) Which one of the following statements is incorrect concerning private placements? A) Terms of the financing can be custom-tailored. B) The securities are not made available to the public. C) The securities are often less marketable. D) Only a small amount of corporate debt is financed in this manner. Answer: D Difficulty: 2 Medium Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) Private placement of debt securities occurs more frequently in: A) smaller-sized firms. B) larger-sized firms. C) firms that are using venture capitalists. D) combination with convertible bonds. Answer: A Difficulty: 1 Easy Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

61) In return for providing funds, venture capitalists generally require: A) collateral equal in value to the funds provided. B) first right to all of the firm's assets. C) an equity position in the firm. D) ownership of the entire firm. Answer: C Difficulty: 1 Easy Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 62) Which one of the following is least likely to explain why entrepreneurs contribute their personal funds to start-up projects? Their contribution: A) acts as a signal to venture capitalists. B) repays debt held by the venture capitalist. C) retains a portion of the firm's equity. D) provides incentive to expend effort. Answer: B Difficulty: 2 Medium Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 63) What is the market value placed on a firm in which an entrepreneur invests $1 million and a venture capitalist invests $3 million in first-stage financing for a 50% interest in the firm? A) $4 million B) $6 million C) $7 million D) $8 million Answer: B Explanation: Firm value = $3m / 0.5 = $6m Difficulty: 2 Medium Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

64) Second-stage financing occurs: A) prior to the initial public offering. B) when company founders sell a portion of their shares. C) after the best efforts of the underwriters. D) when the IPO does not raise sufficient cash. Answer: A Difficulty: 2 Medium Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 65) One of the primary reasons for disbursing venture capital funds in installments is to: A) avoid tax liability. B) identify and cut losses early. C) increase the importance of the venture capitalist. D) take advantage of the time value of money. Answer: B Difficulty: 2 Medium Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) Roadshows: A) give companies an opportunity to thank investors who have bought the new issue. B) describe the meetings that managers have with investment bankers to select the underwriter to an issue. C) provide underwriters and the company's management an opportunity to meet potential investors. D) describe the meetings that management has with the SEC to finalize the issue prospectus. Answer: C Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

67) Stock underwriters are: A) investors seeking low prices. B) regulatory agencies that evaluate equity offerings. C) the firm's founders who guarantee a stock's performance. D) investment banking firms that manage security offerings. Answer: D Difficulty: 1 Easy Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 68) When underwriters offer a firm commitment on a stock issue, they: A) employ their best efforts in selling the stock. B) guarantee the net proceeds to the issuing firm. C) agree to purchase the venture capitalists' shares. D) assure purchasers that the stock will appreciate. Answer: B Difficulty: 1 Easy Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 69) Which one of the following is correct for stock issued under a firm commitment where the underwriter is to receive a spread of 8%? A) The underwriter's profits are guaranteed to be 8%. B) The underwriter must sell at least 92% of the shares. C) The underwriter receives 8% of all shares. D) The underwriter may suffer a loss on the issue. Answer: D Difficulty: 2 Medium Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

70) An underwriter enters into a firm commitment to sell 1 million shares at $20 each, including a $2 spread. How much does the issuing firm receive if only 500,000 shares are sold? A) $9 million B) $10 million C) $18 million D) $20 million Answer: C Explanation: Proceeds to firm = ($20 − 2) × 1m = $18m Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 71) An underwriter sells 2 million shares of stock to the public at $40 per share. The issuing firm receives $73 million before non-underwriting costs. A) The underwriter's spread was 2.14%. B) The underwriter's spread was $40. C) The underwriter's spread was 8.75%. D) The underwriter's spread was 9.59%. Answer: C Explanation: Spread = $(80 − 73) / 80 = 8.75% Difficulty: 3 Hard Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

72) Blue-sky laws exist in order to: A) protect stock underwriters from fraudulent firms. B) restrict the amount of profit from IPOs. C) control the amount of stock owned by one investor. D) protect investors from deceptive firms. Answer: D Difficulty: 2 Medium Topic: Financial market regulation Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) The Securities and Exchange Commission will not permit securities to be sold: A) if they have been overpriced. B) prior to approval of the registration statement. C) unless the issuer guarantees their value. D) until a shelf registration exists. Answer: B Difficulty: 2 Medium Topic: Financial market regulation Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) Prospective investors are advised of a stock's potential risks by the: A) underwriter. B) underpricing laws. C) prospectus. D) initial public offering. Answer: C Difficulty: 1 Easy Topic: Financial market regulation Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

75) One way to reduce the risk of marketing a stock is for the underwriter to: A) offer a firm commitment on the issue. B) set the initial stock price below its true value. C) sell the securities in foreign countries. D) offer price rebates on the stock purchases. Answer: B Difficulty: 1 Easy Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) The "winner's curse" is a reminder that: A) successful bidders may often overpay for an object. B) underwriters charge excessive fees. C) stocks are much riskier than bonds. D) underpricing an issue is a cost to existing owners. Answer: A Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 77) The direct expense of a stock issue includes the: A) cost of underpricing the stock. B) underwriting spread and other expenses. C) underwriting spread, other expenses, and cost of underpricing. D) underwriting spread. Answer: B Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

78) What direct expense is required to market stock if the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each? A) 6.98% B) 7.19% C) 7.75% D) 8.33% Answer: C Explanation: Direct expense % = {$1m + [($43 − 40) × 3m]} / ($43 × 3m) = 0.0775, or 7.75% Difficulty: 3 Hard Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 79) Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the cost of underpricing? A) $81 million B) $91 million C) $101 million D) $111 million Answer: A Explanation: Cost of underpricing = ($70 − 43) × 3m = $81m Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

80) Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the total cost of issuing the securities? A) $81 million B) $91 million C) $101 million D) $111 million Answer: B Explanation: Total cost = [($70 − 40) × 3m] + $1m = $91m Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 81) Assume an issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. In percentage terms, how much of the day's closing market value was absorbed by the total costs associated with the issue? A) 13.33% B) 23.33% C) 33.33% D) 43.33% Answer: D Explanation: Total cost % = {[($70 − 40) × 3m] + $1m} / ($70 × 3m) = 0.4333, or 43.33% Difficulty: 3 Hard Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

82) Stock that is sold through a rights issue: A) is offered for cash to the general investing public. B) will not affect the market price of the shares. C) is limited to sales to existing shareholders. D) must be sold on a firm commitment basis. Answer: C Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) What is the primary reason for a reduction in share value after a successful rights issue? The new shares: A) have higher underwriting expenses. B) are offered at attractive prices. C) reduce the firm's return on equity. D) do not include voting rights. Answer: B Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

84) A rights issue offers the firm's shareholders one new share of stock at $40 for every three shares of stock they currently own. What should be the stock price after the rights issue if the stock sells for $80 per share before the issue? A) $56.67 B) $60.00 C) $70.00 D) $71.33 Answer: C Explanation: New price = [$40 + ($80 × 3)] / (1 + 3) = $70 Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 85) Shelf registration allows firms to: A) purchase securities for up to 2 years without registration. B) incur only short time delays in selling securities. C) wait for 2 years before paying for securities. D) offer rights issues to the general public. Answer: B Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

86) Which one of the following statements is generally true concerning the costs of issuing securities? A) Underpricing is rarely a significant cost. B) Legal and other administrative costs generally average less than $1 million. C) Debt is cheaper to issue than equity. D) There are no economies of scale in security issuance. Answer: C Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) Some investors believe that the decision by management to issue equity as opposed to issuing debt is a signal that: A) the stock is currently undervalued. B) the stock is currently overvalued. C) the firm will avoid dilution of stock value. D) a shelf registration of securities will occur. Answer: B Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Which one of these types of financing commonly provides investors with only sample products? A) Seasoned offering B) Rights offer C) IPO D) Crowdfunding Answer: D Difficulty: 2 Medium Topic: Raising capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31

89) A private placement avoids which one of the following costs? A) Depression in the stock price B) Administration costs C) Registration with the SEC D) Legal costs Answer: C Difficulty: 2 Medium Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) A private placement of securities involves: A) selling only to the firm's current investors. B) nondisclosure of the issuing firm's name until after the sale. C) the exchange of convertible bonds for equity. D) a nonpublic sale of securities to a limited number of investors. Answer: D Difficulty: 1 Easy Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) Which one of the following methods may be particularly cost-effective to smaller issuers of securities? A) Seasoned offerings B) Private placement C) General cash offer D) Best efforts underwriting Answer: B Difficulty: 1 Easy Topic: Private placements and leveraged buyouts Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

92) When a new issue goes wrong and the stock price immediately crashes once trading commences, the IPO investors may: A) sue the SEC for recommending the issue. B) convert their shares into bonds. C) sue the company executives who are still shareholders. D) sue the underwriters for overhyping the issue. Answer: D Difficulty: 2 Medium Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 93) An investor can earn 20% on underpriced IPOs, but will lose 10% on overpriced IPOs. If he is awarded $2,000 worth of shares in an overpriced IPO, how much of the underpriced issue must he be awarded in order to gain $500 total? A) $1,500 B) $2,500 C) $3,500 D) $10,000 Answer: C Explanation: $500 = (0.20 × value of shares) − (0.10 × $2,000); value of shares = $3,500 Difficulty: 3 Hard Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

94) An IPO was priced to sell at $23 a share and closed at $22 a share at the end of the first day of trading. The underwriting spread was 7% of the offer price and the legal, accounting and administrative costs were $160,000. What was the total percentage cost of the issue as a percentage of the market value at the end of the first day if 250,000 shares were offered? A) 3.89% B) 5.68% C) 4.21% D) 3.64% Answer: B Explanation: Total cost % = ({[$22 − $23 × (1 − 0.07)] × 250,000} + $160,000) / ($22 × 250,000) = 0.0568, or 5.68% Difficulty: 3 Hard Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 95) Which one of the following is not an advantage of shelf registration? A) The issuing firm can avoid competition from underwriters. B) Securities can be issued with short notice. C) Securities can be issued in small amounts without excessive costs. D) The firm can take advantage of market conditions. Answer: A Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

96) Second stage financing: A) involves a substantial increase in leverage. B) immediately follows first-stage financing for every new business. C) may involve issuing additional shares of stock. D) occurs when the company is in danger of bankruptcy. Answer: C Difficulty: 2 Medium Topic: Venture Capital Learning Objective: 15-01 Understand how venture capital works. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Firms go public primarily to: A) raise additional capital. B) diversify public debt holders' risk. C) maintain ownership control. D) increase their financial leverage. Answer: A Difficulty: 1 Easy Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 98) In a firm commitment, the underwriter: A) encounters virtually no risk because the spread is fixed. B) is allowed to sell the shares at any price they choose. C) is protected against being stuck with unsold shares. D) is allowed to sell the shares at a price slightly higher than the price it paid to the company. Answer: D Difficulty: 2 Medium Topic: Underwriting Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

99) Those subject to the winner's curse are: A) underwriters. B) uninformed investors. C) firms issuing IPOs. D) venture capitalists. Answer: B Difficulty: 1 Easy Topic: Initial public offerings Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 100) Plasti-tech Inc. has decided to go public and has sold 2 million of its shares to its underwriter for $20 per share. The underwriter then sold them to the public for $22 each. Plastitech also encountered $0.5 million in administrative fees. Soon after the issue, the stock price rose to $25. Find Plasti-tech Inc.'s total cost of this issue including any underpricing. A) $4.5 million B) $9.5 million C) $10.5 million D) $14.5 million Answer: C Explanation: Total cost = [($25 − 20) × 2m] + $0.5m = $10.5m Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

101) Economists have found that the announcement of a new issue of common stock: A) results in a decline in the stock price. B) causes the stock price to rise. C) has no effect on the stock price. D) increases the market value of the stock but only temporarily. Answer: A Difficulty: 2 Medium Topic: Basics of issuing securities Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 102) Currently, M & S Inc. has 2 million shares outstanding selling at $70 a share. A rights issue will be made that allows 1 share to be purchased for every 5 shares currently held by stockholders for $40 each. Which one of the following is true? A) The number of shares outstanding will fall to 1.6 million. B) The firm will raise $13.33 million. C) The stock price will fall to $65. D) The total value of the firm will equal $124 million. Answer: C Explanation: Number of shares issued: (2 million / 5) = 400,000 Number of shares outstanding: 2 million + 0.4 million = 2.4 million Firm will raise: $40 × 400,000 = $16 million Total value of firm will increase from $140 million to $156 million Stock price will fall to: ($156 million / 2.4 million) = $65 Difficulty: 3 Hard Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

103) An underwriter agrees to purchase the shares directly from the issuing firm for $60 million. The underwriter ends up selling all 3 million shares for $23.50 each. What is the implied underwriting spread? A) The underwriter's spread was 18.14%. B) The underwriter's spread was 14.89% C) The underwriter's spread was 12.35%. D) The underwriter's spread was 10.53% Answer: B Explanation: Spread = $(70.5 − 60) / 70.5 = 14.89% Difficulty: 3 Hard Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 104) What direct expense is required to market stock if the issuer incurs $1 million in other expenses to sell 3 million shares at $30 each to an underwriter and the underwriter sells the shares at $32 each? A) 7.29% B) 7.88% C) 8.65% D) 9.02% Answer: A Explanation: Direct expense % = {$1m + [($32 − 30) × 3m]} / ($32 × 3m) = 0.0729, or 7.29% Difficulty: 3 Hard Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

105) Assume the issuer incurs $2 million in other expenses to sell 4 million shares at $55 each to an underwriter and the underwriter sells the shares at $59 each. By the end of the first day's trading, the issuing company's stock price had risen to $68. What is the cost of underpricing? A) $20 million B) $32 million C) $36 million D) $40 million Answer: C Explanation: Cost of underpricing = ($68 − 59) × 4m = $36m Difficulty: 2 Medium Topic: Costs of issuing securities Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 106) A company offers investors the right to buy one additional share at $15 for every four shares currently held. How much should each share be worth after the rights issue if they previously sold for $20 each? A) $15 B) $18 C) $19 D) $20 Answer: C Explanation: New price = ($15 + (4 × $20)) / (1 + 4) = $19.00 Difficulty: 2 Medium Topic: Rights offerings Learning Objective: 15-04 Describe how companies may make private placements of securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 16 Debt Policy 1) When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. Answer: TRUE Difficulty: 2 Medium Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) When asked about key factors of debt policy, financial managers commonly mention the tax advantage of debt and the importance of maintaining their credit rating. Answer: TRUE Difficulty: 1 Easy Topic: Debt Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3) Loan covenants can ensure that companies will accept all positive-NPV investments and reject negative ones. Answer: FALSE Difficulty: 2 Medium Topic: Indenture provisions Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

4) Debt finance does not affect the operating risk but it does add financial risk. Answer: TRUE Difficulty: 1 Easy Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 5) Debt financing affects neither the business risk nor the financial risk of the firm. Answer: FALSE Difficulty: 1 Easy Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) As long as investors can borrow or lend on their own account on the same terms as the firm, they will not pay extra for firm leverage. Answer: TRUE Difficulty: 2 Medium Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 7) Once you recognize the fact that debt also increases financial risk and causes shareholders to demand a higher return on their investment, debt is no cheaper than equity. Answer: TRUE Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

8) At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate. Answer: TRUE Difficulty: 1 Easy Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 9) Debt financing affects neither the operating risk nor the business risk of the firm. Answer: TRUE Difficulty: 1 Easy Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 10) Financial leverage describes debt financing's amplification of the effects of changes in operating income on the returns to stockholders. Answer: TRUE Difficulty: 1 Easy Topic: Financial and operating leverage Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 11) Financial risk is the risk to shareholders that results from debt financing. Answer: TRUE Difficulty: 1 Easy Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

12) MM's proposition I, or the debt-irrelevance proposition, states that the value of a firm is unaffected by its capital structure. Answer: TRUE Difficulty: 1 Easy Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 13) According to MM, debt restructuring will not change the firm's overall value. Answer: TRUE Difficulty: 1 Easy Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 14) According to MM's proposition II the expected return on equity is equal to the expected return on assets for a levered firm. Answer: FALSE Difficulty: 1 Easy Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) MM's proposition II states that the expected return on assets increases as the debt-equity ratio increases. Answer: FALSE Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 4

16) MM's proposition II states that the required return on equity increases as the firm's debtequity ratio increases. Answer: TRUE Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) The benefit of an interest tax shield is captured by the equity holders. Answer: TRUE Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) The risk of tax shields can be reasonably assumed to be the same as that of the interest payments generating them. Answer: TRUE Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) Even after relaxing the MM assumption of no taxes, restructuring should not affect the value of the firm. Answer: FALSE Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 5

20) Costs of financial distress are costs arising from bankruptcy or distorted business decisions before bankruptcy. Answer: TRUE Difficulty: 1 Easy Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 21) The "trade-off theory" of capital structure suggests that firms have an optimal level of debt. Answer: TRUE Difficulty: 2 Medium Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) At some debt-equity ratio, the costs of financial distress are expected to overcome the value of the extra interest tax shield for a firm. Answer: TRUE Difficulty: 1 Easy Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude. Answer: TRUE Difficulty: 1 Easy Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

24) The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price. Answer: TRUE Difficulty: 2 Medium Topic: Pecking-order theory Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) Management's perceived signals to investors form an important component of pecking-order theory. Answer: TRUE Difficulty: 2 Medium Topic: Pecking-order theory Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) Financial slack means having ready access to cash or debt financing. Answer: TRUE Difficulty: 1 Easy Topic: Pecking-order theory Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 27) When additional borrowing causes the probability of financial distress to increase rapidly, the potential costs of distress begin to take a substantial bite out of firm value. Answer: TRUE Difficulty: 1 Easy Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

28) A necessary assumption in the MM's proposition I, or the debt-irrelevance proposition, is that the company and individual borrowing rates are the same. Answer: TRUE Difficulty: 1 Easy Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 29) A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this will generate $12.50 earnings per share. What will happen to EPS if operating income increases by 33.3% to $2.0 million? A) EPS increases by 25% to $15.63. B) EPS increases by 33.3% to $16.67. C) EPS increases by 40% to $17.50. D) EPS increases by 60% to $20.00. Answer: C Difficulty: 2 Medium Topic: Earnings per share Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 30) A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $2,500,000 of shares and substitutes an equal amount of additional debt? A) EPS decreases by 33.3% to $10.00. B) EPS decreases by 6.7% to $11.67. C) EPS increases by 20% to $15.00. D) EPS increases by 80% to $22.50. Answer: D Difficulty: 3 Hard Topic: Earnings per share Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 8

31) A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $3,750,000 of shares and substitutes an equal amount of debt? A) EPS decreases by 33.3% to $10.00. B) EPS stays at $12.50. C) EPS increases by 140% to $30.00. D) EPS increases by 240% to $42.50. Answer: D Difficulty: 3 Hard Topic: Earnings per share Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32) Which one of these is not an underlying assumption of MM Proposition I? A) Capital markets function well. B) Investors can borrow or lend on the same terms as firms. C) Taxes remain at their current non-zero levels. D) Securities are fairly priced. Answer: C Difficulty: 2 Medium Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

33) Fluctuations in a firm's operating income represent: A) financial leverage. B) the weighted-average cost of capital. C) capital structure. D) business risk. Answer: D Difficulty: 1 Easy Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) An increase in a firm's financial leverage will: A) increase the variability in earnings per share. B) always reduce the operating risk of the firm. C) increase the value of the firm in an MM world. D) increase the WACC. Answer: A Difficulty: 2 Medium Topic: Financial and operating leverage Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35) Financial risk refers to the: A) risk of owning equity securities. B) risk faced by equity holders of firms with debt. C) general business risk of the firm. D) possibility that interest rates will increase. Answer: B Difficulty: 2 Medium Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

36) If MM's proposition II without taxes is true, what is the return to investors who invest $20 in a stock, borrow another $20 to buy a share of stock and pay 6% on the borrowed money if the EPS is $1.50? A) 6.0% B) 9.0% C) 12.0% D) 15.0% Answer: B Explanation: Return = [(1.50 × 2) − (20 × 0.06)] / 20 = 0.09 or 9.0% Difficulty: 3 Hard Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes. A) 54.0% B) 60.0% C) 66.7% D) 75.0% Answer: C Explanation: 0.24 = 0.16 + D / E(0.16 − 0.12); D / E = 2 Debt financing % = 2 / (2 + 1) = 0.667, or 66.7% Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

38) Assume a firm is financed with 30% debt on which it pays interest of 9%. What is the expected return on equity if the expected return on assets is 14%? Ignore taxes. A) 16.14% B) 17.86% C) 14.92% D) 15.50% Answer: A Explanation: E(R)e = 0.14 + [0.30 / (1 − 0.30)](0.14 − 0.09) = 0.1614, or 16.14% Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 39) Assume a firm is financed with 60% debt on which it pays interest of 7%. What is the expected return on equity if the expected return on assets is 12%? Ignore taxes. A) 16.14% B) 20.30% C) 19.50% D) 21.67% Answer: C Explanation: E(R)e = 0.12 + [0.60 / (1 − 0.60)](0.12 − 0.07) = 0.1950, or 19.50% Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

40) According to MM Proposition II, as a firm's debt-equity ratio decreases: A) its financial risk increases. B) its operating risk increases. C) the required rate of return on equity increases. D) the required rate of return on equity decreases. Answer: D Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 41) An implicit cost of adding debt to the capital structure is that it: A) adds interest expense to the operating statement. B) increases the required return on equity. C) reduces the expected return on assets. D) decreases the firm's beta. Answer: B Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) When debt is risky: A) bondholders shift some of the firm risk to equity holders. B) equity holders shift some of the firm risk to bondholders. C) the value of the interest tax shield is at its highest. D) there is more overall risk in the firm. Answer: B Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

43) What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 21% tax bracket? A) $75,600 B) $234,000 C) $260,000 D) $550,000 Answer: A Explanation: Annual interest tax shield = 0.12 × $3m × 0.21 = $75,600 Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 44) A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value of the interest tax shield if the tax rate is 21%? A) $245,000 B) $700,000 C) $2,100,000 D) $10,000,000 Answer: C Explanation: PV tax shield = (0.07 × $10m × 0.21) / 0.07 = $2.1m Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

45) If MM's proposition II without taxes is true and no bankruptcy risk exists, how much debt will a company prefer if their cost of debt is 6%, cost of equity is 10% and the corporate tax rate is 21%? A) 0% B) 21% C) 35% D) 100% Answer: D Difficulty: 3 Hard Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 46) When taxes are considered, the value of a levered firm equals the value of the: A) unlevered firm. B) unlevered firm plus the value of the debt. C) unlevered firm plus the present value of the tax shield. D) unlevered firm plus the value of the debt plus the value of the tax shield. Answer: C Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

47) Assume an unlevered firm changes its capital structure to include $1 million in permanent debt at a 7% interest rate. The tax rate is 21%. According to MM I with taxes, the value of the firm will increase by due to this change in its capital structure. A) $35,000 B) $70,000 C) $210,000 D) $700,000 Answer: C Explanation: PV of interest tax shield = 0.21 × $1m = $210,000 Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 48) In a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the: A) firm uses no debt in its capital structure. B) firm uses the maximum amount of debt in its capital structure. C) firm uses a debt-equity ratio of 1.0. D) corporate tax rate approaches 100%. Answer: B Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

49) Calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on its equity, finances 45% of the market value of its assets with debt, and has a tax rate of 21%. A) 13.46% B) 14.00% C) 14.40% D) 18.20% Answer: A Explanation: WACC = (1 − 0.45)(0.18) + 0.45(0.10)(1 − 0.21) = 0.1346, or 13.46% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 50) What is the after-tax cost of debt for a firm in the 21% tax bracket that pays 15% on its debt? A) 9.25% B) 11.85% C) 12.17% D) 14.25% Answer: B Explanation: After-tax cost of debt = 0.15 × (1 − 0.21) = 0.1185, or 11.85% Difficulty: 2 Medium Topic: Cost of debt Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

51) A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What debt-equity ratio produces a WACC of 12%? A) 0.50 B) 0.75 C) 0.67 D) 0.33 Answer: A Explanation: 0.12 = (0.15)(1 − x) + 0.06x; x = 1 / 3 D/E = (1 / 3) / (1 − 1/3) = 1 / 2, or 0.50 Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 52) Which of the following items will NOT change due to the cost of financial distress? A) Cost of debt B) Cost of equity C) Cost of goods sold D) Cost of legal fees Answer: C Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) If the present value of the interest tax shield on debt equals the present value of the costs of financial distress, then the trade-off theory implies that the: A) firm is using the optimal level of debt. B) firm is paying too high an interest rate. C) firm's market value equals its book value. D) firm should increase its use of debt. Answer: A Difficulty: 2 Medium Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) The present value of the costs of financial distress increases as the debt ratio increases because the: A) expected return on assets increases. B) present value of the interest tax shield is greater. C) equity tax shield is depleted. D) probability of default is greater. Answer: D Difficulty: 1 Easy Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

55) When financial disaster is looming, management may borrow to invest in projects having a negative expected NPV because: A) the firm's beta is now negative. B) taxes are no longer a concern. C) the interest tax shield will cover the loan costs. D) the lender bears most of the risk. Answer: D Difficulty: 2 Medium Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) Firms facing financial distress may pass up positive NPV projects rather than commit new equity because: A) they prefer to finance with debt. B) the benefits are shared with the bondholders. C) no cash is available for dividends. D) there is no interest tax shield associated with equity. Answer: B Difficulty: 2 Medium Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) The trade-off theory of capital structure suggests that firms: A) add leverage whenever interest rates are low. B) with higher risk should use less debt. C) should use 50% debt and 50% equity. D) should use debt to overcome high par values of stock. Answer: B Difficulty: 1 Easy Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20

58) The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that: A) minimizes the financial distress costs. B) maximizes the present value of the interest tax shield. C) equates the present values of the incremental interest tax shield and the incremental financial distress costs. D) maximizes the after-tax cash flows that are internally generated. Answer: C Difficulty: 2 Medium Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 59) Firms are more likely to restrict borrowing if the: A) return on the financed project is too high. B) firm's asset base is largely intangible. C) firm's asset beta is zero. D) increased debt decreases the firm's WACC. Answer: B Difficulty: 2 Medium Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) According to the pecking-order theory, managers will often choose to finance with: A) new equity rather than debt, due to bankruptcy costs. B) debt rather than new equity, to avoid a fall in the share price. C) debt rather than retained earnings, to lower the WACC. D) new equity rather than debt, to strengthen EPS. Answer: B Difficulty: 1 Easy Topic: Pecking-order theory Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

61) A firm's capital structure is represented by its mix of: A) assets. B) liabilities and equity. C) assets and liabilities. D) assets, liabilities, and equity. Answer: B Difficulty: 1 Easy Topic: Capital structure Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 62) Restructuring a firm involves changing the: A) mix of liabilities and equity. B) dividend payout policy. C) managerial personnel. D) types of production equipment utilized. Answer: A Difficulty: 1 Easy Topic: Capital structure Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 63) MM Proposition I without taxes states that: A) firms should be all-equity financed to maximize shareholder value. B) shareholders are unaffected by the debt policy of the firm. C) shareholders are indifferent to a firm's value. D) shareholders prefer to invest in all-equity firms. Answer: B Difficulty: 2 Medium Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

64) What is the return on equity for a firm with a return on assets of 15%, a return on debt of 10%, and a 0.75 debt-equity ratio? A) 18.75% B) 20.00% C) 23.75% D) 26.25% Answer: A Explanation: re = 0.15 + 0.75(0.15 − 0.10) = 0.1875, or 18.75% Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 65) An all-equity firm has 1 million shares outstanding with a market value of $10 million. It does not pay tax and has an operating income of $1.5 million. If $2 million of 10% debt is issued and the proceeds used to repurchase shares of stock, then the firm's EPS: A) increases by 20% to $1.80. B) decreases by 40% to $0.9. C) decreases by 20% to $1.20. D) increases by 8.3% to $1.63. Answer: D Explanation: Initially EPS = $1.5 million / 1 million = $1.5 After restructuring VE = $800,000; number of shares = 800,000; net income = $1.5 million − 0.10 × $2 million = $1.3 million; EPS = $1.3 million / 800,000 = $1.63 Difficulty: 3 Hard Topic: Earnings per share Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

66) A firm currently has operating income of $4 million, interest expense of $2 million, and EPS of $2. How low can operating income drop before EPS are reduced by half, to $1? Ignore taxes. A) $3.5 million B) $3.0 million C) $2.5 million D) $2.0 million Answer: B Difficulty: 3 Hard Topic: Earnings per share Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 67) A firm increases its debt ratio from 50% to 60%. In the absence of taxes, an investor can offset the change in capital structure by: A) selling part of her holding and buying debt. B) borrowing money and investing it in the firm's equity. C) holding a diversified portfolio. D) switching her investment to convertible bonds. Answer: A Difficulty: 1 Easy Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 68) MM proposition I states that a firm's value is unaffected by its: A) required rate of return on equity. B) operating income, in the absence of taxes. C) interest rate paid on debt. D) mixture of debt and equity. Answer: D Difficulty: 1 Easy Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24

69) A firm's business risk depends upon: A) its use of debt in the capital structure. B) the risk of the firm's assets and operations. C) the types of debt financing utilized. D) the costs of financial distress. Answer: B Difficulty: 1 Easy Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) The reason that financial leverage increases shareholder risk is that there is: A) more debt which increases the operating risk. B) less equity to absorb the operating risk. C) less business risk to be spread around. D) more financial risk due to reduced business risk. Answer: B Difficulty: 2 Medium Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 71) According to MM, leverage may increase expected earnings per share but still leave the share price unchanged because: A) the firm's operating risk decreases. B) the number of shares is decreased. C) the required return on equity increases. D) the firm is less risky. Answer: C Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

72) A firm has a WACC of 14%, an expected return on equity of 19%, and a debt-to-asset ratio of 60%. If the firm does not pay tax, what is the interest rate on the debt? A) 6.50% B) 9.90% C) 10.67% D) 11.14% Answer: C Explanation: 0.14 = (1 − 0.60)(0.19) + 0.60(Rd); Rd = 0.1067, or 10.67% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 73) In the absence of taxes, which one of the following would not be expected to change with changes in the firm's capital structure? A) Weighted-average cost of capital B) Expected return on equity C) Expected return on assets D) Expected earnings per share Answer: C Difficulty: 1 Easy Topic: Capital structure Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

74) If a firm's expected return on equity equals its expected return on assets, then the: A) expected return on debt exceeds the expected return on assets. B) likelihood of financial distress is high. C) firm has too much debt. D) firm has no debt in its capital structure. Answer: D Difficulty: 1 Easy Topic: Capital structure Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) MM's proposition II without taxes states that the: A) expected return on equity increases as financial leverage increases. B) expected return on assets decreases as expected return on debt decreases. C) firm's capital structure is irrelevant to the firm's overall value. D) greater the proportion of equity, the higher the expected return on debt. Answer: A Difficulty: 1 Easy Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) As a firm's debt-equity ratio approaches zero, the firm's expected return on equity approaches: A) the expected return on debt. B) the expected return on assets. C) its maximum. D) zero. Answer: B Difficulty: 1 Easy Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

77) With risky debt and MM's Proposition II, the expected return on assets equity ratio . A) increases; increases B) decreases; increases C) increases; decreases D) remains constant; increases

as the debt-

Answer: D Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 78) When a firm pays tax, MM's Proposition I no longer holds, and the capital structure of the firm can be important due to the: A) lower tax rates on dividends than on debt. B) higher tax rates on retained earnings than on debt. C) interest tax shield. D) higher operating income from lower dividends. Answer: C Difficulty: 1 Easy Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 79) The interest tax shield is equal to the: A) difference between the interest expense and income taxes. B) amount of interest paid in a given year. C) product of the interest expense and the tax rate. D) product of the debt principal and the interest rate on debt. Answer: C Difficulty: 1 Easy Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 28

80) Any financial benefit derived from the interest tax shield accrues to the: A) bondholders. B) shareholders. C) bondholders and shareholders equally. D) shareholders and the federal government. Answer: B Difficulty: 1 Easy Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) The present value of a perpetual tax shield increases as the firm's tax rate the amount of the debt _ . A) increases; increases B) increases; decreases C) decreases; decreases D) decreases; increases

and as

Answer: A Difficulty: 1 Easy Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

82) How much debt is outstanding if the present value of a perpetual tax shield is $300,000, the tax rate is 21% and the interest rate on the debt is 10%? A) $300,000 B) $1,428,571 C) $3,000,000 D) $3,750,000 Answer: B Explanation: $300,000 = D × 0.21; D = $1,428,571 Difficulty: 2 Medium Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 83) What is the expected rate of return to equity holders if the firm has a tax rate of 21%, the interest rate on debt is 10%, WACC is 15%, and the debt-asset ratio is 60%? A) 12.50% B) 21.25% C) 22.50% D) 25.65% Answer: D Explanation: 0.15 = (1 − 0.60)Re + 0.60(0.10)(1 − 0.21); Re = 0.2565, or 25.65% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

84) When corporate taxes and the cost of financial distress are taken into consideration, the market value of a firm is equal to the value of the all-equity firm the PV of the tax shield the costs of financial distress. A) plus; plus B) minus; plus C) plus; minus D) minus; minus Answer: C Difficulty: 1 Easy Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 85) According to the trade-off theory, if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs, then the: A) tax shield has been calculated incorrectly. B) firm is too heavily levered. C) firm has reached its optimal debt level. D) firm appears to have a low risk of financial distress. Answer: C Difficulty: 1 Easy Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

86) Which ranking of financing from most preferred to least preferred is predicted by the pecking-order theory? A) Debt issue, stock issue, internally generated funds B) Internally generated funds, debt issue, stock issue C) Stock issue, internally generated funds, debt issue D) Internally generated funds, stock issue, debt issue Answer: B Difficulty: 1 Easy Topic: Pecking-order theory Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) Debt may be the preferred form of external financing for many firms because: A) most firms already have too much equity. B) tax rates on equity are lower. C) debt will not adversely affect the firm's financial ratios. D) equity issuance is considered by investors to be a negative signal. Answer: D Difficulty: 1 Easy Topic: Pecking-order theory Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Which one of the following statements is false according to MM's proposition I? A) Firm value is unaffected by the firm's capital structure. B) Proposition I is also called the debt-irrelevance proposition. C) Shareholders should care about the firm's debt policy. D) After restructuring, the firm's value should be the same as it was prior to restructuring. Answer: C Difficulty: 1 Easy Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

89) Debt usage will have an effect on: A) business risk. B) financial risk. C) operating risk. D) asset risk. Answer: B Difficulty: 1 Easy Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) Leverage will A) increase; decrease B) decrease; increase C) increase; increase D) increase; do nothing to

shareholders' expected return and

their risk.

Answer: C Difficulty: 1 Easy Topic: Business and financial risk Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) Calculate the firm's expected return on its assets if its expected return on debt is 10%, its expected return on equity is 20%, and the company cost of capital is 14%. A) 14% B) 15% C) 16% D) 17% Answer: A Explanation: company cost of capital = expected return on assets = 14% Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33

92) A firm with a debt-equity ratio of 0.5, a return on assets of 14%, and a return on debt of 8%, will have a return on equity of: A) 15.25%. B) 16.00%. C) 17.00%. D) 17.33%. Answer: C Explanation: re = 0.14 + 0.5(0.14 − 0.08) = 0.17, or 17% Difficulty: 2 Medium Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 93) As the debt-equity ratio decreases when debt is not risk free: A) debtholders require a higher expected return. B) debtholders require a lower expected return. C) the expected return on equity increases. D) the expected return on assets increases. Answer: B Difficulty: 1 Easy Topic: M and M Proposition II without taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) One advantage of debt financing over equity financing is the: A) tax-deductible dividends. B) tax-deductible interest. C) tax-deductible principal repayment. D) tax-free interest income. Answer: B Difficulty: 1 Easy Topic: Taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34

95) Those who benefit from the interest tax shield are: A) debtholders. B) equityholders. C) both debtholders and equityholders. D) only the firm's customers. Answer: B Difficulty: 1 Easy Topic: M and M Proposition I with taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 96) When a corporation issues permanent debt, its value: A) increases by the present value of the tax shield. B) decreases by the present value of the tax shield. C) increases by the annual interest tax shield. D) decreases by the annual interest tax shield. Answer: A Difficulty: 1 Easy Topic: M and M Proposition I with taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) When corporate taxes are considered, how does leverage affect the WACC? A) An increase in leverage will be offset by a decrease in equity financing, thus leaving WACC unchanged. B) Changes in leverage will affect the WACC only if the interest rate on debt changes. C) Increased leverage will increase the WACC. D) Increased leverage will decrease the WACC. Answer: D Difficulty: 2 Medium Topic: Weighted-average cost of capital Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

98) According to the trade-off theory, optimal capital structure occurs when: A) additional borrowing results in lower financial distress costs. B) additional borrowing is offset by the interest tax shield. C) the tax savings from additional leverage are offset by the increased costs of distress. D) the present value of the tax shield exceeds the value of the all-equity-financed firm. Answer: C Difficulty: 2 Medium Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 99) The possibility of bankruptcy will do all of the following except: A) increase financial distress costs. B) reduce the current market value of the firm. C) reduce the interest rate on debt. D) reduce the possible payoff to stockholders. Answer: C Difficulty: 1 Easy Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 100) Costs of financial distress are greater when a firm increases its: A) intangible assets as a percentage of total assets. B) tangible assets as a percentage of total assets. C) net working capital. D) retained earnings. Answer: A Difficulty: 1 Easy Topic: Financial distress Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

101) Which one of the following statements is true regarding the trade-off theory? A) Highly profitable firms should have low debt ratios. B) All firms should have the same target debt-equity ratio. C) Riskier firms should have high target debt ratios. D) Less risky firms ought to have a greater amount of debt financing. Answer: D Difficulty: 2 Medium Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 102) According to the trade-off theory, capital structure is a trade-off between: A) tangible and intangible asset risk. B) high and low target debt ratios. C) tax savings and financial distress costs. D) tax shields and equity financing. Answer: C Difficulty: 1 Easy Topic: Capital structure Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 103) The pecking-order theory suggests that less profitable firms borrow more because: A) equity issues are more expensive. B) leverage is preferred over raising funds internally. C) debt issues are good omens. D) they have insufficient internal funds. Answer: D Difficulty: 2 Medium Topic: Pecking-order theory Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

104) Financial slack: A) is associated with high leverage B) allows firms to take advantage of good investment opportunities C) solves any agency costs when managers want to empire-build D) is a term that describes a lazy CFO Answer: B Difficulty: 1 Easy Topic: Pecking-order theory Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 105) Which one of these statements corresponds to MM proposition I without taxes? A) Debt interest has no effect on either equity income or firm value. B) Debt interest reduces equity income and increases firm value. C) Debt interest reduces equity income but does not affect firm value. D) The value of a firm increases as its debt-equity ratio increases. Answer: C Difficulty: 2 Medium Topic: M and M Proposition I without taxes Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 106) Which one of these statements correctly applies to an unlevered firm that pays no taxes? A) The return on equity exceeds the WACC. B) The return on assets equals the return on equity and also equals WACC. C) The return on assets equals the return on equity and exceeds WACC. D) The return on equity equals WACC and exceeds the return on assets. Answer: B Difficulty: 3 Hard Topic: Weighted-average cost of capital Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

107) Which one of these is a disadvantage to tax-paying individual investors? A) Receiving interest income rather than dividends B) Receiving capital gains rather than dividends C) Receiving capital gains rather than interest income D) Receiving dividends rather than interest income Answer: A Difficulty: 2 Medium Topic: Taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 108) An increase in a corporation's tax rate will cause: A) an increase in an unlevered firm's return on assets. B) a decrease in a levered firm's WACC. C) an increase in a levered firm's cost of debt. D) a decrease in an unlevered firm's cost of equity. Answer: B Difficulty: 2 Medium Topic: Taxes Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 109) Which of the following pair of firms do you think should be more highly levered: A retailing firm with prime downtown real estate, or a social media company whose major assets are its unique software and client loyalty? Answer: The retailing firm with readily saleable assets. Difficulty: 2 Medium Topic: Financial and operating leverage Learning Objective: 16-05 Understand why a company should adopt a particular capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

110) Which of the following pair of firms do you think should be more highly levered: A biotech firm which may need a large cash injection if its drug trials are successful, or a company with a well-established market and large cash reserves? Answer: The company with a well-established market and large cash reserves. Difficulty: 2 Medium Topic: Financial and operating leverage Learning Objective: 16-05 Understand why a company should adopt a particular capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 111) Which of the following pair of firms do you think should be more highly levered: A taxpaying company, or a company with large tax loss carry-forwards? Answer: The taxpaying company with income to shield. Difficulty: 2 Medium Topic: Financial and operating leverage Learning Objective: 16-05 Understand why a company should adopt a particular capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 112) Which of the following pair of firms do you think should be more highly levered: A risky company, or a safe company? Answer: The safe company. Difficulty: 2 Medium Topic: Financial and operating leverage Learning Objective: 16-05 Understand why a company should adopt a particular capital structure. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 17 Payout Policy 1) Stocks that are purchased on the record date are not entitled to the dividend. Answer: TRUE Difficulty: 1 Easy Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Anyone holding a stock before its ex-dividend date is entitled to the dividend. Answer: TRUE Difficulty: 1 Easy Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) Companies can pay out cash to their shareholders in two ways. They can pay a dividend or they can buy back some of their outstanding shares. Answer: TRUE Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 4) In recent years more than 40% of U.S. corporations did not pay a dividend nor did they repurchase shares. Answer: TRUE Difficulty: 1 Easy Topic: Payout policy observations Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

5) Over the past 30 years stock repurchases have become an increasingly popular way of paying out cash. Answer: TRUE Difficulty: 1 Easy Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) In a three-for-two stock split, each investor would receive one additional share for each two shares already held. Answer: TRUE Difficulty: 2 Medium Topic: Stock splits Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 7) Many companies offer their shareholders an automatic dividend reinvestment plan. This means that the shareholders automatically receive the dividend on the payment date. Answer: FALSE Difficulty: 2 Medium Topic: Dividend reinvestment plans Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 8) Dividends are paid to all shareholders who are recorded in its books on the payment date. Answer: FALSE Difficulty: 2 Medium Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

9) Dividends are paid to all shareholders who are recorded in its books on the record date. Answer: TRUE Difficulty: 2 Medium Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 10) A two-for-one stock split is like a 200% stock dividend. Answer: TRUE Difficulty: 1 Easy Topic: Stock splits Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 11) Investors often interpret a stock split announcement as a signal of management's confidence in the future. Answer: TRUE Difficulty: 2 Medium Topic: Stock splits Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 12) A stock split will affect the stock's price, while a stock dividend will not. Answer: FALSE Difficulty: 2 Medium Topic: Dividend policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

13) Stock repurchases are more volatile than dividends. Answer: TRUE Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) The share price declines when a stock repurchase occurs. Answer: FALSE Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 15) Dividends are likely to shift up and down as earnings fluctuate so that managers can maintain a stable payout ratio. Answer: FALSE Difficulty: 2 Medium Topic: Dividend policy observations Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 16) Corporate dividends are less volatile than corporate earnings. Answer: TRUE Difficulty: 1 Easy Topic: Dividend policy observations Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

17) MM's dividend irrelevance proposition assumes an efficient market with no taxes or issue costs. Answer: TRUE Difficulty: 1 Easy Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) According to the MM dividend irrelevance proposition, since investors do not need dividends to convert their shares to cash, they will not pay higher prices for firms with higher dividend payouts. Answer: TRUE Difficulty: 1 Easy Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) The most common way that companies buy back their stock is to buy it in the market just like any other investor. Answer: TRUE Difficulty: 1 Easy Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

20) The information content of dividends says that dividend increases send good news about cash flow and earnings, while dividend cuts send bad news. Answer: TRUE Difficulty: 1 Easy Topic: Payout policy considerations Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) The longer an investor waits to take capital gains, the lower is the present value of the tax liability. Answer: TRUE Difficulty: 2 Medium Topic: Tax effects on dividends and payouts Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) Firms can increase their stock price by increasing their dividends to a level that appeals to the clientele group that prefers high-dividend stocks. Answer: FALSE Difficulty: 2 Medium Topic: Dividend policy Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 23) A tender offer includes a variable price at which the shares may be repurchased. Answer: FALSE Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

24) A dividend will be paid to shareholders on Friday, May 9. To receive this dividend you must purchase the stock no later than: A) The payment date. B) The with-dividend date. C) The record date. D) The ex-dividend date. Answer: B Difficulty: 2 Medium Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) You currently own 200 shares of stock valued at $6 per share. If the firm declares a 1-for-4 reverse stock dividend you will own shares valued at per share. A) 800; $6 B) 800; $1.50 C) 50; $6 D) 50; $24 Answer: D Explanation: Number of shares = 200 / 4 = 50; Price = $6 × 4 = $24 Difficulty: 2 Medium Topic: Stock splits Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 26) Which method of share repurchase requires investors to submit bids and the companies takes the lowest ones, in sequence? A) Tender offer B) Auction repurchase C) Direct negotiation D) Open-market repurchase Answer: B Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7

27) A stock goes ex-dividend: A) two business days prior to the record date. B) two business days after the declaration date. C) three business days after the record date. D) three business days prior to the payment date. Answer: A Difficulty: 2 Medium Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) What would you expect to happen to the price of a share of stock on the day it goes exdividend if you ignore taxes? The price should: A) increase by the amount of the dividend. B) decrease by the amount of the dividend. C) decrease by one-half the amount of the dividend. D) remain constant. Answer: B Difficulty: 1 Easy Topic: Cash dividends Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) Which one of these is the most common method of share repurchase? A) Tender offer B) Auction repurchase C) Direct negotiation D) Open-market repurchase Answer: D Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

30) Boards of directors may be legally restricted in their declaration of dividends if: A) cash must be borrowed for the dividend payment. B) dividends have increased substantially over a short period of time. C) the dividend would create a situation of insolvency. D) the stock is selling at a low relative price. Answer: C Difficulty: 2 Medium Topic: Payout policy considerations Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) ABC Corp. stock is selling for $30 per share when a 10% stock dividend is declared. If you own 100 shares of ABC Corp. then you will receive: A) shares valued at $3 each. B) $3 times 100 shares = $300 cash. C) $300 plus 10 shares of ABC Corp. D) 10 shares of ABC Corp. Answer: D Explanation: Shares received = 0.10 × 100 = 10 shares Difficulty: 2 Medium Topic: Stock dividends Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 32) Which statement is correct? A) Stock that has been repurchased must be put in the firm's Treasury and cannot be resold. B) Most repurchases are mandatory. Investors are obliged to sell part of their holding back to the company. C) Corporations are much more willing to cut repurchases than dividends. D) Companies like to smooth repurchases. Answer: C Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

33) Which of the following is not a way to repurchase stock? A) open-market repurchase B) repurchase a block of shares from a major shareholder C) make a rights issue D) tender offer Answer: C Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 34) An investor owns 5,000 shares, which is 1% of a corporation's outstanding stock before a stock repurchase. The investor did not sell any of his stock during the 25,000 share repurchase. Which one of the following statements is correct? A) The investor still owns 1% of the corporation. B) The stock's price is likely to drop by 5%. C) The investor owns more than 1% of the corporation. D) The investor now has 5,250 shares. Answer: C Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

35) Which one of these statements is correct? A) Dividends tend to fluctuate in direct relation to changes in annual earnings. B) Managers are less concerned with the change in the dividend than with the actual amount of the dividend. C) Managers tend to avoid smooth dividends as they don't signal the firm's most recent successes. D) Managers tend to only increase dividends when they believe the increased amount can be sustained. Answer: D Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) Stock repurchases may be interpreted by investors as a signal that: A) future repurchases will be forthcoming. B) the firm's shares are underpriced. C) the firm has an increasing number of positive-NPV opportunities. D) stock repurchases will gradually replace the stock dividends. Answer: B Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) A company recently announced a dividend of $2 per share. The stock is currently priced at $38 per share. All things being equal, what is the likely stock price to be on the date of record? A) $36 B) $38 C) $40 D) $42 Answer: B Difficulty: 1 Easy Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 11

38) A firm has current assets of $1.2 million, fixed assets of $3.6 million, and debt of $2.2 million. There are 250,000 shares of stock outstanding. What will be the book value of equity if the firm repurchases 10% of its outstanding shares for $10.40 a share? A) $2,552,000 B) $2,600,000 C) $2,340,000 D) $2,574,000 Answer: C Explanation: Equity = $1.2m + 3.6m − 2.2m − (0.10 × 250,000 × $10.40) = $2,340,000 Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 39) A policy of dividend "smoothing" refers to: A) maintaining a constant dividend payout ratio. B) keeping the regular dividend at the same level indefinitely. C) maintaining a steady progression of dividend increases over time. D) alternating cash dividends with stock dividends. Answer: C Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) How are investors most apt to interpret a reduction in a firm's regular dividend payment? A) Earnings are expected to decline. B) New investments are expected to increase. C) Stock repurchases are expected to increase. D) Share price is expected to increase. Answer: A Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

41) What is the new share price for a corporation with a current share price of $4 that employs a 2-for-9 reverse split? A) $8 B) $16 C) $36 D) $18 Answer: D Explanation: New price = 9 / 2 × $4 = $18 Difficulty: 2 Medium Topic: Stock splits Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 42) If investors are expecting a dividend cut, then the announcement of the decreased dividend payment will: A) cause the stock price to decline by more than the dividend amount. B) not affect the stock price as long as the announcement was in line with expectations. C) cause the stock price to increase if the cut was greater than anticipated. D) signal that the next dividend will be cut even further. Answer: B Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 43) MM's proposition of dividend irrelevance depends upon: A) firms maintaining a constant dividend payout. B) dividends being taxed the same as capital gains. C) the existence of a dividend clientele. D) the efficiency of capital markets. Answer: D Difficulty: 2 Medium Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13

44) A firm has $250,000 to spend on either a one-time special dividend or on a share repurchase program. If the share repurchase is selected, then the firm's: A) value will decrease just as if the dividend option had been selected. B) balance sheet will be unaffected and the share price will remain constant. C) equity balance will be reduced by less than it would have been under the dividend option. D) shareholders will receive less value than under the dividend option. Answer: A Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) Based on the dividend growth model, a lower current payout will not affect the stock price, provided that the: A) required return on the stock is proportionately increased. B) growth rate in dividends remains constant. C) reduction is offset by an increase in the growth rate. D) growth rate is decreased by the percent decrease in the dividend. Answer: C Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 46) Why are dividend changes rather than the absolute level of dividends perceived to be more important to managers and shareholders? A) Managers change dividends only under threatening conditions. B) Dividend changes are thought to signal future expectations. C) MM's argument states that the absolute level of dividends is irrelevant. D) Dividend changes determine whether borrowing must occur. Answer: B Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14

47) Which one of the following signals is most likely to elicit a decrease in share price? A) A repurchase of 5% of the firm's stock B) An increase in the regular quarterly dividend C) A decrease in the regular quarterly dividend D) Borrowing funds in order to pay a cash dividend Answer: C Difficulty: 1 Easy Topic: Dividends and payout policy Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) If a firm does not have adequate profits or cash to pay an expected dividend, what concept is most likely to cause a firm to consider borrowing money to ensure payment of the dividend? A) Clientele effect B) Expectations theory C) Residual dividend theory D) Signaling hypothesis Answer: A Difficulty: 2 Medium Topic: Dividend policy Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 49) An increase in share price following an increase in dividends is logical if the: A) firm borrows to obtain cash for the dividend. B) increased dividend signals higher future earnings. C) dividend is believed to be temporary. D) clientele effect is not important. Answer: B Difficulty: 1 Easy Topic: Dividends and payout policy Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

50) Which one of these parties is most likely to prefer a stock with a high-dividend payout policy? A) Financial institutions B) Retired individuals C) Growth-seeking investors D) Endowment funds Answer: B Difficulty: 1 Easy Topic: Dividends and payout policy Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) An investor buys a stock today for $26, receives a dividend of $2 at the end of the year and then sells the stock for $30. If the dividend is taxed at 37% and the capital gain at 20%, what is his return after tax? A) 23.08% B) 17.15% C) 9.23% D) 31.15% Answer: B Explanation: ($2 + ($30 − $26) − (0.37 × $2) − (0.2 × $4)) / $26 = 0.1715 or 17.15% Difficulty: 3 Hard Topic: Tax effects on dividends and payouts Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

52) What is the difference in the one-year after-tax returns on the following two stocks, assuming a 37% tax rate on dividends and a 20% tax rate on capital gains? Stock A is purchased for $50, pays a $2.5 dividend at the end of the year, and is then sold for $56; stock B is purchased for $60, pays no dividend, but is sold after one year for $70. A) Stock A's after-tax return is higher by 1.27%. B) Stock B's after-tax return is higher by 0.58%. C) Stock A's after-tax return is higher by 0.27%. D) Stock B's after-tax return is higher by 0.73%. Answer: B Explanation: RA = [($2.5 + $56 − $50) − (0.37 × $2.5) − (0.2 × $6)] / $50 = 0.1275, or 12.75% RB = [($70 − 60) − (0.2 × $10) / $60] = 0.1333, or 13.33% Difference = 13.33% − 12.75 = 0.58% Difficulty: 2 Medium Topic: Tax effects on dividends and payouts Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 53) A company is more likely to repurchase stock rather than pay out dividends when the firm: A) wants to distribute excess cash by making a regular commitment to its investors. B) wants to conserve current cash. C) wants to avoid a commitment for future distributions. D) foresees excess cash as a common long-term occurrence. Answer: C Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

54) Capital gains may be preferred by investors over dividends even if dividends and capital gains are taxed at the same rate because: A) taxes on dividends are withheld immediately. B) taxes on capital gains are paid annually. C) taxes on capital gains can be deferred. D) after-tax dividends are less certain than capital gains. Answer: C Difficulty: 1 Easy Topic: Tax effects on dividends and payouts Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) Compare the after-tax returns for a corporation that invests in preferred stock with a 12% dividend yield versus a common stock with no dividend but a 16% capital gain. The corporation's tax rate is 21%. The: A) common stock returns 2.60% less than the preferred. B) preferred stock returns 1.90% less than the common. C) common stock returns 2.32% less than the preferred. D) returns are equal on an after-tax basis. Answer: B Explanation: After-tax returns: RP = 0.12 − (0.12 × 0.50 × 0.21) = 0.1074, or 10.74% RC = 0.16(1 − 0.21) = 0.1264, or 12.64% Difference = 10.74% − 12.64% = −1.90% Difficulty: 2 Medium Topic: Tax effects on dividends and payouts Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

56) Why may a large increase in earnings not translate into a large increase in dividends? A) The earnings will be taxed. B) Some investors may prefer capital gains. C) Managers wish to assess the earning's persistence. D) The earnings may already be a part of retained earnings. Answer: C Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) You purchased a stock today. What should you expect if the stock goes ex-dividend tomorrow? A) A dividend will be declared tomorrow. B) A dividend will be paid tomorrow. C) The stock price should decline tomorrow. D) The stock price has already adjusted for the next dividend payment. Answer: C Difficulty: 2 Medium Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) With respect to the dividend-payment process, the price of a share of stock can logically be expected to drop on: A) the payment date. B) the date of record. C) the ex-dividend date. D) the declaration date. Answer: C Difficulty: 1 Easy Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) Automatic dividend reinvestment plans allow firms to: A) pay dividends on a more frequent schedule. B) reduce their cash outflow to shareholders. C) transform regular dividends into stock dividends. D) avoid the ex-dividend date reduction in stock price. Answer: B Difficulty: 2 Medium Topic: Dividend reinvestment plans Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) Evenglade Corp has 1,000 shares outstanding priced at $10 a share. The company is unsure whether to pay out $1 a share as a dividend or to use the money to repurchase stock. If it pays a dividend, what happens to the stock price? If it repurchases, how many shares will remain and at what price? A) After the dividend payment stock price falls to $9. If Evenglade repurchases, 900 shares remain and the share price falls to $9. B) After the dividend payment stock price falls to $9. If Evenglade repurchases, 800 shares remain and the share price stays at $10. C) After the dividend payment stock price falls to $9. If Evenglade repurchases, 900 shares remain and the share price stays at $10. D) After the dividend payment stock price stays at $10. If Evenglade repurchases, 900 shares remain and the share price rises to $11.11. Answer: C Difficulty: 2 Medium Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

61) Firm X will pay a dividend of $10 next year and its stock is expected to sell at $100 after the payment. Firm Y pays no dividend but its stock is expected to sell at $110. Dividends are taxed at 37% and capital gains are untaxed. If both stocks offer an after-tax return of 8%, what is the price of the two stocks? A) Price of X = $101.85; price of Y = $101.85 B) Price of X = $98.43; price of Y = $101.85 C) Price of X = $100; price of Y = $101.85 D) Price of X = $98.43; price of Y = $100 Answer: B Explanation: Price X = ($100 + (1 − 0.37) × $10) / 1.08 = $98.437; Price of Y = $110 / 1.08 = $101.85 Difficulty: 2 Medium Topic: Tax effects on dividends and payouts Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 62) What effect does a stock dividend have on the book and market values of the firm? A) Both the book and market values increase B) Book value increases; market value decreases C) Book value decreases; market value increases D) Both the book and market values remain constant Answer: D Difficulty: 2 Medium Topic: Stock dividends Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) An investor owns 300 shares of stock currently selling for $70 per share. After a 3-for-2 stock split, the investor will have: A) 200 shares selling for $93.10 each. B) 200 shares selling for $105.00 each. C) 450 shares selling for $46.67 each. D) 450 shares selling for $93.10 each. Answer: C Explanation: New shares = 300 × 3 / 2 = 450 shares New price = $70 × 2 / 3 = $46.67 Difficulty: 2 Medium Topic: Stock splits Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 64) When a corporation engages in a 10% stock repurchase, it: A) offers shareholders 110 shares for every 100 they currently own. B) purchases for cash 10% of the outstanding shares. C) sells treasury stock at a 10% discount to investors. D) issues 10% more stock but holds the shares as treasury shares. Answer: B Difficulty: 1 Easy Topic: Stock repurchases Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

65) A share repurchase is said to be equivalent to the payment of a cash dividend because each strategy: A) causes share price to decline. B) causes share price to remain constant. C) creates the same tax liability for the investor. D) reduces the assets of the firm by the same amount. Answer: D Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) Assuming no market imperfections, which one of the following will not be affected by a repurchase of shares? A) Assets of the firm B) Equity of the firm C) Shares outstanding D) Price per share Answer: D Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) Assuming no market imperfections, which one of the following would not be expected to have an effect on share price? A) Dividend declaration and payment B) Stock repurchase C) Stock dividend D) Stock split Answer: B Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

68) Which one of the following is correct for a firm with $400,000 in net earnings, 50,000 shares, and a 30% payout ratio? A) Retained earnings will increase by $120,000. B) Each share will receive a $1.20 dividend. C) $120,000 will be spent on new investments. D) The dividend per share will be $2.40. Answer: D Explanation: DPS = (0.30 × $400,000) / 50,000 = $2.40 Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 69) A firm is said to be "smoothing" dividends if dividends: A) are paid through an automatic dividend reinvestment plan. B) change more gradually than changes in earnings. C) increase by the same dollar amount each year. D) are paid only in even dollar amounts. Answer: B Difficulty: 1 Easy Topic: Dividends and payout policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) Managers have been characterized as reluctant to increase dividends if: A) dividends were increased in the preceding year. B) earnings have permanently increased. C) the dividend increase cannot be sustained. D) the dividend payout ratio exceeds 20%. Answer: C Difficulty: 1 Easy Topic: Dividends and payout policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

71) Dividend changes are typically viewed by investors as signals of future changes in: A) investment. B) the firm's WACC. C) earnings. D) the clientele effect. Answer: C Difficulty: 1 Easy Topic: Dividends and payout policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 72) An unlevered firm expects to generate and payout free cash flows of $120,000 annually in the form of dividends and share repurchases starting next year. The discount rate is 13% and there are 125,000 shares outstanding. What is the current value per share? A) $7.38 B) $0.96 C) $1.08 D) $6.87 Answer: A Explanation: Share price = ($120,000 / 0.13) / 125,000 = $7.38 Difficulty: 2 Medium Topic: Zero-growth stock Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

73) B Corp has announced four dates (payment date, ex-dividend date, announcement date and record date) associated with its forthcoming dividend. The dates are August 1, October 1, August 30 and August 28. Which one of these dates is the record date and which is the ex-dividend date? A) Record date = October 1, ex-dividend date = August 30. B) Record date = August 28, ex-dividend date = August 30. C) Record date = August 1, ex-dividend date = August 28. D) Record date = August 30, ex-dividend date = August 28. Answer: D Difficulty: 2 Medium Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) MM's proposition concerning dividends contends that shareholders will: A) offer higher prices for higher dividend payouts. B) not offer higher prices for higher dividend payouts. C) offer higher prices for lower dividend payouts. D) purchase only stocks that have high dividend payouts. Answer: B Difficulty: 1 Easy Topic: Payout policy observations Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) MM's assertion that dividend policy will not affect the value of the firm requires that dividend policy does not: A) alter the retained earnings of the firm. B) affect investment and borrowing policies. C) allow the payout ratio to change. D) alter the number of outstanding shares. Answer: B Difficulty: 2 Medium Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26

76) The manager of XYZ Corp. feels that a dividend increase will increase the stock price because many investors value stock with a dividend-discount model. Why might MM disagree with this assertion? A) The increased dividend makes the firm much riskier. B) If investment policy is to remain unchanged, the company will need to replace the cash with a stock issue. C) Investors prefer capital gains over dividends. D) Dividend increases will increase the book value but not the market value of the firm. Answer: B Difficulty: 2 Medium Topic: Dividend policy Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 77) Market imperfections may make the choice between dividends and repurchases relevant. Which of the following is not one of these imperfections? A) Institutional restrictions on stock holdings B) Differences in dividend-payout ratios C) Taxes on dividends and capital gains D) Differences among investors in marginal tax rates Answer: B Difficulty: 1 Easy Topic: Dividend policy Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

78) A stock is currently priced at $65 per share and will pay a $4 dividend in one year. What must the stock sell for in one year to meet investors' expectations of a 15% after-tax return if dividends are taxed at 37% and there are no capital gains taxes? A) $70.75 B) $72.23 C) $73.63 D) $76.00 Answer: B Explanation: 0.15 = ($4 / $65)(1 − 0.37) + (P1 − $65) / $65; P1 = $72.23 Difficulty: 3 Hard Topic: Tax effects on dividends and payouts Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 79) Corporations may have a legitimate preference for dividends over capital gains because: A) capital gains have a 70% tax rate. B) dividends received by corporations are not taxable. C) 40% of dividends received by corporations are exempt from taxation. D) 50% of dividends received by corporations are exempt from taxation. Answer: D Difficulty: 1 Easy Topic: Tax effects on dividends and payouts Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

80) Stock A has a dividend yield of 8% but no capital gain. Stock B offers a capital gain but no dividend. If a corporate investor in the 21% tax bracket earns the same after-tax return from the two stocks, what capital gain does B offer? A) 6.00% B) 8.29% C) 9.06% D) 11.31% Answer: C Explanation: RA = 0.08 − (0.08 × 0.50 × 0.21) = 0.0716, or 7.16% RB = 0.0716 / (1 − 0.21) = 0.0906, or 9.06% Difficulty: 3 Hard Topic: Tax effects on dividends and payouts Learning Objective: 17-04 Show how market imperfections, especially the different tax treatments of dividends and capital gains, can affect payout policy. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 81) The date on which actual dividend checks are mailed to shareholders is the: A) declaration date. B) payment date. C) ex-dividend date. D) record date. Answer: B Difficulty: 1 Easy Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

82) An investor who owns stock on the company's declared. A) ex-dividend B) record C) payment D) declaration

date will receive the dividends

Answer: B Difficulty: 1 Easy Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 83) Which one of the following is the order in which key dividend dates occur? A) Declaration, record, ex-dividend, payment B) Declaration, ex-dividend, record, payment C) Record, declaration, payment, ex-dividend D) Ex-dividend, record, declaration, payment Answer: B Difficulty: 1 Easy Topic: Chronology of dividend payments Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 84) A corporation that has an automatic reinvestment plan: A) forces shareholders to automatically reinvest dividends in the company. B) never physically pays out declared dividends. C) gives shareholders the option of purchasing either debt or equity shares. D) gives shareholders the option to re-invest the dividend in additional shares. Answer: D Difficulty: 1 Easy Topic: Dividend reinvestment plans Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) The primary purpose of laws prohibiting a firm from paying dividends that include its legal capital is to: A) reduce investors' tax liability. B) ensure that the balance sheet balances. C) prevent managers from paying out a substantial proportion of the firm's assets. D) prevent managers from paying large dividends. Answer: C Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) Kappa Corp has just raised its dividend from $2.50 to $5 per share. (It plans to reduce its repurchases by a similar amount.) Caterina Chekov, who owns 100 shares of Kappa does not need the extra cash. What can she do to offset the change in dividend policy? A) reinvest the extra dividend in Kappa stock. B) sell $250 of Kappa stock each year. C) borrow $250 and invest it in Kappa stock. D) Nothing. She should sell out and invest elsewhere. Answer: A Difficulty: 1 Easy Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

87) Kappa Corp and Lambda Corp are identical except that Kappa pays a dividend of $5 per share, while Lambda pays no dividend and uses the cash to repurchase stock. Peter Berngarten owns 100 shares of Kappa. How could he raise the same amount of spending money if instead he owned 100 shares of Lambda? A) He could sell $500 worth of shares of Lambda each year. B) He couldn't; he could not be sure of the price at which he could sell Lambda stock. C) He could sell 5 shares of Lambda each year. D) He could borrow against his holding of Lambda stock. Answer: A Difficulty: 1 Easy Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Zeta Corp has 1,000 shares outstanding. Its stock is priced at $100 a share and shareholders expect Zeta to pay dividends of $10 a year in perpetuity. Now the president suddenly announces that it will keep the total payout the same but will pay only a quarter of the total amount as dividends and use the remaining cash to buy back stock. What will happen to the share price now and how much will the share price grow each year? A) The value of the shares will be unchanged by the announcement and will not grow.0%. B) The share price will be unchanged by the announcement. Subsequently the share price will grow by 7.5% each year. C) The share price will halve and then grow by 7.5% a year. D) The share price will be unchanged by the announcement and will decline by 10% a year. Answer: B Explanation: The share price will be unchanged. Repurchases will cause the number of shares and dividend per share to rise by 7.5% a year. PV = $2.5 / (0.10 − 0.075) = $100. Difficulty: 2 Medium Topic: Dividend policy irrelevance Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

89) Which one of the following statements regarding stock dividends and stock splits is true? A) A two-for-one stock split is equivalent to a 50% stock dividend. B) A three-for-one stock split is equivalent to a 66% stock dividend. C) A three-for-two stock split is equivalent to a 100% stock dividend. D) A three-for-two stock split is equivalent to a 50% stock dividend. Answer: D Difficulty: 2 Medium Topic: Stock splits Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) Stock repurchases: A) decrease the number of authorized shares. B) affect every shareholder. C) are optional to the shareholders. D) always increase shareholder value. Answer: C Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) Research has shown all of the following to be true of the way corporations determine dividends except: A) Firms have short-run target payout ratios. B) Firms have long-run target payout ratios. C) The focus is more on dividend changes rather than absolute dividends. D) Managers try to avoid dividend changes that may need to be reversed. Answer: A Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

92) Which of the following statements is false? A) Most mature companies pay dividends. B) Many companies pay dividends and repurchase stock. C) Repurchases fluctuate more than dividends. D) Stock repurchases have become less common over the past 30 years. Answer: D Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 93) Given a set investment policy and capital structure, then payout policy is a trade-off between and . A) retained earnings; borrowing B) capital budgeting; cash dividends C) cash dividends; stock issues and repurchases D) stock splits; stock dividends Answer: C Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) Which statement is correct? A) the dividend discount model is no longer applicable when there are stock repurchases. B) when valuing free cash flow per share it is important to include both dividends per share and the cash received from repurchases. C) shareholders like dividends because it is the only way that they can get their hands on cash. D) if capital investment and capital structure are held constant, smaller dividends mean larger repurchases. Answer: D Difficulty: 2 Medium Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34

95) With respect to the proposition that dividend policy does not matter, in order to raise an additional $5,600 in cash by issuing stock, the stock sold must be worth: A) more than $5,600. B) $2,800. C) $5,600. D) less than $5,600. Answer: C Difficulty: 1 Easy Topic: Dividend policy irrelevance Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 96) The Beta Corporation has 1,000 shares outstanding and a market value of $90,000. What will be the market value per share after the firm distributes a $5 per share dividend? Ignore taxes and market imperfections. A) $90 B) $85 C) $80 D) $87.50 Answer: B Explanation: New share price = ($90,000 / 1,000) − $5 = $85 Difficulty: 1 Easy Topic: Cash dividends Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

97) Q Corp has decided to pay out an extra $1 million to shareholder, while keeping investment policy and capital structure constant. Which statement is false? A) Q Corp must issue $1 million of stock to replace the lost cash. B) the new shareholders will demand to receive shares worth $1 million. C) the old shareholders will have reduced their stake in the firm by $1 million. D) the reduced stake that old shareholders have in the firm will more than offset the benefit of the higher dividend. Answer: D Difficulty: 2 Medium Topic: Dividend policy irrelevance Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 98) A dividend increase may be used as A) an indicator; high capital gains B) an indicator; tax liability C) a signal; poor prospects D) a signal; good prospects

_ of a firm's

Answer: D Difficulty: 2 Medium Topic: Dividends and payout policy Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 99) Which party receives the greatest tax benefit from receiving dividends rather than capital gains? A) Individual investors B) Corporations C) Financial institutions D) Foundations Answer: B Difficulty: 1 Easy Topic: Tax effects on dividends and payouts Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 36

100) Which of the following statements is correct? A) Investors rightly prefer repurchases because the reduced number of shares increases earnings per share. B) Companies with large repurchase programs usually finance them by a cut in dividends. C) Companies pay out as dividends whatever is left over after making needed capital investments. D) A stock repurchase does not increase stock price but it does avoid the fall in price that would occur on the ex-dividend date. Answer: D Difficulty: 2 Medium Topic: Stock repurchases Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 101) In MM's analysis, which one of these is not fixed? A) Debt payments B) Investment policy C) Capital structure D) Payout decisions Answer: D Difficulty: 1 Easy Topic: Dividends and payout policy Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 102) Three of the following considerations may suggest that the firm should start paying out cash to its shareholders. Which one is not a relevant consideration? A) Is the company generating positive free cash flow? B) The company is earning a high profit margin? C) Does the company have sufficient cash for emergencies and unexpected investment opportunities? D) Is the debt ratio prudent? Answer: B Difficulty: 2 Medium Topic: Payout policy considerations Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37

103) Which one of these firms would you most expect to have the highest payout percentage? A) New technology firm B) Mature firm in a declining industry C) Mature firm with limited growth opportunities D) Rapidly expanding firm in a growth industry Answer: C Difficulty: 2 Medium Topic: Payout policy considerations Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 104) Under which conditions are shareholders most likely to be concerned about agency conflicts? A) Growth firm with financing needs that use most of the firm's available cash flows B) Young firm with negative free cash flows C) Large free cash flows generated by a mature firm D) Mature firm with a low retention ratio and frequent stock repurchases Answer: C Difficulty: 2 Medium Topic: Agency costs and problems Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 18 Long-Term Financial Planning 1) A planning horizon refers to the amount of time necessary to develop the financial plan. Answer: FALSE Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) A common, long-term corporate financial planning horizon would stretch for at least 15 to 20 years. Answer: FALSE Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) Financial plans will rarely succeed unless the forecasts are perfect. Answer: FALSE Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 4) Financial planning focuses on the big picture. Answer: TRUE Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

5) Financial planning may incorporate scenario analysis as part of the planning process. Answer: TRUE Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) The primary aim of financial planning is to obtain better forecasts of future cash flows and earnings. Answer: FALSE Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) Financial planning is concerned with possible surprises as well as the most likely outcomes. Answer: TRUE Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8) Financial planning should attempt to minimize risk. Answer: FALSE Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

9) Financial planning is necessary because financing and investment decisions interact and should not be made independently. Answer: TRUE Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 10) A typical horizon for long-term planning is 5 years. Answer: TRUE Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 11) Individual capital investment projects are not considered in a financial plan unless they are very large. Answer: TRUE Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12) Financial planning requires careful and consistent forecasting. Answer: TRUE Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

13) Financial planning models must include as much detail as possible. Answer: FALSE Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 14) The sustainable growth rate is the rate at which the firm can grow without changing its leverage ratio. Answer: TRUE Difficulty: 1 Easy Topic: Internal and sustainable growth rates Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Financial planning just means formulating the company's response to the most likely events. Answer: FALSE Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16) Adaptability is not a desirable feature in financial plans. Answer: FALSE Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

17) Pro formas are projected or forecasted financial statements. Answer: TRUE Difficulty: 1 Easy Topic: Pro forma statements Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 18) Percentage of sales models are planning models in which the sales forecasts are the driving variables and most other variables are proportional to sales. Answer: TRUE Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 19) The balancing items in a financial planning model are variables that adjust to maintain the consistency of the model. They are also known as plugs. Answer: TRUE Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 20) Debt can be used as a plug item in financial planning. Answer: TRUE Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

21) Financial models identify the best financing plan. Answer: FALSE Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) The decision to acquire fixed assets is unrelated to the current level of excess capacity. Answer: FALSE Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 23) Financial planning models routinely adjust for present value and risk. Answer: FALSE Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 24) If factories are operating below full capacity, sales can increase without investment in fixed assets. However, beyond some sales level, new capacity must be added and additional investment in fixed assets must be made. Answer: TRUE Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

25) A financial planning model will generally include all of the following except the: A) listing of the firm's goals. B) required increase in fixed assets. C) projected sales. D) forecast increase in retained earnings. Answer: A Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) Planners often recommend entering a market for "strategic" reasons because the: A) company is facing too much competition in its original market. B) company may have valuable follow-on investments in the new market. C) immediate investment has a positive net present value. D) manager has a personal interest in a particular market. Answer: B Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) Which one of the following is not typically included among the three major components of a financial planning model? A) Inputs: current financial statements, forecasts of key variables B) Planning model: equations specifying key relationships C) Outputs: pro formas, financial ratios, sources and uses of cash D) Shareholders' risk preferences Answer: D Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

28) Which one of the following is not a reason for compiling financial plans? A) Considering options B) Contingency planning C) Calculating the optimal plan D) Forcing consistency Answer: C Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 29) Calculate the rate at which a firm can grow without changing its leverage if its payout ratio is 70%, equity outstanding at the beginning of the year is $940,000, and its net income for the year is $162,000. A) 5.17% B) 11.67% C) 14.00% D) 16.67% Answer: A Explanation: Sustainable growth rate = (1 − 0.70) × ($162,000 / $940,000) = 0.0517, or 5.17% Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 30) The firm's current financial statements would be included in: A) the inputs of a financial plan. B) the planning model for the financial plan. C) the outputs of the financial plan. D) no part of the financial plan. Answer: A Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

31) The implications of the forecasts from a financial plan are determined by the: A) plan inputs. B) balancing item. C) planning model. D) plowback ratio. Answer: C Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 32) Pro formas refer to: A) plans developed by a certified financial planner. B) the inputs in the financial planning process. C) projected financial statements. D) deviations in results from previous financial plans. Answer: C Difficulty: 1 Easy Topic: Pro forma statements Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 33) Outputs from a financial plan would include such items as: A) sales growth forecasts. B) a percentage of sales planning model. C) a pro forma statement of sources and uses of cash. D) the firm's current financial statements. Answer: C Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

34) When most of the elements of a financial plan are related to sales levels, the plan is: A) less likely to be effective. B) using sales as a plug figure. C) a percentage of sales model. D) not adjusted for inflation. Answer: C Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35) A planner's percentage of sales model forecasts that sales will grow by 20% next year. If costs of goods sold are proportionate at 70% of sales, then costs of goods sold will: A) grow to 90% of sales. B) grow in dollars by 70%. C) not change in dollar amount. D) increase by 20% in dollar terms. Answer: D Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 36) When a firm has no spare capacity, it: A) has no need for new employees. B) currently has no inventory available for sale. C) must issue new equity to grow. D) must usually increase fixed assets to increase sales. Answer: D Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

37) If the pro forma balance sheet shows that total assets must increase by $400,000 while retaining a debt-equity ratio of 0.75 then: A) debt must increase by $300,000. B) equity must increase by the full $400,000. C) debt must increase by $171,429. D) equity must increase by $100,000. Answer: C Explanation: Increase in debt = $400,000 × 0.75 / (0.75 + 1) = $171,429 Difficulty: 3 Hard Topic: External financing need Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 38) If sales growth for XYZ Corporation exceeds 6%, XYZ will need to seek external financing. This means that 6% is the: A) external growth rate. B) internal growth rate. C) optimal growth rate. D) sustainable growth rate. Answer: B Difficulty: 1 Easy Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) If a firm's dividend payout ratio is determined after achieving a specific capital structure, then: A) dividends are an input to the financial plan. B) the capital budget should be revised. C) dividends are being used as a plug item. D) dividend forecasts become crucial to planning. Answer: C Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11

40) A firm has $4 million in total assets and $2.2 million in equity. How much of its $500,000 capital budget should be debt-financed to retain the same debt-equity ratio? A) $50,000 B) $225,000 C) $275,000 D) $450,000 Answer: B Explanation: New debt = $500,000 × ($4m − 2.2m) / $4m = $225,000 Difficulty: 2 Medium Topic: External financing need Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 41) If a firm uses external financing as a plug item, has a new capital budget of $2 million, a net income of $3 million, and a plowback ratio of 40%, how much should be raised in external funds? A) $200,000 B) $600,000 C) $800,000 D) $1,200,000 Answer: C Explanation: EFN = $2m − ($3m × 0.40) = $800,000 Difficulty: 2 Medium Topic: External financing need Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 42) A potential downside to using dividends as the plug item is that: A) changes in dividends may send shareholders mixed signals. B) the plan may suggest negative dividends. C) the firm may have to borrow cash to pay dividends. D) shareholders may receive an excessive return. Answer: A Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12

43) A firm that wants to increase its sustainable growth rate can do so by _ ratio or by the , or both. A) increasing; payout; increasing; ROE B) increasing; plowback; increasing; ROE C) decreasing; plowback; increasing; ROE D) decreasing; payout; decreasing; ROE

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Answer: B Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 44) Alternative "what if?" scenarios can be easily accommodated in financial planning by use of: A) sustainable growth models. B) planning outputs. C) spreadsheet programs. D) bond covenants. Answer: C Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 45) A firm currently has sales of $382,000 and net working capital of $45,840. Assume net working capital changes in direct proportion to sales. What will be the increase in net working capital if sales increase by 8%? A) $1,222 B) $2,809 C) $3,091 D) $3,667 Answer: D Explanation: ΔNWC = 0.08 × $45,840 = $3,667 Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

46) The observation that additions to fixed assets are lumpier than additions to current assets indicates that: A) fixed assets depreciate over time. B) fixed assets can be acquired only through external funding. C) current assets can be acquired in smaller increments. D) dollar for dollar, fixed assets are more expensive than current assets. Answer: C Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 47) A firm can achieve a higher growth rate without raising external capital if it: A) has a high dividend payout ratio. B) has a low ROE. C) has a low debt-to-asset ratio. D) has a low profit margin. Answer: C Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) Other things equal, a firm can grow more rapidly without raising new capital if: A) it has a low ROE. B) it has a high ratio of debt to assets. C) it has a low profit margin. D) it pays out a small proportion of earnings. Answer: D Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

49) If a firm with an asset base of $3 million recently added $150,000 to retained earnings after a dividend payment of $100,000, then its internal growth rate is: A) 1.67%. B) 3.33%. C) 5.00%. D) 8.33%. Answer: C Explanation: IG = $150,000 / $3 million = 0.05, or 5% Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 50) What is the maximum internal growth rate for a firm reporting net income of $500,000, a dividend payout ratio of 40%, and total assets of $10 million? A) 2% B) 3% C) 5% D) 6% Answer: B Explanation: IG = (1 − 0.40)($500,000 / $10m) = 0.03, or 3% Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

51) A firm plans to grow at 6% a year without increasing financial leverage. It expects to earn a 10% return on equity. What proportion of earnings should it plan to pay out? A) 0.40 B) 0.60 C) 0.67 D) 0.00 Answer: A Explanation: SG = 0.06 = 0.10 × (1 − payout ratio) Difficulty: 3 Hard Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 52) A firm has an ROE of 15% and a debt-equity ratio of 40%. If it wishes to grow by 9% a year without external financing, what is the maximum proportion of earnings that it can pay out? A) 1% B) 10% C) 12% D) 16% Answer: D Explanation: IG = 0.09 = (1 − Payout) × 0.15 × 1 / (1 + 0.40); Payout = 0.16, or 16% Difficulty: 3 Hard Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 53) Which one of the following will reduce the internal growth rate, other things equal? A) A higher plowback ratio B) A higher debt-to-asset ratio C) A higher return on equity D) A higher return on assets Answer: B Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

54) What is the sustainable growth rate for a firm with net income of $2.5 million, cash dividends of $1.5 million, and return on equity of 18%? A) 3.0% B) 5.4% C) 7.2% D) 10.8% Answer: C Explanation: SG = [($2.5m − 1.5) / $2.5] × 0.18 = 0.072, or 7.2% Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 55) The sustainable rate of growth assumes that the: A) debt-equity ratio is held constant. B) market to book ratio increases. C) dividend payout ratio decreases. D) external debt remains constant. Answer: A Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) A firm has a policy of not issuing debt and paying out 40% of its earnings. Its asset turnover is 2.0 and its profit margin is 10%. What is its sustainable growth rate? A) 20.0% B) 8.0% C) 3.0% D) 12.0% Answer: D Explanation: SG = (1 − 0.4) × 2.0 × 0.10 = 0.12 Difficulty: 3 Hard Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

57) A firm has sales of $1.2 million, a profit margin of 5%, and a dividend payout ratio of 25%. How much will be added to retained earnings next year if sales increase by 6%? A) $15,900 B) $21,600 C) $47,700 D) $42,000 Answer: C Explanation: Add to RE = ($1.2m × 1.06) × 0.05 × (1 − 0.25) = $47,700 Difficulty: 3 Hard Topic: Financial planning models Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 58) Short-term financial planning rarely looks beyond: A) 1 year. B) 1 month. C) 1 week. D) 1 day. Answer: A Difficulty: 2 Medium Topic: Short-term finance and planning Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 59) If the projected growth rate is less than the firm's sustainable growth rate: A) it should increase its projected growth rate. B) the firm will be required to decrease its plowback ratio. C) its debt-equity ratio will decrease. D) the firm will be required to increase borrowing. Answer: C Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

60) Contingency planning is: A) forecasting the most likely outcomes. B) working through the implications of the most likely outcomes. C) working through the consequences of the plan under different scenarios. D) formulating responses to inevitable surprises. Answer: D Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 61) A major difference between financial planning and forecasting is that financial planning: A) is forward-looking. B) relies on the preferences of management. C) determines the rate of profitability. D) is equally concerned with less likely outcomes. Answer: D Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 62) A firm has current sales of $2.4 million and fixed assets of $1.65 million. The firm is currently operating at 88% of capacity. How high can the firm's sales go without requiring any additional fixed assets? A) $2.423 million B) $2.509 million C) $2.727 million D) $2.836 million Answer: C Explanation: Max sales = $2.4m / 0.88 = $2.727m Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

63) The flexibility of financial plans is evident in the extent that: A) actual profits will deviate from projected profits. B) the plans can be adapted when conditions change. C) use of the plans can be extended. D) planning output is the same regardless of economic conditions. Answer: B Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 64) Dawson Metals is currently operating at 94% of its capacity and has sales of $3.1 million and fixed assets of $2.5 million. How much should the firm budget for fixed asset purchases if sales are projected to increase by 9% next year? A) $0 B) $61,500 C) $43,616 D) $98,407 Answer: B Explanation: Sales from current capacity = $3.1m / 0.94 = $3.298m Sales forecast = $3.1m × 1.09 = $3.379m Fixed assets needed = (3.379 / 3.298) × $2.5m = $2.5615m $2.5615m − $2.5m = $61,500 Difficulty: 3 Hard Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

65) The outputs of a financial planning model often include: A) the firm's current financial statements. B) a range of macroeconomic forecasts. C) the number of employees required. D) projected financial statements of the firm. Answer: D Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) Planners have determined that sales will increase by 20% next year, and the profit margin will remain at 10% of sales. Which one of the following statements is correct if the payout ratio remains at 30%? A) Net income will increase by 10% next year. B) The addition to retained earnings will increase by 20% next year. C) The dividend will increase by 6% next year. D) The addition to retained earnings will equal 6% of the sales increase next year. Answer: B Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) A percentage-of-sales model forecasts that cost of goods sold will remain at 80% of sales. If sales revenues are expected to grow by 20% next year, cost of goods sold: A) will grow by 16%. B) will grow by 20%. C) could grow either faster or slower than sales. D) will remain constant. Answer: B Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

68) A firm's goal is to maintain a 75% debt-equity ratio. How much equity would be required if the results of a financial planning model indicate that the firm's assets will grow to $4 million? A) $1.00 million B) $1.71 million C) $2.29 million D) $3.00 million Answer: C Explanation: Equity = [1 / (1 + 0.75)] × $4m = $2.29m Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 69) If a firm commits to a dividend payment and the amount of debt that it is prepared to issue, what must be the balancing item? A) the profit margin. B) new equity issues. C) cost of goods sold. D) return on equity. Answer: B Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) The final variable to have its value determined in a financial plan is often referred to as the: A) net income. B) balancing item. C) retained earnings plowback. D) growth forecast. Answer: B Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

71) Which one of the following is most apt to occur if a financial plan shows sources of funds to be $100,000 and uses of funds to be $90,000? A) External debt of $10,000 will need to be raised. B) Dividend payments will be decreased by $10,000. C) Cash balances will be increased by $10,000. D) The capital budget will be decreased by $10,000. Answer: C Explanation: Increase in cash = $100,000 − 90,000 = $10,000 Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 72) Increased needs for net working capital are: A) recognized in pro forma balance sheets. B) totally absorbed by retained earnings. C) typically financed with short-term debt. D) ignored due to their great variability. Answer: A Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) How much is required in external financing if first-stage pro forma statements indicate $1 million in net income, $300,000 in dividends, and a $900,000 increase in total assets? A) $200,000 B) $500,000 C) $600,000 D) No external financing is required. Answer: A Explanation: External financing need = $900,000 − ($1m − 300,000) = $200,000 Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

74) If a firm's pro forma statements project a net income of $5,000, dividends of $2,000, and an external financing requirement of $2,000, then: A) The firm must issue new equity. B) The profit margin has declined. C) Total assets need to grow by $5,000. D) The internal growth rate is 15%. Answer: C Difficulty: 3 Hard Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) The first step in constructing a financial planning model is to: A) determine the mix of securities that the company will need to issue. B) determine the amount of external financing that is needed. C) determine what additional fixed assets the company will need. D) project future cash flows from operations. Answer: D Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) The rate at which the assets of a firm can grow without the requirement of any external sources of financing is the: A) internal growth rate. B) sustainable growth rate. C) pro forma growth rate. D) plowback rate. Answer: A Difficulty: 1 Easy Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

77) Which one of the following statements is correct concerning the internal growth rate? A) It is maximized when the payout ratio equals zero. B) It is maximized when the plowback ratio equals zero. C) It cannot be less than the sustainable growth rate. D) It decreases as total assets decrease. Answer: A Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 78) Which one of the following changes will decrease a firm's internal growth rate? A) A decrease in dividends with a given net income B) An increase in net income with a given dividend payout ratio C) A decrease in the plowback ratio D) A decrease in assets with a set dividend payout ratio Answer: C Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 79) Under which one of the following capital structures will a firm's internal growth rate exceed its sustainable growth rate? A) Total debt-to-asset ratio equals 35%. B) Equity-to-debt ratio equals 60%. C) Equity-to-debt ratio equals 125%. D) None of the options. Answer: D Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

80) What would help a firm boost its internal growth rate? A) Plowing back a low proportion of its earnings B) Achieving a high return on equity C) Decreasing reinvested earnings D) Maintaining a low sales-to-total assets ratio Answer: B Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) The sustainable growth rate is the maximum growth rate that the firm can achieve A) without external financing. B) while maintaining its debt ratio. C) without investing in additional fixed assets. D) without excessive strains on management. Answer: B Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 82) The sustainable growth rate: A) increases as ROE decreases. B) increases as the payout ratio decreases. C) is maximized when the plowback ratio equals zero. D) cannot be greater than the internal growth rate. Answer: B Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

83) What is the sustainable growth rate for a firm with $250,000 in net income, $100,000 in common stock dividends, and equity of $1 million? A) 8% B) 10% C) 15% D) 17% Answer: C Explanation: SG = [($250,000 − 100,000) / $250,000] × $250,000 / $1m = 0.15, or 15% Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 84) What is the internal growth rate for a firm with an ROE of 20%, a dividend payout ratio of 40%, and an equity-to-debt ratio of 60%? A) 4.50% B) 5.39% C) 8.00% D) 12.00% Answer: A Explanation: IG = (1 − 0.40) × 0.20 × [0.60 / (1 + 0.60)] = 0.0450, or 4.50% Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 85) Which one of the following would increase the sustainable growth rate? A) Reduce the ROE. B) Increase the asset beta. C) Reduce the payout ratio. D) Reduce the operating leverage. Answer: C Difficulty: 2 Medium Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

86) All of the following are part of the financial planning process except: A) deciding which risks are worth taking. B) analyzing investment and financing options. C) projecting the future. D) minimizing risk. Answer: D Difficulty: 2 Medium Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) Which one of these is least likely to change proportionally with sales? A) Depreciation B) Investment in receivables C) Cost of goods sold D) EBIT Answer: A Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) A firm's internal growth rate is all of the following except: A) the rate below which external financing is needed. B) the ratio of reinvested earnings to assets. C) the maximum growth rate without requiring external sources of new capital. D) the product of the plowback ratio, ROE, and the ratio of equity to assets. Answer: A Difficulty: 1 Easy Topic: Internal and sustainable growth rates Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

89) A financial plan: A) is generally considered to be a useless exercise due to unforeseen events. B) should include all possible contingencies. C) provides a basis for evaluating future performance. D) should always be based on the worst-case scenario. Answer: C Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) In the percentage of sales model, which one of these is most likely to increase in uneven increments as sales increase? A) Cost of raw materials B) Accounts receivable C) Accounts payable D) Fixed assets Answer: D Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 91) Which one of these best describes the relationship between net working capital (NWC) and sales? A) NWC will change by the same percentage as sales. B) NWC is unaffected by changes in the sales level. C) NWC changes by a greater percentage than the change in sales, but the change is linear in nature. D) NWC changes in direct relation to sales, but the change may be less than proportional with sales. Answer: D Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

92) A percentage of sales model projects sales to increase by 5% annually over the next 4 years. If costs are forecast at a constant 80% of sales, and this year's income is $1,250, the forecast income in the fourth year will be: A) $1,447.03. B) $1,826.15. C) $1,595.35. D) $1,519.38. Answer: D Explanation: Net incomeYear 4 = $1,250 × (1 + 0.05)4 = $1,519.38 Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 93) If a firm's sales increase by 12%, and it has no spare capacity, it must increase fixed assets by at least: A) 0%. B) 6%. C) 9%. D) 12%. Answer: D Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) If book equity increases by $2,000, the firm does not issue new equity, and its net income is $2,500, then: A) the firm paid a dividend of $500. B) the firm plowed $500 back into the company. C) $500 went into retained earnings. D) debt increased by $2,000. Answer: A Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30

95) Sources and uses of funds are made equal through: A) a balancing item. B) pro forma financial statements. C) borrowed cash. D) additions to retained earnings. Answer: A Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 96) Which one of the following statements regarding financial planning models is false? A) The models should include as much detail as possible. B) The results of a model are pro forma financial statements. C) The plug variable maintains consistency. D) Financial analysis is not used in financial planning. Answer: A Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Which one of the following is not an output of a financial plan? A) Financial ratios B) Pro forma statements C) Sources and uses of cash statement D) Sales forecasts Answer: D Difficulty: 1 Easy Topic: Financial planning basics Learning Objective: 18-01 Describe the contents and uses of a financial plan. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

98) If a firm does not want to use either dividends or debt as the plug, then the obvious plug is: A) inventory B) cash C) new issue of equity D) fixed assets Answer: C Difficulty: 1 Easy Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 99) A firm has projected sales of $328,000, costs of goods sold equal to 68% of sales, interest of $18,500, a tax rate of 21%, and a dividend payout ratio of 60%. What will be the addition to retained earnings? A) $36,667 B) $27,321 C) $24,002 D) $19,531 Answer: B Explanation: Add to RE = ({[$328,000(1 − 0.68)] − $18,500} × (1 − 0.21)) × (1 − 0.60) = $27,321 Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

100) Assume a firm wants to hold its current long-term debt-to-equity ratio constant at 0.55 and its payout ratio constant at 35%. The firm neither issues nor repurchases shares. If the firm generates $326,000 of net income, what is the maximum amount that the firm can increase its long-term debt? A) $116,545 B) $95,355 C) $122,615 D) $0 Answer: A Explanation: Maximum debt increase = $326,000 × (1 − 0.35) × 0.55 = $116,545 Difficulty: 3 Hard Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 101) A firm's net assets equal 55% of sales. The firm expects sales to increase of $78,000 next year and to generate $6,500 of retained earnings. What is the external financing need? A) $49,400 B) $21,200 C) $28,600 D) $36,400 Answer: D Explanation: EFN = 0.55 × $78,000 − $6,500 = $36,400 Difficulty: 2 Medium Topic: External financing need Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

102) A firm has projected net income of $25 mil and the company will need new assets of $15 mil. If external financing is fixed at $2 mil, what will be the company's dividend? A) $2 million B) $12 million C) $15 million D) $25 million Answer: B Explanation: Dividend = 25 − (15 − 2) = $12 million Difficulty: 2 Medium Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 103) A firm wants to limit its new debt issue to $10 mil and has no interest in adding new equity. Net income is forecasted at $30 mil and new assets of $22 mil will be needed to sustain the growth of the company. What dividend will the company pay to maintain its objectives? A) $10 million B) $14 million C) $18 million D) $24 million Answer: C Explanation: Dividend = 30 − (22 − 10) = $18 million Difficulty: 3 Hard Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

104) A company requires $17 mil in new assets to sustain its current level of growth. The firm forecasts $ 25 mil of net income and investors expect a $12 mil dividend. Since the company does not want any new equity, how much new debt must the company issue to meet its objectives? A) $4 million B) $6 million C) $8 million D) $12 million Answer: A Explanation: New debt = 17 − (25 − 12) = $4 million Difficulty: 3 Hard Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 105) If a growing company has a fixed dividend policy and does not want new shareholders, what must be the balancing item in a long term financial plan? A) New equity B) New debt C) Retained earnings D) Dividend Answer: B Difficulty: 3 Hard Topic: Financial planning models Learning Objective: 18-02 Construct a simple financial planning model. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 19 Short-Term Financial Planning 1) When financial managers are asked the key reason for choosing short-term rather than longterm debt, they often say that they try to match the maturities of the firm's assets and liabilities. Answer: TRUE Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Biotech firms require large amounts of cash if their drugs succeed in gaining regulatory approval. Therefore, these firms often have substantial cash holdings to fund their possible investment needs. Answer: TRUE Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) Unlike long-term planners, short-term planners are concerned only with the most likely outcomes. Answer: FALSE Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation

4) Companies with unusually high cash reserves often hold the cash in tax havens. Answer: TRUE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 5) A company that sells goods to a customer on credit will see no immediate change in its cash position. Answer: TRUE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) A company that pays $5,000 previously owed to one of its suppliers will see a $5,000 decrease in cash. Answer: TRUE Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) Most firms have a permanent investment in working capital. Answer: TRUE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation

8) A company that borrows $1 million short term and invests the proceeds in inventory will see its cash position unchanged. Answer: TRUE Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) Firms with a permanent investment in working capital finance that investment with short-term debt. Answer: FALSE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) The term "tax inversion" refers to the negative tax shield that is created when a firm invests in securities. Answer: FALSE Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

11) Evidence suggests that investors place a particularly high value on liquidity in the case of companies with growth opportunities. Answer: TRUE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 12) A company that sells $5 million of marketable securities will see a $5 million increase in cash. Answer: TRUE Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) The largest inflows of cash usually come from payments by the firm's customers. Answer: TRUE Difficulty: 2 Medium Topic: Preparing the cash budget Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) Unless customers pay cash on delivery, cash flow comes from collections on receivables. Answer: TRUE Difficulty: 1 Easy Topic: Preparing the cash budget Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

15) The primary aim of cash budgeting models is to obtain better forecasts of earnings. Answer: FALSE Difficulty: 1 Easy Topic: Preparing the cash budget Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16) If a firm reduces its accounts payable period, other things equal, it increases its cash holdings. Answer: FALSE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) Firms with surplus cash can use it to increase dividends or buy back securities. Answer: TRUE Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation 18) Short-term financing plans are usually developed by trial and error. Answer: TRUE Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation

19) A reduction in inventory levels would be a source of cash. Answer: TRUE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20) Cash holdings decline when a firm buys raw materials on credit. Answer: FALSE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) If a firm's customers on average take two weeks to pay their bills, then about half of each month's bills will not be paid until the following month. Answer: TRUE Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) A firm that sells marketable securities will see an increase in its working capital but no change in its holdings of cash. Answer: FALSE Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

23) Many high tech firms hold large amounts of marketable securities. Answer: TRUE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 24) Holdings of marketable securities are at worst zero-NPV investments for taxpaying firms. Answer: FALSE Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 25) An increase in current liabilities is a source of cash for the firm. Answer: TRUE Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) The short-term financial plan sets out a strategy for investing any cash surpluses or financing any deficit. Answer: TRUE Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

27) For firms facing financial distress a dollar of cash within the firm is often worth less than a dollar to shareholders. Answer: TRUE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 28) Managers with a large surplus of cash are often tempted to run a less tight ship. Answer: TRUE Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 29) If the firm repurchases its own stock, its cash holdings are unaffected. Answer: FALSE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) Investments in marketable securities are generally a positive NPV investment for tax-paying firms. Answer: FALSE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

31) An increase in long-term assets is a source of cash for the firm. Answer: FALSE Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 32) An increase in accounts payable is a source of cash. Answer: TRUE Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33) A company stretches payables whenever it offers more generous payment terms to its customers. Answer: FALSE Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 34) Firms with large holdings of current assets generally enjoy greater liquidity. Answer: TRUE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

35) Inventory is generally more liquid than receivables. Answer: FALSE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 36) A company that matches maturities will generally try to finance its receivables with longterm debt. Answer: FALSE Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements.; 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) The planning horizon for cash budgeting is usually at least five years. Answer: FALSE Difficulty: 2 Medium Topic: Preparing the cash budget Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

38) Which of the following statements is not true of short-term financial planning? A) The plan should consider possible shortfalls in sales or a delay in collections. B) The plan seeks to ensure that the company will be able to meet its cash needs. C) The planning period is typically five years. D) The plan needs to be based on the best forecasts available. Answer: C Difficulty: 1 Easy Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 39) Which of these events reduces cash holdings? A) The firm changes its terms of sale and gives customers less time to pay for their purchases. B) The firm sells a parcel of land at a profit. C) The firm pays more promptly for its raw materials. D) The firm sells a parcel of land at a loss. Answer: C Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) Which of these assets is likely to be the least liquid? A) receivables B) marketable securities C) inventories of work in progress D) inventories of finished goods Answer: C Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

41) Brad Corp expects to make sales of $80 million in January. In February forecast sales are $90 million, and in March they are $60 million. On average 50% of sales are paid for in the current month, 30% are paid for in the next month, and the remainder in the following month. What is the expected cash flow from operations in March? A) $30 million B) $60 million C) $73 million D) $76.7 million Answer: C Explanation: Cash flow = (0.5 × 60) + (0.3 × 90) + (0.2 × 80) = $73 million Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 42) Which of the following transactions would not be a source of cash: A) The firm issues $1 million of short-term debt and invests the proceeds in inventory. B) A customer pays an outstanding bill. C) The firm sells $10 million of marketable securities. D) The firm receives $10 million from an insurance company to compensate for flood damage earlier that month. Answer: A Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

43) A firm purchases $32 million of materials from suppliers in January, $28 million in February and $25 million in March. Forty percent are supplied cash on delivery. The remainder needs to be paid for in the following month. What is the cash outflow in February? A) $26.2 million B) $29.6 million C) $30.4 million D) $32.0 million Answer: C Explanation: CF = (0.4 × 28) + (0.6 × 32) = $30.4 million Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 44) Splitterfield Foods forecasts the following sales and expenses: June July August 120 150 160 70 80 85 30 38 40

Sales ($ millions) Purchases of raw materials ($ millions) Other expenses ($ millions)

Seventy percent of sales are paid for in the same month and the remainder with a delay of one month. All raw materials are paid for with a delay of one month, other expenses are paid with no delay. What is the expected cash flow from operations in July? A) $29.5 million. B) $32 million. C) $33 million. D) $20 million. Answer: C Explanation: CF = (0.7 × 150 + 0.3 × 120) − 70 − 38 = $33 million Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

45) A toy store does not pay for its purchases of toys from manufacturers until one month later. Suppose that in October it starts to stock up in anticipation of a surge in toy sales in December,when is it most likely to have a negative operating cash flow? A) It should never have a negative operating cash flow as long as its business is profitable. B) In October because this is when it starts to stock up. C) In November because this is when it will need to pay for the increased inventory. D) In December because this is when the toys will start to move off the shelves. Answer: C Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 46) Which one of the following statements best describes the total capital requirement for most profitable firms? A) The general trend in the total capital requirement is downward sloping. B) The total capital requirement tends to be constant over long periods of time. C) There are seasonal fluctuations around the total capital requirement trend. D) The total capital requirement must be funded with short-term debt. Answer: C Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

47) When a firm finances long-term assets with short-term sources of funding, it: A) reduces the risk of cash shortage. B) will generally have lower interest expense. C) improves the leverage ratio. D) violates the principle of matched maturities. Answer: D Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) The principle of matched maturities in finance refers to: A) finding sources of funds with the longest maturity, in order to avoid liquidity crises. B) funding long-term assets with long-term sources and short-term assets with short-term financing. C) using as much short-term financing as possible due to the lower cost of interest. D) buying marketable securities when demand is high and borrowing short-term when demand is low. Answer: B Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

49) Which one of the following is more likely for a firm practicing the relaxed strategy of longversus short-term borrowing at the height of sales demand? A) It will borrow heavily on a short-term basis. B) At the height of demand, it will invest heavily in marketable securities. C) It will borrow on both a long-term and a short-term basis. D) Its long-term financing will approximately equal its total capital requirements. Answer: D Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 50) When internally generated cash is temporarily insufficient to meet a firm's cash need, the firm following a middle-of-the-road policy for longversus short-term financing will: A) borrow short term. B) borrow long term. C) hold marketable securities. D) payoff all debts. Answer: A Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) A firm's permanent working capital refers to the: A) difference between fixed assets and current assets. B) maximum difference between current assets and current liabilities. C) portion of net working capital that is financed from long-term sources. D) amounts that must be held to meet debt covenants. Answer: C Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16

52) Firms that continually invest in nontrivial amounts of marketable securities may be guilty of: A) excessive short-term borrowing. B) not matching their sources and uses of cash. C) holding excessive current liabilities. D) incurring extra taxes. Answer: D Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 53) What happens to a firm whose uses of cash exceed its sources of cash during an accounting period? A) It has a loss of net working capital. B) It declares a net loss on the income statement. C) It experiences a decrease in sales. D) It experiences a decrease in its cash balance. Answer: D Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) Which one of the following would not be considered a use of cash? A) Dividends B) Decreased accounts payable C) Depreciation D) Increased accounts receivable Answer: C Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

55) Avatar Corp solves its cash shortage by paying its bills a week late but loses a 1% discount by doing so. This is equivalent to borrowing at an annual interest rate of: A) 52.0%. B) 12.8%. C) 68.6%. D) 1.0%. Answer: C Explanation: Annual Interest Rate = 1 / (0.99) ^ 52 = 68.6% Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 56) A firm starts with $5,000 of accounts receivables and ends the period with $4,000 of receivables. If it collected $4,000 of receivables during the period, what was the amount of sales? A) $19,000 B) $20,000 C) $21,000 D) $24,000 Answer: A Explanation: Sales = $4,000 − 5,000 + 20,000 = $19,000 Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

57) A firm had $2,800 cash at the beginning of the period. During the period, the firm collected $1,600 in receivables, paid $1,850 to supplier, had credit sales of $4,200, and incurred cash expenses of $2,300. What was the cash balance at the end of the period? A) $4,450 B) $250 C) $2,850 D) $1,250 Answer: B Explanation: $2,800 + 1,600 − 1,850 − 2,300 = $250 Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 58) Which one of the following is least likely to be correct for a firm that repeatedly stretches its payables? A) The firm may receive more favorable status from suppliers. B) The firm may reduce its explicit short-term interest expense. C) The cost of forgone discounts may exceed the cost of bank credit. D) The firm may be labeled as a credit risk. Answer: A Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) A firm must decide between borrowing from a bank at 12% interest or stretching its payables for one quarter. If it stretches the payables it will forgo a 2% discount for timely payment. Based solely on cash flows, which is the cheaper solution? A) Stretching saves the firm approximately 8% per year. B) Use the bank loan; forgoing a cash discount is costly. C) Stretch the payables and finance at a savings of approximately 3.75% annually. D) Use the bank loan because it represents simple interest. Answer: C Explanation: Annual cost of foregone discount = 1.024 − 1 = 8.24% Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 60) A firm starts the week with payables of $172,000. It pays $80,000 of outstanding bills, and purchases $44,000 of raw materials on one month's credit. What is the level of payables at the end of the week? A) $136,000. B) $208,000. C) $96,000. D) $216,000. Answer: A Explanation: $172,000 − $80,000 + $44,000 = $136,000 Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

61) A firm starts the week with payables of $172,000, it pays $$80,000 of outstanding bills, and purchases $44,000 of raw materials on one month's credit. What is the change in its cash balance over the week? A) −$36,000 B) +$96,000 C) −$80,000 D) +$92,000 Answer: C Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 62) Which of the following will not reduce an imminent cash shortage? A) Phoning customers who have overdue bills. B) Issuing common stock to repay long-term debt. C) Postponing purchase of a new machine. D) Rolling over maturing bank debt. Answer: B Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) Zeta Stores places orders for 60% of the sales forecast in the next month and for 40% of the sales forecast for the following month. It pays for these goods with a 2-month delay. If sales for August are forecast at $10 million and sales for September and October are forecast at $12 million, what will be the forecast cash outflow in September? A) $10.8 million. B) $15.6 million. C) $4.8 million. D) $9.6 million. Answer: A Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 64) Zeta Stores places orders for 60% of the sales forecast in the next month and for 40% of the sales forecast for the following month. It pays for these goods with a 1-month delay? If sales for August are forecast at $10 million and sales for September and October are forecast at $12 million, what will be the forecast cash outflow in September? A) $10.8 million B) $15.6 million C) $4.8 million D) $9.6 million Answer: D Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

65) A firm that stretches its payables gains an extra 1 month before it needs to pay for its purchases of raw materials but it loses a 2% discount for prompt payment. This is like borrowing at an effective annual interest rate of: A) 19.40% B) 24.00% C) 26.53% D) 27.43% Answer: D Explanation: EAR = [1 + (($100 − 98) / $98)]12 − 1 = 0.2743, or 27.43% Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 66) Which statement does not correctly describe short-term financial decisions? A) Most firms finance short-term assets with short-term borrowing. B) Most firms maintain a positive investment in working capital. C) Most firms finance their investment in working capital with short-term debt. D) Liquidity is particularly valued by small firms that face relatively high costs to raising funds on short notice. Answer: C Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

67) There are three steps to constructing a cash budget. Which of the following is not one of those steps? A) Calculate whether the firm is facing a cash shortage or surplus. B) Forecast the uses of cash. C) Set a policy for deciding how much time to give customers to pay. D) Forecast the sources of cash. Answer: C Difficulty: 1 Easy Topic: Preparing the cash budget Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Remember AACSB: Reflective Thinking Accessibility: Keyboard Navigation 68) Before settling on a final short-term financial plan, the manager needs to ask several questions. Which question is the manager least likely to ask? A) Does the plan yield satisfactory financial ratios? B) Would the firm do better to arrange long-term financing to cover any cash shortage? C) Has the firm estimated its EVA correctly? D) Does the company need a larger reserve of cash or marketable securities to cover emergencies? Answer: C Difficulty: 1 Easy Topic: Short-term financial plan Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

69) Clopton Inc. forecasts cash sales of $18 million in January, $23 million in February and $25 million in March. Credit sales in these three months are forecast at $80 million, $110 million and $145 million. On average 50% of credit sales are paid for in the current month, 30% in the next month, and the remainder in the following month. What is the expected cash inflow in March? A) $121.5 million B) $102 million C) $127 million D) $146.5 million Answer: D Explanation: CF = 25 + (0.5 × 145) + (0.3 × 110) + (0.2 × 80) = $146.5 million Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 70) When managers are continually short-term lenders, they are said to follow a: A) middle-of-the-road financing strategy. B) restrictive financing strategy. C) relaxed financing strategy. D) permanent working-capital strategy. Answer: C Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

71) When the length of the financing is directly related to the life of the asset being financed, the firm is said to follow a: A) policy of maturity matching. B) restrictive financing strategy. C) matched depreciation strategy. D) minimum working capital strategy. Answer: A Difficulty: 1 Easy Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 72) Which one of these is most associated with a disadvantage of the relaxed strategy of longversus short-term financing? A) Transaction costs are required to continually obtain financing. B) Short-term investment income is often unattractive. C) Investment opportunities must frequently be ignored. D) Long-term financing has burdensome tax consequences. Answer: B Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) Which one of the following is a use of cash? A) Net income B) Repayment of a bank loan C) Reduction in accounts receivable D) Depreciation Answer: B Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 26

74) Which of the following would increase the firm's cash balance? A) increase the cash dividend B) increase the accounts payable C) increase accounts receivable D) increase inventory Answer: B Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) Managers are alerted to projected cash shortages by means of the: A) statement of sources and uses of cash. B) pro forma balance sheet. C) cash budget. D) monthly bank statements. Answer: C Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) In the preparation of cash budgets, capital expenditures are: A) not included because these items are depreciated. B) included as sources of operating cash. C) included as uses of cash and make the budget lumpy. D) traditionally offset as a use of cash by interest income. Answer: C Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

77) Managers who "stretch their payables" are attempting to: A) repay more recent bills before earlier bills. B) improve their current ratio before preparing financial statements. C) offer finished goods at a discount for quicker repayment. D) obtain short-term financing. Answer: D Difficulty: 1 Easy Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 78) Which one of the following would not be included as a source of short-term financing? A) Line of credit from a bank B) Increase in the minimum operating cash balance C) Sale of marketable securities D) Stretching of accounts payable Answer: B Difficulty: 1 Easy Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

79) For a recent period, a firm collected $38,200 on accounts receivable, paid $19,700 to suppliers on trade credit, paid $12,000 in cash expenses, purchased for cash a $42,000 piece of equipment that will be depreciated straight-line to zero over 4 years, and had $59,000 of sales of which 15% were cash sales. The firm also paid $13,500 in taxes and interest. The beginning cash balance was $11,300. How much did the firm need to borrow in order to maintain a minimum cash balance of $10,000? A) $38,850 B) $37,550 C) $7,350 D) $30,000 Answer: A Explanation: Cash balance = $11,300 + 38,200 − 19,700 − 12,000 − 42,000 + (0.15 × $59,000) − 13,500 − 10,000 = −$38,850; Thus, the firm needs to borrow $38,850. Difficulty: 3 Hard Topic: Short-term financial plan Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 80) The Boat Works started the month with $1.28 million in accounts receivable. Sales for the month were $3.4 million. The firm collects 35% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A) $2.21 million B) $1.19 million C) $3.49 million D) $2.71 million Answer: A Explanation: Ending A / R = $1.28m + 3.4m − 1.28m − (0.35 × $3.4m) = $2.21m Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

81) The Boat Works started the month with $3.21 million in accounts receivable. Sales for the month were $7.84 million. The firm collects 18% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A) $4,621,200 B) $6,428,800 C) $9,061,000 D) $1,411,200 Answer: B Explanation: Ending A / R = $3.21 + 7.84m − 3.21m − (0.18 × $7.84m) = $6,428,800 Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 82) A firm that follows a relaxed strategy toward the total capital requirement will be a: A) short-term borrower. B) short-term lender. C) long-term lender. D) long-term borrower. Answer: B Difficulty: 2 Medium Topic: Short-term financial policy Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

83) Issuing additional long-term debt of $5 million and buying new long-term assets worth $4 million and short-term assets of $1 million will result in a net cash flow of: A) $5 million B) $9 million C) $0 million D) $4 million Answer: C Explanation: Issuing new long-term debt is a source of cash and buying new assets is a use of cash. So, the net cash flow is zero. Difficulty: 1 Easy Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) A firm has $50 million and $60 million credit sales during the first two quarters of the year. Eighty percent of the receivables are collected in the same quarter and the balance in the next quarter. What will be the total collection for the firm in the second quarter? A) $55 million B) $58 million C) $88 million D) $98 million Answer: B Explanation: Q2 collections = (1 − 0.80) × $50m + 0.80 × $60m = $58m Difficulty: 2 Medium Topic: Cash collections Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

85) A firm has a need for cash in a specific quarter. Which of the following is least likely to be part of a short-term financial plan to raise cash? A) Bank loan B) New equity C) Securities sold D) Stretched payables Answer: B Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 86) Stretching payables costs a company 1% per month. This is equivalent to borrowing at what annual interest rate? A) 11.23% B) 11.97% C) 12.82% D) 13.02% Answer: C Explanation: EAR = [1 + (($100 − 99)/$99)]12 − 1 = 0.1282 or 12.82% Difficulty: 2 Medium Topic: Short-term financial plan Learning Objective: 19-03 Develop a short-term financing plan that meets the firm's need for cash. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

87) A mattress store had monthly sales of $20,000, $18,000 and $15,000 in the months of December, January, and February, respectively. Collections are usually 50% in cash, 30% in one month and the balance at the end of two months. Assuming no bad debt, how much cash will the store collect in February? A) $16,600 B) $16,700 C) $16,800 D) $16,900 Answer: D Explanation: CF = (15,000 × 0.5) + (18,000 × 0.3) + (20,000 × 0.2) = $16,900 Difficulty: 2 Medium Topic: Sources and uses of cash Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 20 Working Capital Management 1) Large payments between businesses are generally made electronically through either CHIPS or Fedwire. Answer: TRUE Difficulty: 1 Easy Topic: Cash management processes Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Inventory makes up the bulk of the current assets of retail firms. Answer: TRUE Difficulty: 1 Easy Topic: Working capital requirements Learning Objective: 20-01 Understand why firms need to invest in working capital. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) The potential benefits of additional credit analysis should always be weighed against the incremental costs. Answer: TRUE Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

4) Absent any possibility of repeat orders, if the default probability is less than the profit margin, you should extend credit for the sale. Answer: TRUE Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) Firms are more likely to grant credit the higher the probability that a potential customer will become a repeat customer. Answer: TRUE Difficulty: 1 Easy Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) The more liberal the terms of the collection policy, the lower the potential for bad debts and unprofitable sales. Answer: FALSE Difficulty: 1 Easy Topic: Collection policy Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) A firm that buys on credit is in effect borrowing from its supplier. Answer: TRUE Difficulty: 1 Easy Topic: Cost of credit Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

8) Just-in-time inventory management seeks to reduce inventory levels. Answer: TRUE Difficulty: 1 Easy Topic: Inventory management. Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 9) Commercial paper is usually used to finance overseas trade. Answer: FALSE Difficulty: 1 Easy Topic: Credit instruments Learning Objective: 20-09 Understand the principal sources of short-term loans. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 10) Extending trade credit can increase the probability of repeat orders. Answer: TRUE Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) The decision to offer credit depends on the probability of payment. You should grant credit if the expected profit from doing so is greater than the profit from refusing. Answer: TRUE Difficulty: 1 Easy Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

12) Bond ratings are an expensive source of credit information on publicly traded companies. Answer: FALSE Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 13) An aging schedule is a statement sent to customers who are delinquent in their payments. Answer: FALSE Difficulty: 1 Easy Topic: Collection policy Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) Optimal inventory levels are lower when carrying costs are high, and when the cost of restocking inventories is low. Answer: TRUE Difficulty: 1 Easy Topic: Inventory management. Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Since defaults can be costly, it is cost-effective to undertake a full credit analysis of all customers. Answer: FALSE Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

16) Checks that have been mailed but not yet cleared result in float. Answer: TRUE Difficulty: 1 Easy Topic: Float costs and management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 17) Short-term securities have high interest-rate risk. Answer: FALSE Difficulty: 1 Easy Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 18) Lock-box systems allow local banks to collect and process the firm's remittances from that area. Answer: TRUE Difficulty: 1 Easy Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 19) As the number of inventory orders per year increases, the total order costs decrease. Answer: FALSE Difficulty: 1 Easy Topic: Economic order quantity (EOQ) model Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

20) Checks tend to be a more popular method of payment in the United States than in many other developed countries. Answer: TRUE Difficulty: 1 Easy Topic: Cash management processes Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 21) Most money market instruments have a high degree of liquidity. Answer: TRUE Difficulty: 1 Easy Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) Repos are long-term unsecured loan agreements. Answer: FALSE Difficulty: 1 Easy Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 23) The cash cycle is the period between a firm's payment for materials and collection on its sales. Answer: TRUE Difficulty: 1 Easy Topic: Cash cycle Learning Objective: 20-01 Understand why firms need to invest in working capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

24) Bank certificates of deposit are the safest and most liquid of all the money market securities. Answer: FALSE Difficulty: 1 Easy Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) A firm's inventory period can be estimated by the ratio of inventory to daily cost of goods sold. Answer: TRUE Difficulty: 1 Easy Topic: Cash cycle Learning Objective: 20-01 Understand why firms need to invest in working capital. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 26) The cost of an ACH transaction is relatively small compared to a CHIPs of Fedwire? Answer: TRUE Difficulty: 2 Medium Topic: Cash management processes Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 27) Which of the following is not a current asset? A) an investment in a money market mutual fund. B) money due to suppliers. C) inventory of raw materials D) unpaid customer bills. Answer: B Difficulty: 2 Medium Topic: Working capital requirements Learning Objective: 20-01 Understand why firms need to invest in working capital. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7

28) The economic order quantity: A) is the order size that minimizes the order costs. B) is independent of forecast sales. C) is based on sales, carrying costs, and order costs. D) increases as cost per order decreases. Answer: C Difficulty: 1 Easy Topic: Inventory management.; Economic order quantity (EOQ) model Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) Which of these firms will benefit the most from a lock-box service? A) A firm that has a large number of suppliers B) A firm that writes a large number of checks daily C) A firm that has a geographically dispersed customer base D) A firm that sells goods to a very limited number of customers Answer: C Difficulty: 2 Medium Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

30) A firm that is located in New York receives on average 2,000 checks a day from its customers in the Twin Cities area. Average payment per check is $1,500. A bank in the Twin Cities is offering a lock-box arrangement for collection and processing of these checks at a cost of $0.50 per check. This arrangement will reduce the float by 2 days. The daily interest rate for the firm is 0.02%. What is the net saving from the lock-box arrangement? A) $200 B) $400 C) $1,000 D) $1,200 Answer: A Explanation: Reduction in float = 2,000 × $1,500 × 2 days = $6m Daily interest savings = $6m × 0.0002 = $1,200 Daily processing cost = $0.50 × 2,000 = $1,000 Net daily savings = $1,200 − 1,000 = $200 Difficulty: 3 Hard Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 31) Which one of the following terms of sale is the most restrictive? A) Net 30 B) 2/10, net 4 C) CBD D) COD Answer: C Difficulty: 1 Easy Topic: Credit terms Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

32) At what point does a customer's unpaid account become delinquent when the terms of sale are 2/10, net 60? A) 11 days after the sale B) 31 days after the sale C) 61 days after the sale D) 71 days after the sale Answer: C Difficulty: 1 Easy Topic: Credit terms Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33) Which statement is true about terms of trade credit of 2/10, net 30? A) A 10% cash discount is offered for payment before 30 days. B) A 2% cash discount can be taken for payment before the 10th of the following month. C) A 10% cash discount can be taken if paid by the second day after invoicing. D) No cash discount is offered after the tenth day. Answer: D Difficulty: 1 Easy Topic: Credit terms Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) What effective annual rate of interest is being charged to a customer who is granted credit terms of 3/15, net 45 when the customer foregoes the discount and pays on the last date prior to being delinquent? A) 44.86% B) 48.29% C) 37.67% D) 41.84% Answer: A Explanation: EAR = [1 + (0.03 / (1 − 0.03))]365 / (45 − 15) − 1 = 0.4486, or 44.86% Difficulty: 2 Medium Topic: Costs of credit Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 10

35) What is the cash cycle for a firm with a receivables period of 40 days, a payables period of 30 days, and an inventory period of 60 days? A) 10 days. B) 50 days. C) 70 days. D) 130 days. Answer: C Explanation: Cash conversion cycle = 60 + 40 − 30 = 70 days Difficulty: 1 Easy Topic: Cash cycle Learning Objective: 20-01 Understand why firms need to invest in working capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) With terms of 4/15, net 60, what is the implied interest rate for forgoing a cash discount and paying at the end of the credit period? A) 25.63% B) 28.19% C) 39.25% D) 61.15% Answer: C Explanation: EAR = [1 + (0.04 / (1 − 0.04))]365 / (60 − 15) − 1 = 0.3925, or 39.25% Difficulty: 2 Medium Topic: Costs of credit Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 37) What happens to the implied interest rate on trade credit as the time interval between the discount period and payment period is decreased? A) The rate declines. B) The rate increases. C) The rate remains constant. D) It is impossible to predict without knowing the actual length of discount period. Answer: B Difficulty: 2 Medium Topic: Credit terms Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11

38) When sales are made without the accompaniment of a formal debt contract, the sales are said to be on: A) conditional sale terms. B) open account. C) trade credit. D) sight draft. Answer: B Difficulty: 1 Easy Topic: Credit instruments Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 39) Under the terms of a sight draft, the buyer's bank: A) is instructed to make immediate payment. B) treats the invoice like a postdated check. C) forwards the acceptance to the seller until due. D) enters into a factoring arrangement. Answer: A Difficulty: 1 Easy Topic: Credit instruments Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 40) A time draft that has been signed by the customer is termed: A) a trade discount. B) a conditional sale. C) a trade acceptance. D) an overdue account. Answer: C Difficulty: 1 Easy Topic: Credit instruments Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

41) Which one of the following statements is correct about banker's acceptances? A) They are equivalent to a sight draft. B) They represent the norm for installment sales. C) The bank guarantees payment of the invoice. D) The bank retains title to the merchandise. Answer: C Difficulty: 1 Easy Topic: Credit instruments Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) Which one of the following is not included in the five Cs of credit? A) Character B) Condition C) Consumption D) Capital Answer: C Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 43) Credit scoring systems can be used to: A) reduce the effective cost of trade. B) determine the cost of goods sold. C) evaluate Dun and Bradstreet reports. D) evaluate credit risk based on the borrower's characteristics. Answer: D Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

44) What is the cash cycle for a firm with $3 million average inventories, $1.5 million average accounts payable, a receivables period of 40 days, and annual sales of $20 million and an annual cost of goods sold of $18 million? A) 14.59 days. B) 46.25 days. C) 136.25 days. D) 70.42 days. Answer: D Explanation: Cash conversion cycle = $3m / ($18m / 365) + 40 − $1.5m / ($18m / 365) = 70.42 days Difficulty: 1 Easy Topic: Cash cycle Learning Objective: 20-01 Understand why firms need to invest in working capital. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) Which of the following transactions is likely to incur the most float cost to the recipient? A) ACH B) Check C) CHIPs D) Fedwire Answer: B Difficulty: 1 Easy Topic: Float costs and management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 46) The set of rules that determines whether or not credit should be extended is known as: A) credit analysis. B) credit policy. C) multiple discriminate analysis. D) the terms of trade credit. Answer: B Difficulty: 1 Easy Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 14

47) What credit decision is appropriate for a potential customer that offers a 75% chance of paying on a $10,000 sale which has an 80% cost? A) Grant credit since the expected profit is $3,200. B) Grant credit since the expected profit is $800. C) Refuse credit since the expected profit is negative. D) Refuse credit since the expected loss is zero. Answer: C Explanation: Expected profit from offering credit = 0.75 × PV($10,000 − 8,000) − 0.25 × PV($8,000) < $0 Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 48) What is the expected payoff on a $2,000 sale that has a 30% profit margin if there is a 20% probability of default? A) $1,000 B) $120 C) $600 D) $200 Answer: D Explanation: Expected payoff = 0.8 × 0.3 × $2,000 − (0.2 × 0.70 × $2,000) = $200 Difficulty: 2 Medium Topic: Credit analysis Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 49) Firms should be more prepared to sell on credit to high-risk customers if: A) the profit margin is low. B) the probability of repeat orders is low. C) the profit margin is high. D) the firm's sales representative is paid on commission. Answer: C Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 15

50) Which one of the following statements typically describes the break-even probability of collection for repeat sale customers? A) The break-even probability is higher than for single sale customers. B) The break-even probability is lower than for single sale customers. C) The break-even probability does not change between single sale and repeat sale customers. D) Sales should never be refused for customers offering the potential of repeat sales. Answer: B Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) An aging schedule illustrates the relationship between: A) the time history with a customer and the number of repeat sales. B) the average sale size and profitability over time. C) customer ages and the average size of sales. D) an accounts receivable and its time outstanding. Answer: D Difficulty: 1 Easy Topic: Collection policy Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 52) Money market securities usually have a maturity of: A) more than 1 year. B) less than 1 year. C) 1 to 3 years. D) less than a week. Answer: B Difficulty: 1 Easy Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

53) A $1,200 invoice dated January 1 has credit terms of 3/10, net 30. If the buyer pays January 4, how much will he need to pay? A) $1,164 B) $1,080 C) $900 D) $1,200 Answer: A Explanation: Discounted payment = (1 − 0.03) × $1,200 = $1,164 Difficulty: 2 Medium Topic: Credit terms Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 54) Which of the following is correct concerning terms of trade credit of 4/10, EOM, net 90? A) The discount period expires on the last day of the month. B) The invoice becomes delinquent 90 days after the last day of the month. C) The discount period ends on the 10th day of the following month. D) The discount period ends either 10 days after invoicing or at the end of the month, whichever is earlier. Answer: C Difficulty: 1 Easy Topic: Credit terms Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) If goods are sold on terms of 5/10, net 90, what effective interest rate is if the purchaser pays on day 90? A) 20.00% B) 22.81% C) 24.93% D) 26.37% Answer: D Explanation: EAR = [1 + (0.05 / (1 − 0.05))]365 / (90 − 10) − 1 = 0.2637, or 26.37% Difficulty: 2 Medium Topic: Costs of credit Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 17

56) Which one of the following changes to the terms of credit would increase the effective annual interest rate charged? A) Increasing the cash discount percentage B) Extending the discount period and payment period by 10 days each C) Extending the payment period only D) Decreasing the discount period only Answer: A Difficulty: 3 Hard Topic: Costs of credit Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) Which one of the following is most likely to discourage purchasers from taking a discount? A) A higher discount percentage B) A shorter payment period C) A longer discount period D) A longer payment period Answer: D Difficulty: 1 Easy Topic: Credit terms Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) Which of the following strategies should a cash-strapped firm adopt if the effective interest rate charged on trade credit is lower than the bank's interest rate? A) Take the discount but pay after the discount period. B) Borrow from the bank and take the discount. C) Ignore the discount, pay at the end of the period. D) Take the discount and hope for longer payment float. Answer: C Difficulty: 1 Easy Topic: Cost of credit Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) What is the daily net cost of holding a cash balance of $2.5 million, if the daily interest rate is 0.025% and the average transaction cost of investing money overnight is $50? A) $121 B) $171 C) $575 D) $675 Answer: C Explanation: Net opportunity cost = (0.00025 × $2.5m) − $50 = $575 Difficulty: 2 Medium Topic: Cash management general Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 60) Which one of the following credit agreements provides the least protection to the seller? A) Banker's acceptance B) Time draft C) Open account D) Commercial draft Answer: C Difficulty: 1 Easy Topic: Credit instruments Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 61) The purpose of credit analysis is to: A) reconcile the accounts receivable balance. B) modify the terms of trade credit. C) organize the right side of the balance sheet. D) decide whether or not to grant credit to a customer. Answer: D Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

62) Which one of the following would not be a customary source of credit information on customers? A) Dun and Bradstreet B) Chamber of Commerce C) Credit Bureau D) Customer's bank Answer: B Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 63) The five Cs of credit refer to the: A) credit reports issued by Dun and Bradstreet. B) interpretation of numerical credit scoring systems. C) attributes that help determine creditworthiness. D) financial ratios used to determine a customer's creditworthiness. Answer: C Difficulty: 1 Easy Topic: Credit analysis Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) In field warehousing the inventory is held by the: A) borrowing firm. B) lending institution. C) independent warehousing company. D) firm and the lender jointly. Answer: C Difficulty: 1 Easy Topic: Inventory management. Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

65) In general, a firm's credit policy should grant credit whenever the expected: A) loss from default is less than the cost of the product. B) profit from granting credit exceeds the profit from refusing. C) profit exceeds the price of the product. D) probability of a loss is less than 50%. Answer: B Difficulty: 1 Easy Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) If the probability of collection is 65%, should you grant credit to a customer wishing to purchase a $2,000 item that cost $1,333.33 to produce? Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A) No; the expected loss is $33.33. B) No; the expected loss is $150.00. C) Yes; the expected profit is $33.33. D) Yes; the expected profit is $150.00. Answer: A Explanation: Expected profit = 0.65[$2,000 − $1,333.33] − (1 − 0.65)[$$1,333.33] = −$33.33 Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

67) What is the break-even probability in the following case? A customer wishes to purchase a $2,000 item that has been marked up to 50% over cost. Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A) 55.67% B) 66.67% C) 77.67% D) 88.67% Answer: B Explanation: p = profit margin = 0.6667, or 66.67% Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 68) What is the minimum probability of collection that should be accepted by firms that have a 25% profit margin? Ignore the time value of money and assume that there is no chance of subsequent sales. A) 20% B) 25% C) 50% D) 75% Answer: B Difficulty: 1 Easy Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 69) Which of the following would be more likely to justify granting credit? A) A higher profit margin B) A lower probability of payment C) A higher discount rate D) A lower selling price Answer: A Difficulty: 1 Easy Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22

70) Why should the possibility of a repeat order increase a firm's willingness to grant credit? A) The expected cash flow from two orders is twice that from one order. B) The sales rep would earn increased commission. C) The customer can be given more time to pay. D) Payment on the first order increases the chance of payment on subsequent orders. Answer: D Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 71) A revolving line of credit is: A) a secured loan to be amortized over three to five years. B) a one-time short-term, unsecured, amortized loan. C) an agreement allowing the firm to borrow up to a specific total amount on demand from a bank. D) a long-term, permanent source of funding. Answer: C Difficulty: 3 Hard Topic: Credit analysis Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 72) A break-down of accounts receivable according to the length of time outstanding is known as a(n): A) amortization schedule. B) sources of cash flow statement. C) receivables inventory. D) aging schedule. Answer: D Difficulty: 1 Easy Topic: Collection policy Learning Objective: 20-02 Describe the usual steps in a firm's credit management policy. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

73) Check conversion is the process of: A) recording all checks electronically for retention purposes. B) displaying a copy of all your checks on your bank statements. C) debiting your bank account at the point of sale when you pay by check. D) converting a one-time payment into repetitive payments of equal amount. Answer: C Difficulty: 2 Medium Topic: Cash management processes Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) Which type of inventory would a bank be most willing to accept as security for a loan? A) Cabbages growing in a farmer's field B) Produce on the shelves of a grocery store C) An inventory of t-shirts featuring the winners of last month's Superbowl D) Boats owned by a boat dealer Answer: D Difficulty: 2 Medium Topic: Credit terms Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) A primary purpose of restricting the investment of idle cash balances to money market instruments is to: A) obtain government guarantees on the investment. B) minimize transaction costs. C) minimize interest-rate risk. D) maximize possible capital appreciation. Answer: C Difficulty: 1 Easy Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

76) A firm's inventory and accounts payable periods are 80 and 42 days, respectively. If the cash cycle is 65 days, what is the firm's receivable period? A) 103 days B) 57 days C) 38 days D) 27 days Answer: D Explanation: Cash cycle = 65 = A / R period + 80 − 42; A / R period = 27 days Difficulty: 2 Medium Topic: Cash cycle Learning Objective: 20-01 Understand why firms need to invest in working capital. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 77) The longer the firm's accounts payable period, the: A) longer the firm's cash cycle. B) greater the delay in the accounts receivable period. C) less the firm must invest in net working capital. D) shorter the firm's inventory period. Answer: C Difficulty: 1 Easy Topic: Cash cycle Learning Objective: 20-01 Understand why firms need to invest in working capital. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 78) Commercial paper is unsecured. Therefore, the companies that issue this short-term security: A) are typically large firms with top credit quality. B) frequently default. C) are typically small firms with top credit quality. D) are firms that have government-sponsored guarantees for the debt. Answer: A Difficulty: 1 Easy Topic: Credit terms Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

79) Which one of the following is not a carrying cost to holding inventory? A) Risk of being short of inventory and unable to satisfy orders B) Lost interest on funds tied up in inventory C) Spoilage D) Possible obsolescence Answer: A Difficulty: 1 Easy Topic: Inventory management. Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 80) A firm is considering a one-time sale of $100,000 to a customer. The cost of goods sold for this sale is $90,000. If the probability of the customer paying is 0.8, what is the expected profit from this transaction? A) $0 B) −$10,000 C) +$8,000 D) +$10,000 Answer: B Explanation: Expected profit = 0.8($100,000 − 90,000) − (1 − 0.8)($90,000) = −$10,000 Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 81) What is the break-even probability of collection when the present value of revenues from a sale is $100,000 and the present value of cost is $87,000? A) 1.00 B) 0.87 C) 0.74 D) 0.13 Answer: B Explanation: p = $87,000 / $100,000 = 0.87 Difficulty: 2 Medium Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 26

82) A firm with probability of default. A) a high B) an average C) a low D) a zero

_ profit margin is best situated to extend credit to customers with a high

Answer: A Difficulty: 1 Easy Topic: Credit policy Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 83) Term loans: A) may be parceled out among a syndicate of banks. B) are commonly self-liquidating. C) are traded on the New York Stock Exchange are traded on the New York Stock Exchange. D) are commonly repaid within 270 days. Answer: A Difficulty: 2 Medium Topic: Credit analysis Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

84) What is the annual gain to a firm with daily sales of $30,000 if it can speed up collections by 3 days, assuming an annual opportunity cost of funds of 8%? A) $2,400 gain B) $7,200 gain C) $30,000 gain D) $90,000 gain Answer: B Explanation: Float is reduced by $90,000. If invested at 8% a year, gain = $90,000 × 0.08 = $7,200 Difficulty: 2 Medium Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 85) Which one of these is not a characteristic of a concentration system of collections? A) All surplus funds are electronically transferred to a centralized account. B) Check clearing times are increased. C) Customer payments are directed to a local collection center. D) Collection time is reduced. Answer: B Difficulty: 1 Easy Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

86) The Canine Kennel uses 600 cases of dog food annually and orders 40 cases in each shipment. The annual carrying cost per case is $5 and the economic order quantity is 25 cases. Which one of these statements best applies to this situation? A) The current annual ordering costs exceed $5 per case. B) The firm needs to increase its average inventory level of dog food. C) The current annual ordering costs are less than the carrying costs. D) The firm needs to reduce the number of orders placed per year. Answer: C Explanation: At 40 cases per order, the size of the order exceeds the EOQ of 25 cases. This means the carrying costs are larger than the order costs. See Figure 20.7 in the text. Difficulty: 1 Easy Topic: Inventory management.; Economic order quantity (EOQ) model Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) The Automated Clearing House (ACH) A) arranges for checks to be cleared. B) serves as an accounting system for credit cards. C) provides a mechanism for banks to transfer money directly to a firms' suppliers or employees. D) is a system for making large-value international cash payments. Answer: C Difficulty: 2 Medium Topic: Cash management processes Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

88) Potential savings from a lock-box system will be reduced by: A) the additional processing time required. B) the additional mailing time required. C) local bank charges. D) an increase in interest rates. Answer: C Difficulty: 1 Easy Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) Which one of the following conditions would make a lock-box system potentially more attractive to a firm? A) Decline in interest rates B) A 2-day reduction in mail time rather than a 3-day reduction C) Larger payments D) Slower processing time Answer: C Difficulty: 1 Easy Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

90) How much money can be saved annually by setting up a lock-box system that will process 500 checks per day at a cost of $0.15 per check if each check averages $220, collection float is reduced by 3 days, and the annual interest rate is 8%? (Use a 365-day year.) A) −$2,125 B) −$975 C) $2,650 D) $26,325 Answer: B Explanation: Annual savings = (500 × $220 × 3 × 0.08) − (500 × $0.15 × 365) = −$975 Difficulty: 2 Medium Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 91) Which one of the following is not an inventory carrying cost? A) Insurance expense for the inventory B) Opportunity cost of capital for inventory investment C) Cost of buying raw materials D) Cost of shelf space Answer: C Difficulty: 1 Easy Topic: Inventory management.; Inventory costs Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

92) A 6-month Treasury bill sells at a discount of 1%. What is the effective annual interest rate? A) 0.85% B) 1.01% C) 1.52% D) 2.03% Answer: B Explanation: Price of bill = 100 − 1 / 2 = 99.5 Annual interest rate = (100 / 99.5)2 − 1 = 0.0101 Difficulty: 2 Medium Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 93) If the marginal order cost exceeds the marginal carrying cost of inventory, then the firm: A) has minimized its total carrying costs. B) should increase its order size. C) should decrease its order size. D) has maximized its order costs. Answer: B Difficulty: 1 Easy Topic: Economic order quantity (EOQ) model; Inventory costs Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

94) Assume a firm can either hold cash paying no interest or invest in marketable securities. Which one of the following might induce the manager to hold higher cash balances today? A) The cost of borrowing is high relative to interest rates on marketable securities. B) Future cash flows are relatively predictable. C) The cost of cash balances is relatively high. D) Bank interest rates are expected to decrease. Answer: A Difficulty: 2 Medium Topic: Cash management general Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 95) Which of the following is not a money market instrument? A) U.S. Treasury bill with 91 days until maturity B) Commercial paper with 180 days until maturity C) 5-year Treasury bond D) A repurchase agreement, backed by U.S. government securities, with a 1-week maturity Answer: C Difficulty: 1 Easy Topic: Money market securities Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments.; 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 96) Which one of the following statements is true of repurchase agreements? A) Their initial maturity is greater than 1 year. B) They are an unsecured form of borrowing. C) U.S. Treasury securities serve as their collateral. D) They make explicit, rather than implicit, interest payments. Answer: C Difficulty: 1 Easy Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33

97) Which of the following statements is false? A) Optimal inventory levels involve a trade-off between carrying costs and order costs. B) Carrying costs include the cost of storing goods as well as the cost of capital tied up in inventory. C) Optimal inventory levels are lower when storage or interest costs are high and are higher when restocking costs are high. D) Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal inventory level rises, but more than proportionately. Answer: D Difficulty: 2 Medium Topic: Inventory management. Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 98) How much value would be added to a firm that could permanently reduce its cash collection period by 2 days if daily collections average $10,000 and the opportunity cost is 5% annually? A) $1,000 B) $1,200 C) $10,000 D) $20,000 Answer: D Explanation: PV of daily interest = [$10,000 × 2 × (0.05 / 365)] / (0.05 / 365) = $20,000 Difficulty: 3 Hard Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

99) Which of the following is not an advantage of wire transfer systems? A) makes record-keeping easier to automate. B) allows individuals to pay for goods when travelling abroad. C) can ensure that payments arrive exactly on time. D) very low cost to additional transactions. Answer: B Difficulty: 2 Medium Topic: Cash management processes Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 100) By using a lock box system, a firm is able to reduce its float by 3 days. Given an annual interest rate of 3% and annual collections of $350 million, what is the projected annual interest earned by using the lock box? A) $66,303 B) $76,409 C) $86,301 D) $90,568 Answer: C Explanation: Interest earned = (0.03/365) x 3 x $350 mil = $86,301 Difficulty: 2 Medium Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

101) A 3-month Treasury bill sells at a discount of 0.75%. What is the effective annual interest rate in basis points? A) 75.00 bps B) 75.15 bps C) 75.25 bps D) 75.35 bps Answer: D Explanation: Price of bill = 100 − 0.75 / 4 = 99.8125 Annual interest rate = (100 / 99.8125)4 − 1 = 0.007535 or 75.35 basis points Difficulty: 2 Medium Topic: Money market securities Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 102) A firm's annual opportunity cost of capital is 6%. By use of a lock box they can reduce their cash collection period by 3 days. If daily collections are $20,000 what is the PV of their lock box? A) $60,000 B) $50,000 C) $40,000 D) $30,000 Answer: A Explanation: PV of daily interest = [$20,000 × 3 × (0.06 / 365)] / (0.06 / 365) = $60,000 Difficulty: 3 Hard Topic: Cash collections management Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 21 Mergers, Acquisitions, and Corporate Control 1) When a firm is taken over, its management is usually replaced. Answer: TRUE Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Takeovers are often described as part of a broader market for corporate control. Answer: TRUE Difficulty: 2 Medium Topic: Motives for mergers and acquisitions Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) A vertical merger is one between firms at different levels of the production process. Answer: TRUE Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 4) Instead of selling part of its operations, companies sometimes spin off a business by separating it from the parent firm and distributing to its shareholders the stock in the newly independent company. Answer: TRUE Difficulty: 2 Medium Topic: Divestitures and restructurings Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 1

5) Allergan's sale of its generic drug business to Teva Pharmaceutical was an example of a divestiture. Answer: TRUE Difficulty: 1 Easy Topic: Divestitures and restructurings Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 6) Carve-outs and spin-offs both provide shares of the new firm to the divesting firm's shareholders. Answer: FALSE Difficulty: 1 Easy Topic: Divestitures and restructurings Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 7) If a segment of a business is unrelated to the rest of the firm's activities, that segment is more likely to be spun off or carved out. Answer: TRUE Difficulty: 1 Easy Topic: Divestitures and restructurings Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 8) Changing management is the only reason that firms make acquisitions. Answer: FALSE Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

9) A merger must have the approval of at least 51% of the shareholders of each firm. Answer: FALSE Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 10) The expected savings from merging two banks often come from consolidating operations and eliminating redundant costs. Answer: TRUE Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) A conglomerate merger is defined as the merger of two or more Fortune 500 companies. Answer: FALSE Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 12) It is always more efficient to integrate vertically than to outsource part of one's business. Answer: FALSE Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

13) By offering to buy shares directly from a target's shareholders, the acquiring firm can bypass the target firm's management altogether. Answer: TRUE Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) Vertical integration makes sense when two firms are highly dependent upon each other. Answer: TRUE Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 15) Evidence shows that investors will generally pay a premium for diversified firms. That is a good reason for firms to merge. Answer: FALSE Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 16) If a merger creates synergy, then the two firms are worth more together than apart. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

17) Target firms frequently deter potential bidders by devising poison pills, which make the company unappetizing. Answer: TRUE Difficulty: 1 Easy Topic: Defensive tactics Learning Objective: 21-04 Describe takeover defenses. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 18) Strictly speaking, the purchase of the stock or assets of another firm is an acquisition. Answer: TRUE Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 19) A typical poison pill may give existing shareholders the right to buy the company's shares at half price as soon as a bidder acquires more than 15% of the shares. The bidder is not entitled to the discount. Answer: TRUE Difficulty: 1 Easy Topic: Defensive tactics Learning Objective: 21-04 Describe takeover defenses. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 20) Firm A's shareholders will be better off with a stock offer than with a cash offer if A makestoo generous of an offer for Firm B. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5

21) The Williams Act in addition to state laws sets forth the rules for tender offers. Answer: TRUE Difficulty: 2 Medium Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 22) Economies of vertical integration are one possible source of synergy in mergers. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) Contrary to logic, firms that enjoy complementary resources in the production process are rarely good candidates for merger. Answer: FALSE Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) An economic gain is derived from mergers when two firms are worth more combined than separate. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

25) Amendments to the corporate charter that attempt to circumvent mergers are known as poison pills. Answer: FALSE Difficulty: 1 Easy Topic: Defensive tactics Learning Objective: 21-04 Describe takeover defenses. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 26) On average, stockholders in target firms earn higher returns from mergers than the acquiring firm's stockholders. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 27) If investors believe a firm may be acquired, its market value is likely to be higher than its stand-alone value. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) Management buyouts are generally all-equity financed by the new shareholders. Answer: FALSE Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-05 Explain some of the motivations for leveraged and management buyouts. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

29) Tax inversion refers to the fact that mergers often result in extra capital gains taxes for shareholders. Answer: FALSE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 30) One motive for acquiring a firm is to stop wastage of the target firm's cash reserves. Answer: TRUE Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) The 1980s were a time of little merger activity. Answer: FALSE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 32) In general, shareholders of the target firm benefit from takeovers. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

33) Leveraged buyouts are acquisitions where a large fraction of the purchase price is financed with debt. Answer: TRUE Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 34) The value of the target firm's bonds tend to decrease when a leveraged buyout is announced. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35) The free-cash-flow theory supports the notion that the market gain from an LBO is basically the present value of the firm's future cash flows that would otherwise have been wasted. Answer: TRUE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) Only the U.S. has antitrust laws that can affect mergers and acquisitions. Answer: FALSE Difficulty: 2 Medium Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

37) In a merger the acquiring firm buys only the debt of the target firm. Answer: FALSE Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 38) It is easier for individual investors to diversify their risk by buying shares in different firms than for the firms to combine their operations. Answer: TRUE Difficulty: 2 Medium Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) In mergers financed by cash, the merger cost is not affected by the size of the merger gain. Answer: TRUE Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) A territorial tax system is an incentive for a company to pursue a tax inversion based merger. Answer: FALSE Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

41) When shareholders attempt to garner additional votes in an attempt to oust management, it is called a: A) management buyout. B) tender offer. C) proxy contest. D) poison pill. Answer: C Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 42) When one firm merges with another, the: A) boards of directors will merge also. B) merger must be approved by 75% of the shareholders of the target firm. C) assets will be merged but the liabilities will not. D) target firm will cease to exist as a separate public company. Answer: D Difficulty: 2 Medium Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 43) A tender offer is one in which the firm's: A) management offers to sell the company to an acquirer. B) board of directors offers to sell the company to the public. C) shareholders are given the opportunity to sell their shares to a would-be acquirer. D) management offers to buy all outstanding shares of the corporation. Answer: C Difficulty: 2 Medium Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

44) When an outside group acquires a firm, primarily through the use of borrowed funds, the acquisition is known as a: A) management buyout. B) tender offer. C) leveraged buyout. D) successful proxy fight. Answer: C Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 45) When a firm's management takes the firm private with the aid of substantial debt, it is known as a management: A) tender offer. B) greenmail offer. C) buyout. D) hostile takeover. Answer: C Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 46) A spinoff is an action in which: A) the management bids for and acquires the firm. B) one firm issues stock to acquire another firm. C) successful product lines are sold to competitors. D) a portion of the firm's assets is sold off to form a new company. Answer: D Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 12

47) If an automobile manufacturer were to acquire one of the firms listed below, which acquisition would be called a horizontal merger? A) A steel mill B) A rival manufacturer C) A tire producer D) A bank Answer: B Difficulty: 2 Medium Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) If Snapper Lawnmowers were to acquire Briggs and Stratton (gasoline-powered engines), the merger would be classified as a: A) conglomerate. B) leveraged buyout. C) horizontal merger. D) vertical merger. Answer: D Difficulty: 2 Medium Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 49) A conglomerate merger occurs when: A) both partners are large in size. B) large synergies are expected to develop. C) firms from different industries merge. D) both management teams remain intact after the merger. Answer: C Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

50) Mergers may provide reductions in average production cost as a result of: A) increased market price. B) increased financing. C) economies of scale. D) diversification. Answer: C Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) Which one of the following might you recommend to a firm with excessive free cash flow? A) Acquire a firm to diversify B) Acquire a firm to bootstrap earnings C) A leveraged buyout D) A repurchase of shares Answer: D Difficulty: 2 Medium Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) Diversification is often a poor motive for mergers because: A) vertical integration is rarely successful. B) investors can diversify on their own account. C) it does not produce economies of scale. D) the increase in taxes overcomes any gains in earnings. Answer: B Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) One indication that investors expect no synergy from a merger would be that the: A) total market value of the merged firms does not change. B) P/E ratio of the merged firms' changes. C) acquiring firm financed the merger with cash. D) merged firms are from different industries. Answer: A Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) An increase in earnings per share may be increased by a merger if the: A) number of shares has increased. B) price of the acquirer's stock increases. C) acquirer's P/E ratio is higher than that of the target. D) firm's additional earnings are spent on legal expenses of the merger. Answer: C Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) The cost of a merger may outweigh the potential gain if the: A) present value of the acquired firm exceeds the price paid for it. B) present value of the merged firms is greater than the sum of their individual values. C) merger allows cost savings to occur. D) acquired firm's shareholders receive more than the value of their firm. Answer: D Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

56) Firm B's 1 million shares of stock currently sell for $12 each, but firm A is preparing a tender offer of $18 per share. Firm A estimates the NPV of the merger to be $5 million. What percentage of the merger gains will be captured by firm B's stockholders? A) 33.33% B) 50.00% C) 66.67% D) 54.55% Answer: D Explanation: Firm B % of gain = [($18 − $12) × 1m] / {[($18 − 12) × 1m] + $5m} = 0.5455, or 54.55% Difficulty: 3 Hard Topic: Merger and acquisition analysis Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 57) The cost of a merger equals the: A) cash paid for the target firm. B) increase in total earnings minus the price paid. C) premium paid over the target's value as a separate entity. D) sum of cash and stock paid for the target firm. Answer: C Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

58) ABC Corp. has offered 1 million shares having a total market value of $8 million for XYZ. After the merger is announced, shares in ABC trade for $7 each. If ABC is confident about XYZ's value, then the cost of the merger: A) increased by $1 million. B) decreased by $1 million. C) increased by $9 million. D) remained constant. Answer: B Explanation: Preannouncement: Cost of merger = ($8 × 1m) − Value of acquired firm Post announcement: Cost of merger = ($7 × 1m) − Value of acquired firm Difference = ($7 − 8) × 1m = −$1m Since the value of XYZ is assumed constant, the cost of the merger has decreased by $1 million. Difficulty: 3 Hard Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 59) In the case of a merger that is stock financed, the merger cost may change if the: A) value of the target firm's shares changes after the merger announcement. B) value of the acquiring firm's shares changes after the merger announcement. C) long-term interest rates increase. D) merger is either horizontal or vertical. Answer: B Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

60) The shareholders of firm A have offered 1 million shares valued at $10 each to acquire firm B. After the merger is announced, stock A trades for $9 per share. Which of the following statements is false? A) Firm A appears to have overbid for firm B. B) The NPV of the merger may differ from expectations. C) Shareholders of firm A absorb all the additional "cost." D) Firm A's stockholders are better off than if the merger were cash financed for $10 million. Answer: C Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 61) Large-scale efforts to make a firm less appealing in the midst of a potential merger are known as: A) proxy fights. B) leveraged buyouts. C) shark attractants. D) poison pills. Answer: D Difficulty: 1 Easy Topic: Defensive tactics Learning Objective: 21-04 Describe takeover defenses. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 62) Other things equal, which one of the following groups of stakeholders often lose value as a result of an LBO? A) Selling stockholders B) Buying stockholders C) Pre-LBO bondholders D) Investment bankers Answer: C Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) The free-cash-flow theory of takeovers predicts that firms: A) without free cash flow will become the most common LBOs. B) with free cash flow will continue to be the acquirers. C) with excess cash do not have a tendency to use it wisely. D) with excess cash tend to have the most carve-outs. Answer: C Difficulty: 2 Medium Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) A change to the corporate charter that requires that any merger must be approved by a supermajority of shareholders is known as: A) an LBO. B) a proxy contest. C) a carve-out. D) a shark-repellent. Answer: D Difficulty: 1 Easy Topic: Defensive tactics Learning Objective: 21-04 Describe takeover defenses. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 65) Which of the following is not a mechanism for changing a firm's management? A) A proxy contest B) A leveraged buyout C) A poison pill D) A takeover Answer: C Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

66) Proxy fights generally occur when a group is trying to: A) rewrite the corporate charter. B) bring about economies of scale. C) replace the current board and management team. D) pursue a public tender offer. Answer: C Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) One of the reasons why proxy fights are often unsuccessful is that: A) management is always viewed as performing its job well. B) management can use corporate resources to defend against the fight. C) mergers are a cheaper form of changing management. D) shareholders are unconcerned with corporate management. Answer: B Difficulty: 1 Easy Topic: Shareholder voting Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 68) Which one of the following is false concerning a proposed merger of firms? A) The acquired firm will cease to exist. B) Shareholders of the acquired firm may receive securities in the acquiring firm. C) Mergers are sometimes combinations of equals. D) Shareholder approval to merge is not required. Answer: D Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

69) A public offer to purchase the shares of existing stockholders in order to take the firm over is called a: A) tender offer. B) carve-out. C) spin-off. D) divestiture. Answer: A Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 70) When a management team buys the firm from current shareholders while continuing to manage and often incurring large segments of debt, it is known as a: A) management buyout. B) spin-off. C) successful greenmail attempt. D) corporate breakup. Answer: A Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

71) If Georgia Pacific (lumber products) were to acquire a national homebuilding firm, the combination would be termed a: A) horizontal merger. B) vertical merger. C) conglomerate merger. D) spin-off by the national homebuilding firm. Answer: B Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 72) Which one of the following is least likely to provide a motivation for vertical integration? A) A continuous source of raw materials B) A desire to spread fixed costs across more output C) Access to an efficient distribution channel D) Acquisition of an established customer base Answer: B Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) Cash-rich firms often make questionable acquisitions, rather than pay out the cash to shareholders. This: A) is because diversification is too costly for individuals. B) is an example of an agency problem. C) is because diversification eliminates inefficiencies. D) is an example of the bootstrap game. Answer: B Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

74) Firms with substantial amounts of free cash flow often discover that: A) conglomerate mergers are the best use for the funds. B) accounting profits are what truly matter. C) they have become takeover targets. D) their capital budgets have been too low. Answer: C Difficulty: 1 Easy Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 75) The "Bootstrap Game" is played somewhat in defiance of traditional merger logic in that it: A) provides immediate benefit through improved management. B) does not offer a positive NPV from the merger. C) stays in effect only until EPS are increased. D) does not require the approval of a majority of shareholders. Answer: B Difficulty: 2 Medium Topic: Motives for mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) Mergers that attempt to bootstrap earnings may obtain increased current earnings per share at the expense of: A) a higher price-earnings ratio. B) higher total combined market value. C) reduced future growth prospects. D) increased free cash flow. Answer: C Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

77) Firms that are acquired to take advantage of bootstrapping often have: A) a lower price-earnings ratio than the acquirer. B) a higher price-earnings ratio than the acquirer. C) more outstanding shares than the acquirer. D) a higher market valuation than the acquirer. Answer: A Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 78) If two merged firms are shown to have a higher combined market value than the sum of their individual market values, then: A) there are economic gains. B) the firms were previously underpriced. C) the merger provides diversification to investors. D) there is no cost involved in the merger. Answer: A Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 79) If the shareholders of an acquired firm capture all of the merger's gain, then the: A) cost of the merger is zero. B) NPV of the merger is zero. C) EPS will increase. D) acquiring firm retains all merger benefits. Answer: B Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

80) Why is it not sufficient to state that a merger should occur simply because the economic gains are positive? A) Gains are typically of an accounting nature. B) Shareholders of the target firm may capture all of the gains. C) Merger costs should be negative after discounting. D) The merger's gain must also exceed its NPV. Answer: B Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) Firms A and B were each currently worth $50 million but generated a $20 million gain when merged. If the cost of the merger was $5 million, how much did firm A pay for firm B? A) $50 million B) $55 million C) $60 million D) $65 million Answer: B Explanation: Cash paid = $50m + 5m = $55m Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 82) When two firms merge, the value of the acquiring firm will change by the: A) gain from the merger. B) NPV minus the cost of the merger. C) NPV of the merger. D) cost of the merger. Answer: C Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

83) CBA Corp. is worth $15 million as a stand-alone firm. ABC Corp. has offered 350,000 shares valued at $50 each to acquire CBA. After the announcement, however, the price of ABC's shares falls to $45. What was the cost of the merger? A) −$1.75 million B) $0.75 million C) $1.75 million D) $3.25 million Answer: B Explanation: Cost = (350,000 × $45) − $15 million = $0.75 million Difficulty: 3 Hard Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 84) Which one of the following statements is correct concerning the cost of two firms merging? The cost: A) is fixed when the merger is financed with cash. B) can be affected by postmerger gains if cash is used. C) decreases as the postmerger share price increases when stock is used to finance the merger. D) is not determined until after the merger, regardless of the type of financing. Answer: A Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 85) Why might shareholders of an acquiring firm prefer to finance mergers with stock rather than with cash? A) Stock financing is always less costly due to tax consequences. B) The EPS decreases when mergers are financed with cash. C) Target-firm shareholders will bear part of the cost if merger benefits were overestimated. D) All merger gains go to the acquirer when financed with stock. Answer: C Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26

86) Realizing the benefits of a merger is easier when the merging companies have differing: A) computer systems. B) pay structures. C) resources. D) company cultures. Answer: C Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) The most likely interpretation of headlines that read "ABC Corp. adopts shark repellent" is that ABC: A) wants to increase the difficulty of a takeover. B) has made a tender offer for the shares of another firm. C) will merge only with small-sized partners. D) desires to reduce the costs of being acquired. Answer: A Difficulty: 1 Easy Topic: Defensive tactics Learning Objective: 21-04 Describe takeover defenses. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Shares of a corporation can, under certain circumstances, be priced at different amounts to different investors under the terms of a: A) proxy agreement. B) public tender offer. C) poison pill. D) shark repellent. Answer: C Difficulty: 1 Easy Topic: Defensive tactics Learning Objective: 21-04 Describe takeover defenses. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

89) What does empirical evidence suggest about the distribution of gains from mergers? A) Shareholders of the acquired firm gain the most. B) Shareholders of the acquiring firm gain the most. C) Neither group of shareholders is likely to gain. D) Both groups of shareholders gain equally. Answer: A Difficulty: 1 Easy Topic: Real-world studies of mergers and acquisitions Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) What type of financing is typically instrumental in bringing about leveraged buyouts? A) Common-stock financing B) Preferred-stock financing C) Investment-grade bonds D) Speculative-grade bonds Answer: D Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 91) According to the free-cash-flow theory of takeovers, many acquisitions are motivated by: A) an illogical assessment of earnings prospects. B) the remaining costs of the merger. C) the belief that free cash flow will no longer be misused. D) losses experienced by arbitrageurs and other speculators. Answer: C Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

92) Firm B's 1 million shares of stock currently sell for $20 each. Firm A estimates the economic gain from the merger to be $10 million and is prepared to offer $22 cash for each share of B. What percentage of the merger gain will be captured by firm B's shareholders? A) 20.00% B) 33.33% C) 50.00% D) 60.00% Answer: A Explanation: B's % of the gain = [($22 − 20) × 1m] / $10 million = 0.20, or 20% Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 93) XYZ Corp has made a cash tender offer for 2 million shares of ABC Corp. at a price of $20, which is $6 higher than ABC's current stand-alone value. What is the cost of the merger? A) $40 million B) $28 million C) $12 million D) Zero Answer: C Explanation: $6 × 2m = $12m Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

94) A merger is expected to produce cost savings of $50 million and the acquired firm's shareholders will receive a premium of 20% over the $150 million value of their firm. The gain of the merger to the acquirer is: A) $20 million. B) $30 million. C) $50 million. D) $130 million. Answer: A Explanation: GainA = $50 million − ($0.20 × $150m) = $20m Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 95) Which one of the following is not a method of changing the management of a firm? A) Proxy contest B) Merger and acquisition C) LBO D) MBO Answer: D Difficulty: 1 Easy Topic: Mergers, acquisitions, and divestitures Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

96) Which one of the following is correct concerning a spin-off? A) A division of a firm is reconstituted as a new firm. B) An unprofitable division is divested. C) A division of a firm is bought by its managers. D) The spin-off generates no free cash flow. Answer: A Difficulty: 1 Easy Topic: Divestitures and restructurings Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Splitting one firm into four separate firms is an example of a: A) leveraged buyout. B) spin-off. C) management buyout. D) tender offer. Answer: B Difficulty: 1 Easy Topic: Divestitures and restructurings Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 98) The merger between Uptown Bank and Downtown Bank is an example of a: A) vertical merger. B) horizontal merger. C) conglomerate merger. D) direct merger. Answer: B Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

99) If Microsoft were to acquire Dell Computer, it would be an example of a: A) vertical merger. B) horizontal merger. C) conglomerate merger. D) distribution-channel merger. Answer: A Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 100) Conglomerate mergers involve companies in: A) similar lines of business. B) different stages of the corporate life cycle. C) unrelated lines of business. D) different countries. Answer: C Difficulty: 1 Easy Topic: Types of mergers and acquisitions Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 101) A merger adds value by creating synergies. Which one of these is not a possible source of synergy? A) Economies of scale B) Economies of vertical integration C) Combined complementary resources D) Diversification Answer: D Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-01 Explain why it may make sense for companies to merge. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

102) Which one of the following is the most appropriate reason for an acquiring firm's shareholders to prefer using stock financing for acquisitions? A) There is no cash outflow. B) It mitigates the effects of overvaluation of the target firm. C) It mitigates the effects of undervaluation of the target firm. D) It avoids dilution of shares. Answer: B Difficulty: 2 Medium Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 103) Which one of the following statements is correct for a firm that has undergone a leveraged buyout? A) Its shares are no longer traded publicly. B) Its capital is mostly equity financed. C) Its shares are not traded publicly. D) It has a larger shareholder base. Answer: C Difficulty: 2 Medium Topic: Types of mergers and acquisitions Learning Objective: 21-03 Describe ways that companies change their ownership or management. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

104) Empirical studies show that the operating efficiency of firms having undergone a leverage buyout over the following 3 years. A) increases B) decreases C) does not change D) shows no clear trend Answer: A Difficulty: 2 Medium Topic: Real-world studies of mergers and acquisitions Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 105) Kates Café has 2 million shares outstanding at a price of $23 each. Hanks Heaters is preparing a tender offer of $25 per share. Kate estimates the NPV of the merger to be $8 million. What percentage of the merger gains will be captured by Hanks stockholders? A) 33.33% B) 50.00% C) 66.67% D) 54.55% Answer: A Explanation: Hanks % of gain = [($25 − $23) × 2m] / {[($25 − 23) × 2m] + $8m} = 0.3333, or 33.33% Difficulty: 3 Hard Topic: Merger and acquisition analysis Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

106) Kates Café is looking to purchase Hanks Heaters for $20 million. Hanks heaters currently has a market value of $16 million. Kates Café is valued at $35 million and forecasts $3 million of synergies for the merger. What is the likely value of Kates Café if the merger is successful? A) $42 million B) $35 million C) $36 million D) $38 million Answer: A Explanation: Value = 35 + 3 − (16 − 20) = $42 million Difficulty: 3 Hard Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 107) Which of the following is not an example of a shark repellant? A) Rights issue B) Staggered board C) Super majority D) Tender offer Answer: D Difficulty: 1 Easy Topic: Defensive tactics Learning Objective: 21-04 Describe takeover defenses. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 108) Which of the following is NOT a likely basis for considering a cross border inversion merger? A) Lower foreign tax rates B) Domestic taxation on foreign profits C) Lower regulatory burden D) Territorial tax system Answer: D Difficulty: 1 Easy Topic: Merger and acquisition analysis Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 35

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 22 International Financial Management 1) The New York Stock Exchange is one of few markets to have a higher daily volume than the foreign exchange market. Answer: FALSE Difficulty: 1 Easy Topic: Foreign exchange markets Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) The direct exchange rate quotes the number of U.S. dollars that can be exchanged for one unit of a foreign currency. Answer: TRUE Difficulty: 1 Easy Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) The number of pesos that can be purchased with one U.S. dollar is referred to as an indirect quote. Answer: TRUE Difficulty: 1 Easy Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

4) According to interest rate parity, the interest rate differential must be equal to the differential between forward and spot exchange rates. Answer: TRUE Difficulty: 2 Medium Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 5) The international Fisher effect states that nominal interest rates should be equal in all countries. Answer: FALSE Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) The spot rate is $1 = C$1.02. The 3-month forward rate is $1 = C$1.03. The Canadian dollar is selling at a forward premium. Answer: FALSE Difficulty: 2 Medium Topic: Spot and forward rates Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

7) Interest rate parity suggests that it is cheaper to borrow in a currency with a low nominal rate of interest. Answer: FALSE Difficulty: 2 Medium Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8) Transaction risk can usually be identified and hedged. Answer: TRUE Difficulty: 1 Easy Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 9) A U.S. importer of a Japanese product should sell Japanese yen forward to avoid the risk of an appreciation of the yen. Answer: FALSE Difficulty: 2 Medium Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) Interest rate parity tells us that the cost of buying yen forward is exactly the same as the cost of borrowing dollars, buying yen in the spot market, and leaving them on yen deposit. Answer: TRUE Difficulty: 2 Medium Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3

11) Even if a firm neither owes nor is owed foreign currency, it still may be affected by currency fluctuations. Answer: TRUE Difficulty: 1 Easy Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12) You can purchase a futures contract on any currency. Answer: FALSE Difficulty: 2 Medium Topic: Foreign exchange markets Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 13) The forward exchange rate is the rate for immediate exchange of two currencies. Answer: FALSE Difficulty: 1 Easy Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 14) If the yen is trading at a forward discount relative to the dollar, then you'll receive less yen per dollar in the future. Answer: FALSE Difficulty: 1 Easy Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Futures contracts offer an alternative way to buy foreign currency forward.

Answer: TRUE Difficulty: 1 Easy Topic: Foreign exchange markets Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 16) If inflation is expected to be higher in the U.S. than in Mexico, then the peso is forecasted to depreciate against the dollar. Answer: FALSE Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 17) According to the international Fisher effect, the differences in nominal interest rates across countries reflect the differences in their expected rates of inflation. Answer: TRUE Difficulty: 1 Easy Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 18) Forward rates are always equal to the actual future exchange rates. Answer: FALSE Difficulty: 1 Easy Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 19) Forward contracts are standardized contracts sold in organized exchanges. Answer: FALSE 5

Difficulty: 1 Easy Topic: Foreign exchange markets Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 20) The law of one price implies that when converted into the same currency a commodity should sell at the same price in all countries. Answer: TRUE Difficulty: 1 Easy Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 21) The nominal interest rate is the difference between the real interest rate and inflation. Answer: FALSE Difficulty: 1 Easy Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 22) If the international Fisher effect is valid, then expected real interest rates in all countries should be equal. Answer: TRUE Difficulty: 1 Easy Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 23) Buying currency in the forward market is a common method of hedging currency risk. Answer: TRUE Difficulty: 1 Easy 6

Topic: Hedging with forward contracts Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 24) If real interest rates are different across countries, investors will shift their money into countries with high real interest rates. Answer: TRUE Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 25) An indirect quote is the rate of one unit of foreign currency expressed in U.S. dollars. Answer: FALSE Difficulty: 1 Easy Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 26) If the interest rate in one country increases, then the value of that country's currency increases in the forward market. Answer: FALSE Difficulty: 1 Easy Topic: Spot and forward rates Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) If the USD is trading at a forward premium relative to the Euro, we should expect goods to be more expensive for holders of USDs in the future. Answer: FALSE Difficulty: 1 Easy 7

Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) High inflation rates are usually associated with: A) low nominal interest rates. B) high nominal interest rates. C) high real interest rates. D) low real interest rates. Answer: B Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 29) If the international Fisher effect holds, what will be the effect of an increase of a country's nominal interest rates on the country's currency? A) The currency will appreciate. B) The currency will depreciate. C) There will be no significant change in the currency's value. D) The currency will sell at a forward premium. Answer: B Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

30) If purchasing power parity holds, what will happen to the currency of a country with high inflation? A) The currency will appreciate. B) The currency will depreciate. C) There will be no significant change in the currency's value. D) The currency will sell at a forward premium. Answer: B Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) You can value overseas investments using the NPV of the cash flows. Which of the following adjustment is necessary to calculate the NPV? A) Adjust the cost of capital by the forward exchange rate and then discount the foreign cash flows B) Convert the foreign cash flows into domestic currency and use the domestic opportunity cost of capital for discounting C) Use the domestic discount rate to discount the foreign cash flows D) Convert the foreign cash flow into domestic currency and use the foreign cost of capital for discounting Answer: B Difficulty: 2 Medium Topic: International capital budgeting Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

32) If the exchange rate of euros/U.S. dollars is USD1.351 = EUR1, then: A) it takes 1.35 euros to buy one US dollar. B) the euro is worth less than one U.S. dollar. C) one dollar is worth approximately €.74. D) one dollar is worth approximately €1. Answer: C Difficulty: 1 Easy Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33) How many dollars will it take for a U.S. citizen to purchase a Japanese product priced at 60,000 yen if the indirect exchange rate is JPY104 = USD1? A) $577 B) $700 C) $5,769 D) $62,400 Answer: A Explanation: 60,000¥ × ($ / 104¥) = $577 Difficulty: 1 Easy Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

34) If the Yen is trading at a spot price of 111 yen to 1 USD and the 1 year forward rate is 115 yen to 1 USD? What is the premium or discount of the Yen, relative to the USD? A) 3.48% discount B) 3.48% premium C) 3.60% discount D) 3.60% premium Answer: C Explanation: Discount = (115−111) / 111 = 0.036 Difficulty: 2 Medium Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 35) Country A has a higher inflation rate than Country B. In this case Country A will have the: A) a depreciating currency. B) higher nominal interest rate. C) an appreciating currency. D) higher real interest rate. Answer: A Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

36) A sandwich costs $6.79 in the U.S. The exchange rate is CAD0.98 = USD1 dollar. What does the identical sandwich have to cost in Canada for the law of one price to exist? A) C$6.93 B) C$6.79 C) C$6.65 D) C$6.86 Answer: C Explanation: $6.79 × (C$0.98 / $1) = C$6.65 Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 37) Suppose the spot rate for the Canadian dollar is CAD1.034 = USD1, the 3-month forward rate is CAD1.036 = USD1, and the 1-year forward rate is CADS1.039. = USD1. If no other information is available, what will be your guess about the spot rate in 1 year? A) 1.034 B) 1.036 C) 1.039 D) 1.037 Answer: C Difficulty: 1 Easy Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

38) Suppose that the spot exchange rates against the US dollar are:

SEK9.3924 = USD1 CHF1.5231 = USD1 JPY123.380 = USD1

What rate do you think a Japanese bank would quote for exchanging Swiss francs into Swedish krone? A) SEK6.167 = CHF1 B) SEK0.162 = CHF1 C) SEK13.136 = CHF1 D) SEK1 = CHF1 Answer: A Explanation: Cross-rate = SEK9.3924 = CHF1.5231 SEK6.167 = CHF1 Difficulty: 2 Medium Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

39) Suppose that a bank quotes the following rates:

JPY 58.00 = CHF1 CHF1.52 = USD1 JPY123.38 = USD1

Which of the following transactions would produce an arbitrage profit for a US investor? A) Buy 123.38 yen, exchange them for Swiss francs and sell the Swiss francs that you receive. B) Buy 1.52 Swiss francs, exchange them for Japanese yen and sell the yen that you receive. C) Buy both Japanese yen and Swiss francs. D) There are no transactions that would not involve at least some risk. Answer: A Explanation: $1 buys 123.38 yen, which can be converted into 123.38 / 58.00 = 2.127 francs, which in turn buys 2.127 / 1.52 = $1.40. Difficulty: 3 Hard Topic: Triangular arbitrage Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 40) Suppose the 1-year interest rate in Canada is 4% while it is 3% in the U.S. The indirect spot rate is CAD1.02 = USD1. What is the indirect 1-year forward rate? A) CAD1.0299 = USD1 B) CAD1.0608 = USD1 C) CAD1.0200 = USD1 D) CAD1.0302 = USD1 Answer: A Explanation: 1-year forward rate = C$1.02 × (1.04 / 1.03) = C$1.0299 Difficulty: 2 Medium Topic: Spot and forward rates Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

41) If the direct exchange rate between U.S. dollars and pounds sterling is USD1.50 = GBP1, how much should you be willing to pay to receive £350? A) $175.00 B) $233.33 C) $367.50 D) $525.00 Answer: D Explanation: ₤350 × 1.50 = $525.00 Difficulty: 2 Medium Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 42) The main purpose in contracting to purchase foreign currency in the forward market is to: A) earn a premium on the exchange. B) lock into a future currency price now. C) take advantage of future price reductions. D) avoid the more expensive spot rates. Answer: B Difficulty: 1 Easy Topic: Currency Hedging Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

43) Which one of the following is correct if you have contracted to purchase 1,000 Swiss francs 3 months forward at a rate of CHF1.6 = USD1? A) You pay $625 today for the francs. B) You pay $1,600 today for the francs. C) You pay $625 three months from now for the francs. D) You pay $1,600 three months from now for the francs. Answer: C Explanation: 1,000 / 1.6 = $625 Difficulty: 2 Medium Topic: Currency Hedging Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 44) If the spot exchange rate of Mexican pesos for U.S. dollars is MXN9.8=USD1 and the peso is trading at a forward premium of 3%, then you will receive: A) more than 9.8 pesos per dollar in the future. B) less than 9.8 pesos per dollar in the future. C) 9.83 pesos per dollar in the future. D) 10.09 pesos per dollar in the future. Answer: B Difficulty: 2 Medium Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

45) If the spot exchange rate between euros and dollars is USD1.1=EUR1 before the dollar depreciates by 10%, how many dollars will it take after the depreciation has occurred to pay an invoice of €500? A) $550 B) $611 C) $500 D) $345 Answer: B Explanation: (500 × 1.1) / 0.9 = $611 Difficulty: 2 Medium Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 46) The theory that, when measured in a common currency, the price of a product should be the same in two countries is referred to as the law of: A) exchange rates. B) large numbers. C) spot rates. D) one price. Answer: D Difficulty: 1 Easy Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

47) If prices in the United States rise less rapidly than in Canada, which of the following would be expected according to purchasing power parity? A) The value of the Canadian dollar will decline, relative to the U.S. dollar. B) The value of the U.S. dollar will decline, relative to the Canadian dollar. C) Inflation in the U.S. will exceed inflation in Canada. D) The exchange rate will be unaffected by the price changes. Answer: A Difficulty: 1 Easy Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) If exchange rates adjust to reflect inflation differentials across countries, then: A) the law of one price is wrong. B) spot and forward rates will be equal. C) nominal interest rates will be equal across countries. D) purchasing power parity holds. Answer: D Difficulty: 1 Easy Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

49) Suppose that inflation next year is 8% in Japan and 4% in the United States. If the current spot rate is JPY107 = USD1, what is the expected spot rate at the end of the year? A) JPY102.72 = USD1 B) JPY103.04 = USD1 C) JPY111.12 = USD1 D) JPY111.82 = USD1 Answer: C Explanation: Expected spot rate = 107 × [1.08 / 1.04)] = JPY111.12 = USD1 Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 50) The pound is expected to appreciate by 2% against the dollar. If the expected inflation rate in the United States is 5% and purchasing power parity holds, what is the expected inflation rate in the United Kingdom? A) 1.3% B) 2.9% C) 4.1% D) 7.0% Answer: B Explanation: 1.02 = 1.05 / (1 + UK inflation). UK inflation = 0.029, or 2.9% Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

51) Which one of the following is more likely to be roughly equal across countries? A) Nominal interest rates B) Real interest rates C) Inflation rates D) Forward premium Answer: B Difficulty: 1 Easy Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) The international Fisher effect predicts that differences in nominal interest rates between countries reflect differences in: A) real rates of interest. B) purchasing power parity. C) the standard of living. D) expected inflation. Answer: D Difficulty: 1 Easy Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) Expected inflation in the United States is 6%. What do you expect to happen to prices in Japan, if the nominal interest rate is 10% in the United States and 6% in Japan? A) Expected Japanese inflation is 1.79%. B) Expected Japanese inflation is 2.15%. C) Expected Japanese inflation is 6.22%. D) Expected Japanese inflation is 10.00%. Answer: B Explanation: 1.06 / 1.10 = (1 + Japanese inflation) / 1.06. Japanese inflation = 0.0215, or 2.15% Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 54) Suppose the one-year interest rate in the United States is 7%. What would you expect the interest rate to be in the UK if expected inflation is 4% in the United States and 8% in the UK? A) 5.19% B) 7.93% C) 9.08% D) 11.12% Answer: D Explanation: 1.07 / 1.04 = (1 + r) / 1.08; r = 0.1112, or 11.12% Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

55) You exchange USD100,000 into Hong Kong dollars today at HKD7.8= USD1, earn 7% on your Hong Kong investment, and exchange back into US dollars at a rate of HKD8.0 = USD1. How much wealthier are you as a result? A) $2,600 B) $4,325 C) $6,000 D) $9,744 Answer: B Explanation: ($100,000 × 7.8 × 1.07 / 8) − $100,000 = $4,325 Difficulty: 3 Hard Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 56) If a country's currency trades at a forward premium, interest rate parity would predict that: A) that country will have the higher interest rate. B) that country will have the lower interest rate. C) the two countries will have the same interest rate. D) that country could have a higher or lower interest rate. Answer: B Difficulty: 1 Easy Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

57) Which one of the following is advised when evaluating a capital project in a foreign country if you are concerned about political risk? A) The project should be abandoned until this risk disappears. B) The project's cost of capital rate should be decreased to offset the perceived risk. C) The domestic discount rate should be increased to account for the added risk. D) The project cash flows should be decreased to recognize the possibility of bad outcomes. Answer: D Difficulty: 1 Easy Topic: International capital budgeting Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) Current 1-year interest rates are 4% and 8% in the United States and Spain, respectively. The anticipated inflation in the United States is 2%. If the international Fisher effect holds, what is the expected inflation rate in Spain? A) 4.00% B) 4.04% C) 5.92% D) 6.00% Answer: C Explanation: Inflation in Spain = [1.08 / (1.04 / 1.02)] − 1 = 0.0592, or 5.92% Difficulty: 3 Hard Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

59) If you buy yen forward when the yen is selling at a forward premium, you will get: A) more yen than if you buy yen today on the spot market. B) fewer yen than if you buy yen today on spot market. C) the same number of yen as on the spot market, but with a lower commission. D) the expectation of more yen, but the difference is not locked in. Answer: B Difficulty: 2 Medium Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 60) According to the expectations theory of exchange rates, what change is expected in the future spot exchange rate if the forward rate trades at an 8% discount? A) The spot rate is expected to appreciate by 8%. B) The spot rate is expected to depreciate by 8%. C) The spot rate is expected to depreciate by 4%. D) No change is expected in the spot rate. Answer: A Difficulty: 1 Easy Topic: Spot and forward rates Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 61) If interest rates are higher in Italy than in the United States, US investors can earn a higher expected return by investing in Italian bonds unless the euro is expected to: A) appreciate against the dollar. B) depreciate against the dollar. C) offer a higher real rate of return than the dollar. D) offer a lower real rate of return than the dollar. Answer: B Difficulty: 2 Medium Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

62) You are importing TV sets worth ¥10 million from a Japanese manufacturer, and this amount is payable after 6 months. You can hedge your exchange risk by: A) buying Japanese yen in the forward market. B) selling Japanese yen in the forward market. C) borrowing Japanese yen. D) doing nothing – it is impossible to hedge. Answer: A Difficulty: 1 Easy Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 63) Buckingham plc, a British corporation, owes $1 million due in 2 months. How can Buckingham hedge the exchange risk? A) Sell pounds in the spot market B) Buy pounds in the forward market C) Sell dollars in the spot market D) Buy dollars in the forward market Answer: D Difficulty: 1 Easy Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

64) A firm must make a large future payment in a foreign currency and wants to hedge the associated exchange rate risk. Which one of the following identifies the cost of such a hedge? A) difference between expected and current spot rates B) difference between expected and current forward rates C) difference between the forward premium and the forward discount D) difference between the forward rate and the expected future spot rate Answer: D Difficulty: 2 Medium Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 65) An indirect exchange rate can be converted to a direct exchange rate by: A) dividing the indirect rate by the number of U.S. dollars required to purchase one unit of the other currency. B) dividing the indirect rate by 100. C) multiplying the indirect rate by the spot rate. D) taking the inverse of the indirect rate. Answer: D Difficulty: 1 Easy Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

66) Yesterday the spot exchange rate of yen-to-dollar was JPY105 = USD1. What is today's spot exchange rate if the yen has appreciated 10% against the dollar today? A) JPY94.5 = USD1 B) JPY95.5 = USD1 C) JPY116.7 = USD1 D) JPY105 = USD1 Answer: A Explanation: Today's spot rate = 105 × 0.9 = JPY94.5 = USD1 Difficulty: 2 Medium Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 67) Which one of the following is correct when foreign currency is bought in the forward market? A) A fixed amount is paid when initiating the contract. B) A fixed amount is paid at the end of the contract. C) The amount to be paid is determined and paid at the end of the contract. D) The amount to be paid is determined periodically and paid in installments during the contract. Answer: B Difficulty: 1 Easy Topic: Currency Hedging Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

68) Which one of these is an example of operational hedging? A) Producing goods in a foreign country for sale in the U.S B) Manufacturing goods in the country where they will be sold C) Producing products in one location and distributing them internationally D) Offsetting every spot trade with an opposing forward trade Answer: B Difficulty: 2 Medium Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 69) Today, you purchased 125,000 yen 6-months forward at JPY130 = USD1 per dollar. The spot rate today is JPY128 =USD1. If the yen appreciates by 10% over the next six months, how many dollars must you pay to acquire the 125,000 yen? A) $0 B) $961.54 C) $976.56 D) $1,085.07 Answer: B Explanation: Dollar cost = 125,000 / 130 = $961.54 Difficulty: 2 Medium Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

70) Which of the following is correct when contracting ahead in the forward exchange market? A) At contract close you pay either the forward rate that was contracted or the then-current rate. B) Contracting ahead is always cheaper than waiting to pay spot rates. C) Your cost is locked in from the beginning of the contract, regardless of market changes. D) Paying the spot price is safer than contracting forward. Answer: C Difficulty: 2 Medium Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 71) Consider the following spot exchange rates for the British pound, the Japanese yen, the euro and the Swedish krona: USD1.60 = GBP1, JPY105 = USD1, USD0.625 = EUR1, and SEK6.2 = USD1. If gold sells for $290 per ounce in the United States, which one of the following prices for 1 ounce of gold seems to violate the law of one price? A) £181.25 B) ¥30,450 C) €405 D) kr1,798 Answer: C Explanation: £181.25 × 1.60 = $290 ¥30,450 / 105 = $290 €405 × 0.625 = $253.13 violates the law of one price. kr1,798 / 6.2 = $290 Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

72) Assume you can exchange $1 for either C$1.03 or €0.74. How many Canadian dollars can be acquired with one euro? A) C$0.7622 B) C$1.2900 C) C$1.3919 D) C$0.7184 Answer: C Explanation: 1.03 / 0.74 = C$1.3919 Difficulty: 1 Easy Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 73) According to the theory of purchasing power parity, exchange rates will adjust to offset differences in: A) interest rates across countries. B) forward rates across countries. C) expected inflation rates across countries. D) international Fisher rates. Answer: C Difficulty: 1 Easy Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

74) If purchasing power parity holds, what is the expected German inflation rate, if the US expected inflation rate is 3%, the spot exchange rate is USD0.667= EUR1 and the expected spot rate is USD0.625 = EUR1? A) 2.8% B) 7.1% C) 9.9% D) 11.4% Answer: C Explanation: 1 + expected German inflation = 1.03 × 0.667 / 0.625 = 1.099 Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 75) What would you expect to occur if the expected rate of inflation in the United States is considerably lower than the expected inflation in Germany? A) The expected spot rate of €/$ will decrease. B) The current spot rate of €/$ will increase. C) The dollar should appreciate against the euro. D) The dollar should depreciate against the euro. Answer: C Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

76) What would you expect to be the relationship between real rates of interest in Japan and the United States if inflation is expected to be 3% in Japan and 6% in the United States? A) Japan's real interest rate should be 3% higher than in the United States. B) Japan's real interest rate should be 3% lower than in the United States. C) Japan's real interest rate should be half as high as in the United States. D) Real interest rates should be equal in both countries. Answer: D Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 77) If nominal interest rates are 5% in the United States and 8% in Mexico, you should convert the expected cash flows on your Mexican project into US dollars: A) by assuming that the Mexican peso will appreciate by about 3% a year. B) by assuming that the Mexican peso will depreciate by 8% a year. C) by assuming that the dollar will appreciate by 5% a year. D) by assuming that the Mexican peso will depreciate by about 3% a year. Answer: D Difficulty: 2 Medium Topic: International capital budgeting Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

78) You have the opportunity to invest in the United States at 6% or invest in an equally risky Australian investment that offers 20%. This is too good to be true! The current exchange rate is AUD1.65 = USD1. Which one of the following do you suspect about this 1-year investment? A) Expected inflation is higher in the United States. B) The 1-year forward exchange rate is AUD1.8679 = USD1. C) Real interest rates are higher in the United States. D) The Australian dollar is selling forward at an 8.48% premium relative to the dollar. Answer: B Explanation: Forward rate = 1.65 × 1.20 / 1.06. AUD1.8679 = USD1 Difficulty: 2 Medium Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 79) Which one of these is probably the best means of reducing or offsetting political risk? A) Refusing any foreign government assistance in building the infrastructure required for your foreign operations B) Borrowing money in the country in which you have foreign operations to fund those activities C) Manufacturing a complete product in a foreign country using only resources from that country D) Paying for all foreign operations with cash originating in the home country Answer: B Difficulty: 2 Medium Topic: Political risk Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

80) Which one of the following appears to be a safe assumption when there is no difference between the forward and spot exchange rates between two currencies? A) The countries have equal nominal interest rates. B) The spot rate is expected to change. C) Expected inflation is less than the nominal rate. D) Both currencies are selling at a premium relative to the other. Answer: A Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 81) What is the expected spot rate for Japanese yen one year from now if the current spot rate is JPY106 = USD1 and the yen is selling 1-year forward at JPY114 = USD1? A) JPY78.9 = USD1 B) JPY98.0 = USD1 C) JPY106.0 = USD1 D) JPY114.0 = USD1 Answer: D Difficulty: 1 Easy Topic: Spot and forward rates Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 82) The international Fisher effect is valid in the long run because: A) inflation rates are equal in different countries. B) investors will move their money into countries with high real interest rates. C) investors will move their money into countries with high nominal interest rates. D) investors will move their money into countries with low inflation. Answer: B Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34

83) The spot exchange rate for the Canadian dollar is CAD1.02 = USD1. The 6-month interest rate in the United States is 2.5% and 3.0% in Canada. What is the 6-month forward rate for the Canadian dollar? A) CAD1.005= USD1 B) CAD1.025 = USD1 C) CAD0.985= USD1 D) CAD1.02= USD1 Answer: B Explanation: 6-month forward rate = 1.02 × (1.03 / 1.025) = CAD1.025 = USD1 Difficulty: 2 Medium Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 84) One of the drawbacks of using forward contracts to hedge foreign exchange risk from payables is that the: A) transaction costs in the forward market are high. B) forward rates are always lower than spot rates. C) hedged currency could appreciate during the period. D) hedged currency could depreciate during the period. Answer: D Difficulty: 1 Easy Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) A US firm has a contractual payment of £1 million due in 3 months. Which one of the following actions would incur exchange rate risk? A) Buy pounds now at the current spot rate. B) Buy pounds in 3 months at the current spot rate. C) Contract forward today to buy pounds in 3 months. D) Buy pounds today in the futures market. Answer: B Difficulty: 2 Medium Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 86) Assume the spot exchange rate for the Swiss franc is CHF0.90 = USD1 and the 1-year forward rate is CHF0.871 = USD1. If the 1-year interest rate in the U.S. is 5%, what is the 1-year interest rate in Switzerland? A) 2.00% B) 1.62% C) 1.50% D) 1.33% Answer: B Explanation: Swiss interest rate = 1.05 × 0.871 / 0.9 − 1 = 0.0162, or 1.62% Difficulty: 3 Hard Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

87) What is the cost of hedging a 2 million euro commitment if the spot rate is USD1.60 = EUR1, the forward rate is USD1.55 = EUR1, and the spot rate is not expected to change before payment becomes due? A) $0 B) $25,000 C) $40,323 D) $36,667 Answer: C Explanation: Cost of hedge = cost of buying at the forward price − cost of buying at the expected spot price = 2,000,000 / 1.55 − 2,000,000 / 1.60 = $40,323 Difficulty: 2 Medium Topic: Currency Hedging Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 88) The 2-year interest rate is 6.0% in Mexico and 3.0% in the USA. An American company forecast that its new plant in Mexico will produce a cash flow of 1.3 million pesos in year 2. If the current spot rate is MXN20.0 = USD1, what is the expected dollar cash flow from the plant in year 2? A) $27.54 million. B) $61,373. C) $63,160. D) $1.26 million. Answer: B Explanation: 2-year forward rate = 20 ×(1.06 / 1.03)2 = MXN21.182 = USD1 Expected cash flow = 1.3 million / 21.182 = $61,373 Difficulty: 1 Easy Topic: International capital budgeting Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

89) You have estimated the cash flows in pesos from a project in Switzerland and also the dollarbased cost of capital for the project. To compute the project NPV in dollars, you now need to compute the: A) current spot rate only. B) opportunity cost of capital measured in terms of the foreign currency. C) implied forward exchange rate for each year in which the project has cash flows. D) actual spot rates for each year in which the project has cash flows. Answer: C Difficulty: 2 Medium Topic: International capital budgeting Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) If managers are worried about the political risks involved in an overseas investment, they should probably adjust: A) the discount rate. B) the projected cash flows. C) both the discount rate and the cash flows. D) the exchange rate. Answer: B Difficulty: 1 Easy Topic: International capital budgeting Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

91) If the direct quote for the euro is USD1.35=EUR1, then the indirect quote for the euro is: A) EUR0.51 = USD1. B) EUR0.74 = USD1. C) EUR0.68 = USD1. D) EUR0.65 = USD1. Answer: B Difficulty: 1 Easy Topic: Exchange rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 92) Assume the current spot price is USD1.32 = GBP1 and the 3-month forward rate is USD1.34 = GBP1. Which one of these statements is correct given these rates? A) The pound is selling at a forward premium relative to the dollar. B) The real interest rate in the U.S. is higher than the real rate in the U.K. C) The dollar is expected to appreciate. D) The dollar is selling at a forward premium relative to the pound. Answer: A Difficulty: 2 Medium Topic: Spot and forward rates Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

93) The spot exchange rate for the British pound is USD1.30 = GBP1. The annual inflation rate in the U.S. is 2% compared with 4% in the U.K. What is the anticipated exchange rate at the end of the year if purchasing power parity is valid? A) USD1.28 = GBP1 B) USD1.39 = GBP1 C) USD1.51 = GBP1 D) USD1.63 = GBP1 Answer: A Explanation: Expected exchange rate = 1.30 × 1.02 / 1.04 = 1.28 Difficulty: 2 Medium Topic: Purchasing power parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 94) The current 1-year nominal interest in the United States is 7%. If the anticipated inflation for the coming year in the United States is 2.5%, what is the real interest rate in the U.S.? A) 4.21% B) 4.39% C) 4.50% D) 7.18% Answer: B Explanation: r = 1.07 / 1.025 − 1 = 0.0439, or 4.39% Difficulty: 2 Medium Topic: International Fisher effect Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation

95) The one year forward rate is quoted as 115 yen per 1 USD. The spot rate is quoted as 112 yen per 1 USD. What is the one year interest rate in Japan is the US 1 year interest rate is 3.5%? A) 3.50% B) 4.98% C) 6.27% D) 7.85% Answer: C Explanation: 1 yr Japanese rate = (115 / 112) × (1.035) − 1 = 0.0627 or 6.27% Difficulty: 2 Medium Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 96) You can make a one year $1,000,000 investment in Mexico at an interest rate of 12%. Conversely, you may borrow in the USA at a rate of 4%. If the spot exchange rate is 11 Peso per 1 USD and the one year forward rate is 12 Peso per 1 USD, what profit will you make from such an investment? A) $13,333 profit B) $13,333 loss C) $40,000 profit D) $40,000 loss Answer: B Explanation: Cost of US loan = 1,000,000 × 1.04 = $1,040,000 Value of Mexican investment = (1,000,000 × 11 × 1.12) / 12 = $1,026,667 Profit = 1,026,667 – 1,040,000 = − 13,333 Difficulty: 3 Hard Topic: Interest rate parity Learning Objective: 22-02 Understand the basic relationships among spot exchange rates, forward exchange rates, interest rates, and inflation rates. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 23 Options 1) The seller of a put option is betting that the market value of the stock will decrease. Answer: FALSE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 2) The VIX is an estimate of expected future market volatility. Answer: TRUE Difficulty: 1 Easy Topic: Capital market performance Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) A call option is worthless if the underlying stock is worthless. Answer: TRUE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 4) The lower limit on a call option's value is equal to the greater of zero or the exercise price minus the stock price. Answer: FALSE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

5) A strategy of buying the stock and selling the put is called a protective put. Answer: FALSE Difficulty: 1 Easy Topic: Option types and features Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) The value of a call option increases as the exercise price decreases. Answer: TRUE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 7) The Financial Accounting Standards Board (FASB) requires that companies recognize the fact that employee stock options are valuable and therefore are an expense just like salaries and wages. Answer: TRUE Difficulty: 2 Medium Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 8) The Financial Accounting Standards Board (FASB) stipulates that companies must use an option valuation model to estimate the fair value of any option grants and then deduct this value when calculating profits. Answer: TRUE Difficulty: 1 Easy Topic: Generally Accepted Accounting Principles (GAAP) Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

9) The value of both call and put options increases as the variability of the stock price decreases. Answer: FALSE Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 10) Callable bonds allow the investor to redeem the bond at face value or let the bond remain outstanding until maturity. Answer: FALSE Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) Warrants do not expire. Answer: FALSE Difficulty: 1 Easy Topic: Warrants Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 12) Convertible bonds give the investor the option to acquire the firm's stock in exchange for the value of the underlying bond. Answer: TRUE Difficulty: 1 Easy Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

13) Callable bonds give the call option to the issuing firm and hence reduce the value of the bond. Answer: TRUE Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) The longer the time until expiration of a call option, the lower the value of the option. Answer: FALSE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) Only at the expiration date can an investor expect to find the value of call options above their lower bound. Answer: FALSE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16) Stock price volatility is beneficial to option holders. Answer: TRUE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

17) Unlike call options, the option to abandon a real asset can never be more valuable as time to expiration increases. Answer: FALSE Difficulty: 1 Easy Topic: Capital budgeting options Learning Objective: 23-03 Recognize options in capital investment proposals. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 18) A callable bond gives the issuer a potentially valuable option in the case of changing interest rates. Answer: TRUE Difficulty: 1 Easy Topic: Option combinations Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19) At expiration a call option will have no value if the stock price is less than exercise price. Answer: TRUE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 20) At expiration a put option will have no value if the stock price is less than the exercise price. Answer: FALSE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

21) A protective put is a way to eliminate the downside risk of holding stock. Answer: TRUE Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 22) The value of a call option increases as the exercise price increases. Answer: FALSE Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) When the stock price is very high compared with the exercise price, the value of the call option approximates the difference between the stock price and the present value of the exercise price. Answer: TRUE Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 24) Warrants are long-term call options on a company's stock issued by an organized stock exchange. Answer: FALSE Difficulty: 1 Easy Topic: Warrants Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

25) A warrant is a long-term call option that is always "in the money" at the time of issuance. Answer: FALSE Difficulty: 2 Medium Topic: Warrants Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 26) A callable bond will have a lower value than a straight bond with the same coupon rate and maturity. Answer: TRUE Difficulty: 1 Easy Topic: Option combinations Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 27) The floor of a convertible bond is the value of the underlying bond. Answer: TRUE Difficulty: 1 Easy Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 28) The value of a convertible bond is always less than the value of a straight bond with similar coupon and maturity. Answer: FALSE Difficulty: 1 Easy Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

29) Awarding company executives with warrants as compensation incentivizes them to increase the value of the company's stock price. Answer: TRUE Difficulty: 1 Easy Topic: Warrants Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) The writer of a call option hopes that the stock price will: A) decrease. B) increase. C) split. D) produce quarterly cash dividends. Answer: A Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) Adding warrants as a "sweetener" to bonds will: A) reduce the value of the bond. B) increase the coupon rate of the bond. C) increase the value of the package. D) make the bond riskier. Answer: C Difficulty: 2 Medium Topic: Warrants Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

32) If you own a call and a put on a stock with the same exercise price and exercise date, your payoffs: A) will be positive only if the stock price rises. B) will be positive only if the stock price declines. C) will always be positive and will increase with the size of the stock price change. D) will always be positive but will be larger if the stock price is relatively stable. Answer: C Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 33) Which one of the following is true for the owner of a call option? A) The loss potential is unlimited. B) The profit potential is unlimited. C) The option price exceeds the exercise price. D) There is no expiration date, unless the option is a European call. Answer: B Difficulty: 1 Easy Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) An increase in which one of the following will reduce the value of a call option? A) Interest rate B) Time to expiration C) Volatility of stock price D) Exercise price Answer: D Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

35) What is the difference between an American call option and a European call option? A) The European call has a final exercise date. B) The American call trades only on domestic stocks. C) The European call can be exercised only on one day. D) The American call generates profits regardless of which direction the stock moves. Answer: C Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) What is the option buyer's total profit or loss per share if a call option is purchased for $5, has a $50 exercise price, and the stock is valued at $53 at expiration? A) −$5 B) −$2 C) $3 D) $8 Answer: B Explanation: $53 − 5 − 50 = −$2 Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 37) The maximum possible payoff to the owner of a put options is: A) the stock price. B) the exercise price minus the stock price. C) the option's exercise price. D) there is no maximum. Answer: C Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

38) Which one of the following option traders receives the price of the option? A) Option sellers B) Option buyers C) Both option sellers and buyers D) Neither buyers nor sellers receive the price Answer: A Difficulty: 1 Easy Topic: Option types and features Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) Which one of the following is true for an investor who purchased a share of stock for $45 and purchased a put option on the stock with an exercise price of $45? A) The investor profits when the stock decreases in value. B) The minimum payoff on the position is $45. C) The investor is protected against upside potential. D) Increases in the value of the stock will go to the seller of the put. Answer: B Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) An investor purchased a share of stock for $42 and at the same time paid $2 to purchase a put option on the stock with an exercise price of $40. What is her profit or loss if the stock is worth $30 at expiration? A) $6 B) −$6 C) −$4 D) $4 Answer: C Explanation: $40 − 42 − 2 = −$4 Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

41) Which combination of positions will protect the owner from downside risk? A) Buy the stock and buy a call option B) Sell the stock and buy a call option C) Buy the stock and buy a put option D) Buy the stock and sell a put option Answer: C Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) If you feel strongly that a stock price will move a lot, but are unsure of the direction, you could: A) buy both a put and a call. B) sell both a put and a call. C) buy a put and sell a call. D) buy two puts. Answer: A Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 43) A stock is currently selling for $70 per share. What is the lower limit on the value of a call option with an exercise of $90? A) −$20 B) $0 C) $10 D) $20 Answer: B Explanation: Lower limit on call = max[0,(stock price − exercise price)] = max[0,($70 − 90)] = $0 Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

44) Why does the value of a call option increase as the interest rate increases? A) The stock seller must pay the call owner more interest. B) The present value of the exercise price is reduced. C) As interest rates increase, stock prices increase. D) Interest rate increases reduce the option value. Answer: B Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) Which of the following statements is true of the holder of a call option? A) Option holders pay no income taxes. B) Holders of a call option have restricted profits. C) Option holders do not receive dividends. D) Investors in call options do not have to exercise them and therefore cannot sustain losses. Answer: C Difficulty: 2 Medium Topic: Option types and features Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 46) How much must the stock be worth at expiration in order for the buyer of a call option to break even if the exercise price is $50 and the cost of the call was $4? A) $46 B) $50 C) $52 D) $54 Answer: D Explanation: Break even = $50 + 4 = $54 Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

47) What is the most an investor can lose if sells a call on the firm's stock with an exercise price of $100? A) $100 B) $0 C) $50 D) Unlimited losses Answer: D Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) Which one of the following call options would command the higher price, other things equal? (All months are within the same calendar year.) A) October expiration, $45 exercise price B) December expiration, $40 exercise price C) March expiration, $45 exercise price D) June expiration, $40 exercise price Answer: B Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 49) Put-call parity states that: A) Price of stock + price of call = price of put + PV(exercise price) B) Price of stock + PV(exercise price) = price of call + price of put C) Price of stock + price of put = price of call + PV(exercise price) D) Price of stock = price of put + price of call − exercise price Answer: C Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

50) Executive stock options are issued with the hope that the recipients will: A) sell the shares they currently own thereby diversifying the firm's ownership. B) work to increase the value of the firm's stock. C) never exercise them. D) sell their shares at the option's exercise price. Answer: B Difficulty: 2 Medium Topic: Employee stock options Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) The major difference between options on real assets and options on financial assets is that options on: A) financial assets are costly. B) financial assets have a higher probability of positive payoff. C) real assets are implicit, rather than explicit. D) real assets are not influenced by price volatility. Answer: C Difficulty: 2 Medium Topic: Capital budgeting options Learning Objective: 23-03 Recognize options in capital investment proposals. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 52) The option to abandon a project investing in real assets can be considered to have an exercise price equal to the: A) historical cost of the asset. B) resale value of the asset at abandonment. C) foregone revenues anticipated from the project. D) foregone interest on the bonds used to finance the real assets. Answer: B Difficulty: 2 Medium Topic: Capital budgeting options Learning Objective: 23-03 Recognize options in capital investment proposals. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

53) Investors who hold warrants essentially have a: A) put option on the firm's bonds. B) put option on the firm's equity. C) call option on the firm's bonds. D) call option on the firm's equity. Answer: D Difficulty: 1 Easy Topic: Warrants Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) The conversion ratio for a convertible bond equals the: A) number of interest payments that must be received prior to conversion. B) number of bonds necessary to convert into one share of stock. C) number of shares of stock that can be exchanged for one bond. D) floor value beneath which the bond price cannot fall. Answer: C Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 55) If a $1,000 convertible bond with a market value of $950 has a conversion ratio of 25 when the firm's stock is selling for $36 per share, then: A) the bond will be converted immediately. B) the bond is violating its price floor. C) conversion now would give the investor a profit of $900. D) the conversion value of the bond is $900. Answer: D Explanation: Conversion value = 25 × $36 = $900 Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

56) If a $1,000 convertible bond has a conversion ratio of 50 and the firm's equity is currently selling for $22 per share, then the: A) bond should trade for at least $900. B) bond should trade for at least $1,000. C) bond should trade for at least $1,100. D) firm will have already converted the bond. Answer: C Explanation: Conversion value = 50 × $22 = $1,100 Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 57) Which one of the following conditions will typically be present when a firm calls a bond prior to maturity? A) The firm is in poor financial health. B) Interest rates have risen substantially since the bond was issued. C) Interest rates have fallen substantially since the bond was issued. D) The call option is about to expire. Answer: C Difficulty: 1 Easy Topic: Bond refunding Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 58) The value of a callable bond equals the value of a straight bond: A) plus the value of the bondholder's call option. B) minus the value of the bondholder's call option. C) plus the value of the issuer's call option. D) minus the value of the issuer's call option. Answer: D Difficulty: 2 Medium Topic: Bond valuation Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

59) A 10% convertible bond has a conversion ratio of 25. The firm's common stock is currently selling at $35. If the bond is about to mature, what is its value? A) $875 B) $1,000 C) $1,125 D) $1,875 Answer: B Explanation: Conversion value = 25 × $35 = $875. Investors will prefer to let the bond mature and receive $1,000. Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 60) Which one of the following statements is correct? A) A convertible bond will be worth less than a similar non-convertible bond. B) A callable bond will be worth less than a similar non-callable bond. C) A callable bond will be worth more than a similar convertible bond. D) Warrants are always worth more than convertible bonds. Answer: B Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

61) A put and a call both have the same maturity and both have an exercise price which is equal to the current stock price. The interest rate is 5%. Which option should sell for a higher price? A) the put. B) both should sell for the same price. C) the call. D) can't say without knowing the variability of the stock. Answer: C Explanation: From put-call parity Price of call = price of stock + price of put − PV(exercise price). If the exercise price = the stock price, price of the call is greater than that of the put. Difficulty: 3 Hard Topic: Options Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 62) Which one of the following is correct for the owner of a June call on XYZ Corp. with an exercise price of $60? XYZ Corp. currently trades at $55 and the option at $3. A) XYZ stock will go to $63 per share within the option period. B) The option should be exercised now. C) The option owner's current profit is $3 per share. D) The option may expire without value. Answer: D Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

63) It is May and you own a June call on ABC Corp. with an exercise price of $50. The option trades at $40 and ABC is trading at $86. What should you do? A) Exercise the option now and take the profits. B) Buy the stock of ABC Corp because option traders seem to be optimistic about its prospects. C) Sell your ABC stock before its price declines. D) Sit and wait until the June expiration. Answer: D Difficulty: 2 Medium Topic: Option types and features Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 64) At what point does the value of a call option lie furthest above its lower bound (that is, the maximum of zero or the stock price − exercise price)? A) When the stock price is zero. B) When the stock price is very high relative to the exercise price. C) When the stock price equals the exercise price. D) It depends on the maturity of the option. Answer: C Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 65) You own a September put on CBA Corp. with an exercise price of $80. CBA stock currently trades at $80 and the put at $5. Which of the following is definitely true? A) The option will continue to gain value until its September expiration. B) The owner should exercise now in order to avoid further losses. C) Decreases in the CBA stock price will be translated directly into additional option value. D) $20 is the maximum value for this option. Answer: C Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

66) The buyer of a put option has a(n) to sell the underlying asset and the option seller has a(n) to buy the underlying asset. A) obligation; obligation B) obligation; right C) right; right D) right; obligation Answer: D Difficulty: 1 Easy Topic: Option types and features Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 67) Joe sold a put option on ZZZ Corp. with an exercise price of $40. The option is about to expire and ZZZ stock is currently trading at $28 per share. What is the value of Joe's position? A) $12 B) −$12 C) $8 D) $16 Answer: B Explanation: Value of Joe's Position = $40 − $28 = −$12 Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 68) Maria sold a call option on XXX Corp. with an exercise price of $50. The option is about to expire and stock XXX is currently trading at $40. What is the value of Maria's position? A) −$10 B) $0 C) $7 D) $10 Answer: B Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

69) The payoffs from investing in an option contract are designed so that: A) both the buyer and the seller of the contract will profit. B) the seller's (buyer's) gain is the buyer's (seller's) loss. C) roughly 20% of sellers and 50% of buyers profit. D) there are no profits but there are also no losses. Answer: B Difficulty: 1 Easy Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) Under what circumstance will the buyer of a put option need to fulfill her obligation? A) When the stock price has declined below the exercise price. B) When the stock price has increased above the exercise price. C) The put buyer has an equal obligation regardless of the relationship between stock and exercise prices. D) The put buyer has no obligation. Answer: D Difficulty: 2 Medium Topic: Option types and features Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 71) Which one of the following statements is correct for an investor who has purchased portfolio insurance by owning a stock and buying a put option on that stock? A) The investor profits when the stock price declines. B) Maximum profitability occurs when the stock price equals the exercise price. C) The value of the position can decline no further than the option's exercise price. D) The option will certainly be exercised. Answer: C Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

72) A call option will have the highest value when the stock price is: A) far above the exercise price. B) closest to the exercise price. C) approaching zero. D) less than the exercise price. Answer: A Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) When does a change in the value of a call option come closest to matching the change in the price of the stock? A) When the stock is priced far above the exercise price. B) When the stock is priced far below the exercise price. C) When the stock is priced near zero. D) Changes in call value always come close to matching changes in stock price. Answer: A Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) At what point is the dollar payoff from owning a call option on a stock greater than the payoff from owning the stock itself? A) When stock price exceeds exercise price at expiration. B) When exercise price exceeds stock price at expiration. C) When stock price equals exercise price at expiration. D) Call payoff never exceeds stock payoff. Answer: D Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

75) What is the lower bound on the value of a put option? A) Maximum of zero or exercise price − stock price B) Maximum of zero or stock price − exercise price C) Stock price − exercise price D) Exercise price − stock price Answer: A Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 76) The value of a call option increases as the time to expiration increases because: A) the exercise price continually decreases. B) the opportunity increases for the stock price to exceed the exercise price. C) the dividends accumulate while waiting to be paid. D) the option can be repeatedly exercised. Answer: B Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 77) Stocks that have more volatile price changes have more valuable call options because call holders: A) capture upside potential without additional downside risk. B) realize that volatility decreases the present value of the exercise price. C) have too little variability in the exercise price. D) have transferred all risk to put holders. Answer: A Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

78) Of the following four put options that can be purchased on a stock, which would you expect to have the highest price? (All option months are in the same calendar year.) A) September put; $65 exercise price B) September put; $75 exercise price C) December put; $65 exercise price D) December put; $75 exercise price Answer: D Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 79) A share of stock is currently priced at $20 and will change with equal likelihood to either $40 or $10. A call option with a $20 exercise price is available on the stock. The interest rate is zero. Which of the following positions will provide (approximately) the same payoffs as the option? A) Buy 0.667 shares and lend $6.67 B) Buy 0.667 shares and borrow $6.67 C) Buy 0.5 shares D) Sell 0.667 shares and borrow $0.667 Answer: B Explanation: If share price falls to $10, option is worth $0 and position in share is worth $6.67 − $6.67 = $0 If share price rises to $40, option is worth $20 and position in share is worth 0.667 × $40 − $6.67 = $20 Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

80) Which of the following is not a real option? A) If tanker rates fall, the company can lay up its fleet B) The extra warehouse space allows the company to expand C) The company replaces an ageing machine tool D) If oil prices rise the company can switch to using gas Answer: C Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 81) Real options are: A) options on real assets such as an option to abandon. B) call and put options traded on organized exchanges. C) call options such as warrants and convertible bonds. D) put options such as those held by shareholders of a firm with financial leverage. Answer: A Difficulty: 1 Easy Topic: Capital budgeting options Learning Objective: 23-03 Recognize options in capital investment proposals. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 82) Corporations that attach warrants to their bonds are hoping to: A) repurchase shares of outstanding stock. B) convert the bonds into stock at a later date. C) increase the value of the bonds. D) increase the price of their shares. Answer: C Difficulty: 1 Easy Topic: Warrants Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

83) If a convertible bond can be thought of as a straight bond with a call option, then the call is owned by the , and the exercise price is the . A) debt issuer; stock price B) debt issuer; straight bond value C) bond investor; stock price D) bond investor; straight bond value Answer: D Difficulty: 1 Easy Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) Why should a convertible bond always be valued at more than its bond value or its conversion value up until maturity? A) The bond holder is receiving higher interest rates. B) The holder can decide later whether to own the bond or the stock. C) The conversion ratio may be decreased. D) The bond does not have to be given up to exercise the option. Answer: B Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

85) A 10-year convertible bond has a face value of $1,000, a 9% coupon, and a conversion ratio of 30. The stock is currently priced at $35. If a comparable straight bond would have a yield of 9%, what is the minimum value of the call option provided by the convertible? A) $0 B) $5 C) $50 D) $65 Answer: C Explanation: Bond value = $1,000 because coupon rate = market rate Conversion value = 30 × $35 = $1,050 Value of call = $1,050 − 1,000 = $50 Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 86) Which one of the following is correct? A) There is an upper bound on a callable bond's price. B) Callable bond prices are higher than those of comparable straight bonds. C) The attraction of callable bonds to the issuer increases as interest rates increase. D) The investor in a callable bond owns the call option. Answer: A Difficulty: 2 Medium Topic: Option combinations Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

87) The value of a call option at expiration will be equal to the maximum of zero or the: A) stock price. B) exercise price. C) stock price minus the exercise price. D) exercise price minus the stock price. Answer: C Difficulty: 1 Easy Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Kingston Lisle shares are currently selling at $75. The value of a call option on the company's shares with an exercise price of $60 and several months to expiration is: A) less than $15. B) greater than $15. C) equal to $15. D) zero. Answer: B Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 89) You purchased a call option with an exercise price of $50. If you exercise the option when the stock price is $60, your proceeds will be: A) $10. B) $0. C) $4. D) $16. Answer: A Explanation: $60 − $50 = $10 proceeds Difficulty: 1 Easy Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

90) Three months ago you bought a put option with an exercise price of $100. What is the value of this option at expiration if the stock price is $110? A) $10 B) −$110 C) $0 D) −$10 Answer: C Explanation: Stock price is greater than exercise price, so the put option has zero value. Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 91) A firm is planning to issue a callable bond with a coupon rate of 8% and 10 years to maturity. A straight bond with a similar coupon is priced at $1,000. If the value of the issuer's call option is $60, what is the value of the callable bond? A) $940 B) $970 C) $1,000 D) $1,060 Answer: A Difficulty: 2 Medium Topic: Convertible securities Learning Objective: 23-04 Identify options that are provided in financial securities. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 92) A stock is selling for $85 at the expiration of an option contract. Which of the following options on the stock will most likely be exercised? A) Call option with exercise price of $65 B) Put option with exercise price of $65 C) Call option with exercise price of $85 D) Put option with exercise price of $85 Answer: A Difficulty: 1 Easy Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30

93) Which one of the following changes will reduce the value of a call option? A) An increase in the stock price B) An increase in the exercise price C) An increase in the volatility of the stock price D) An increase in interest rates Answer: B Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 94) An investor who sells a put option profits if: A) stock prices go up. B) stock prices go down. C) the put is exercised. D) interest rates go up. Answer: A Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 95) A call option has an exercise price of $60. When the option expires, the price of the stock is exactly $60. What is the value of your call option? A) $1 B) −$1 C) Zero D) $60 Answer: C Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

96) The value of a put at expiration is defined as the: A) minimum of zero or the stock price minus the exercise price. B) minimum of zero or the exercise price minus the stock price. C) maximum of zero or the stock price minus the exercise price. D) maximum of zero or the exercise price minus the stock price. Answer: D Difficulty: 2 Medium Topic: Option valuation fundamentals Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) You purchased a stock for $36 a share, a call option with an exercise price of $35, and a put option with an exercise price of $34. What will be the value of your position when the options expire if the stock price is $37? A) $39 B) $37 C) $40 D) $2 Answer: A Explanation: Stock value = $37; call value = $2; put value = $0 Difficulty: 3 Hard Topic: Option combinations Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

98) You purchased a stock for $43 a share, sold a call option with an exercise price of $40, and bought a put option with an exercise price of $45. What will be the value of your position when the options expire if the stock price is $48 a share? A) $48 B) $46 C) $56 D) $40 Answer: D Explanation: Stock value = $48: call position = −$8; put position = $0 Difficulty: 3 Hard Topic: Option combinations Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 99) You purchased a stock and a put option on the stock with an exercise prices of $40 a share. What will be the value of your position when the option expires if the stock price is $28 a share? A) $40 B) $28 C) $12 D) $32 Answer: A Explanation: Stock value = $28: put position = $12 Difficulty: 3 Hard Topic: Option combinations Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 100) If you sell a put option, your maximum payoff is equal to: A) The maximum of zero or the stock price − the exercise price. B) The maximum of the exercise price − the stock price or zero. C) zero. D) the exercise price. Answer: C Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 33

101) You pay $4 for a call option with an exercise price of $20. If you exercise the option when the underlying stock is valued at $26, what is your net profit from the investment? A) $2 B) $4 C) $6 D) $8 Answer: A Explanation: Gross profit = 26 − 20 = $6 Net profit = 6 − 4 = $2 Difficulty: 1 Easy Topic: Option valuations and payoffs Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 102) A put option with 70 days until expiration has an exercise price of $30 and the underlying stock currently trades at a price of $27. Which of the following is the most likely option price? A) $1.00 B) $2.00 C) $3.00 D) $4.00 Answer: D Difficulty: 1 Easy Topic: Option valuation fundamentals Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

103) A professional sports franchise has a generous offer to buy their team, but would first like to see if they can negotiate a new city financed stadium before considering the offer. What kind of option would they like to have during the negotiation? A) Abandonment option B) Flexibility option C) Warrant D) Call Answer: A Difficulty: 2 Medium Topic: Option valuations and payoffs Learning Objective: 23-02 Understand the determinants of option values. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Fundamentals of Corporate Finance, 10e (Brealey) Chapter 24 Risk Management 1) The majority of large companies use derivatives in some way to manage their risk. Answer: TRUE Difficulty: 1 Easy Topic: Risk management Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 2) Insurance is often an effective way to reduce risk when the insurance company can spread its risk over many different policies. Answer: TRUE Difficulty: 1 Easy Topic: Risk management Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 3) A swap is an arrangement by two counterparties to exchange one stream of cash flows for another. Answer: TRUE Difficulty: 1 Easy Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 4) A company that hedges simply passes the risk on to someone else. Answer: TRUE Difficulty: 2 Medium Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation

5) Unless the corporation has reason to believe that the odds are stacked in its favor, it should use derivatives for speculation, not for hedging. Answer: FALSE Difficulty: 1 Easy Topic: Hedging Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 6) Futures contracts are custom-tailored forward contracts. Answer: FALSE Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation 7) Properly managed, hedging can be a very profitable activity. Answer: FALSE Difficulty: 2 Medium Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 8) Firms use options to speculate not to reduce risk. Answer: FALSE Difficulty: 1 Easy Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

9) Mexico purchased call options to lock in the price of its oil and create a base floor for its revenue stream. Answer: FALSE Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Communication Accessibility: Keyboard Navigation 10) A firm might enter a swap contract whereby it agrees to make a series of regular payments in one currency in return for receiving a series of payments in another currency. Answer: TRUE Difficulty: 1 Easy Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11) Swap contracts can be based on either interest rates or currencies. Answer: TRUE Difficulty: 2 Medium Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 12) A commodity producer can place a floor on its revenues by selling put options on the commodity. Answer: FALSE Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 3

13) A producer that uses options to reduce downside risk is buying a "protective put." Answer: TRUE Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14) A commodity producer that uses put options to reduce the risk of a fall in commodity prices is effectively buying insurance. Answer: TRUE Difficulty: 1 Easy Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 15) An oil producer would sell, rather than buy, crude oil futures to protect against falling oil prices. Answer: TRUE Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 16) Futures contracts are standardized to expire on the same day each year. Answer: FALSE Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

17) Buyers of financial futures place an order to buy a financial asset at a future date. Answer: TRUE Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 18) Speculators are a necessary component of well-functioning futures markets. Answer: TRUE Difficulty: 1 Easy Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 19) Forward contracts are marked to market. Answer: FALSE Difficulty: 1 Easy Topic: Hedging with forward contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 20) In a typical interest rate swap the two parties will exchange a series of fixed payments for a series of payments that are linked to the level of interest rates. Answer: TRUE Difficulty: 2 Medium Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

21) Hedging may increase a company's debt capacity. Answer: TRUE Difficulty: 1 Easy Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 22) By using options a firm can (at a cost) protect against increases in raw material prices, while continuing to benefit from price decreases. Answer: TRUE Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23) Unlike options, the purchase of a futures contract is a binding obligation to purchase at a fixed price at contract maturity. Answer: TRUE Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 24) The profit to the buyer of a futures contract is equal to the initial futures price minus the ultimate market price. Answer: FALSE Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

25) Investors can hedge against a change in house prices by purchasing real estate futures contracts. Answer: TRUE Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 26) Exchange traded futures contracts allow the seller to choose the place of delivery for the commodity. Answer: FALSE Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 27) Both the seller and the buyer in a futures contract are required to put up margin. Answer: TRUE Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 28) A farmer can avoid delivery on a futures contract by buying an offsetting futures contract. Answer: TRUE Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

29) Companies should always leave investors to hedge for themselves. Answer: FALSE Difficulty: 1 Easy Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 30) The derivatives market is characterized by: A) shrinking activity. B) the introduction of new contracts. C) low turnover. D) regular IPOs. Answer: B Difficulty: 1 Easy Topic: Futures exchanges Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 31) A bond investor who is worried about future fluctuations in interest rates could: A) enter into a swap to pay both a fixed and a floating rate. B) enter into a swap to pay a fixed rate and receive a floating rate. C) enter into a swap to pay a floating rate and pay a fixed rate. D) enter into a swap to receive both a fixed and a floating rate. Answer: B Difficulty: 1 Easy Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

32) Which one of the following is not generally considered a benefit of hedging? A) Hedging reduces business risk. B) Hedging allows prices to be locked in ahead of time. C) Hedging can be very profitable. D) Hedging can stabilize profits. Answer: C Difficulty: 2 Medium Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 33) Which one of the following futures contracts is written on an asset that cannot be delivered? A) U.S. Treasury bills B) Wheat C) Standard and Poor's index D) British pounds Answer: C Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 34) How might a firm such as General Mills protect itself against fluctuations in raw material prices for breakfast cereals? A) Buy commodity futures B) Sell commodity futures C) Buy put options on commodities D) Sell put options on commodities Answer: A Difficulty: 1 Easy Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

35) The buyer of a credit default swap: A) gains protection against a fall in house prices. B) gains protection against default by a pension scheme. C) insures the seller against a fall in house prices. D) gains insurance against default on a bond. Answer: D Difficulty: 2 Medium Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 36) What form of insurance would you suggest for a producer that wishes to be protected from future price decreases but wants to benefit from any future price increases? A) Buy a call option on the asset B) Sell a call option on the asset C) Buy a put option on the asset D) Sell a put option on the asset Answer: C Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 37) Which one of the following is not correct concerning futures contracts? A) Futures contracts entail an obligation rather than an option. B) The contract price is set at the beginning of the contract. C) The contracts are exchange-traded. D) Gains and losses are not settled until the contract expires. Answer: D Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

38) Selling a futures contract may be appropriate for someone who wishes to: A) lock in a future sales price. B) lock in a future purchase price. C) speculate that future spot prices are going up. D) have a ready market in which to sell a product. Answer: A Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 39) A speculator who buys a futures contract is betting that prices will expiration of the contract. A) decrease B) increase C) remain constant D) guarantee high profits

by the

Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 40) A speculator who sells a futures contract is betting that prices will expiration of the contract. A) decrease B) increase C) remain constant D) Be unusually volatile

by the

Answer: A Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 11

41) What happens to the price of a futures contract as expiration draws closer? A) The futures price exceeds the spot price of the asset. B) The futures price is exceeded by the spot price of the asset. C) The futures price approaches the spot price of the asset. D) There is no relationship between the futures price and spot price as the contract approaches expiration. Answer: C Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 42) When a commodity futures reaches its expiration, the seller usually: A) delivers the commodity to the futures buyer. B) delivers the commodity to the futures exchange. C) takes an offsetting futures position and settles in cash. D) adds the profit or loss to his margin account and continues to trade. Answer: C Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 43) A commodity producer who is worried about future prices can best hedge by: A) buying a futures contract. B) selling a futures contract. C) buying a call option. D) selling a call option. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

44) A farmer sells corn futures for March delivery at $7.50 per bushel. In March the spot price of corn is $7.20 per bushel. Which of the following is correct? A) The futures buyer is required to deliver corn to the farmer at $7.20. B) The farmer has locked in an effective price of $7.50 per bushel. C) The farmer would have been better off without the futures contract. D) The farmer will receive $7.35 per bushel which is the average of the spot and futures prices. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 45) A milling company buys a futures contract that requires it to take delivery of 5,000 bushels of wheat at a price of $6.80 per bushel. At expiration the spot price of wheat is $6.68 per bushel. The miller: A) has saved $0.12 per bushel through hedging. B) has locked in an effective price of $6.80 per bushel. C) can choose not to take delivery since the price declined. D) has locked in an effective price of $6.68 per bushel. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

46) A milling company buys a futures contract that requires it to take delivery of 5,000 bushels of wheat at a price of $6.75 per bushel. Next day the price of the future is $6.80. The miller: A) must pay an extra $0.05 a bushel into its margin account. B) can withdraw $0.05 from its margin account. C) does not need to do anything until the contract matures. D) can't say without knowing what happened to the spot price. Answer: A Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 47) Yesterday you sold six-month futures on the S&P index at a price of 2,100. Today the index closed at 2,050 and the future at 2,140. You get a call from your broker. Is he: A) asking you to pay $40 times the contract size into your margin account? B) asking you to pay $50 times the contract size into your margin account? C) telling you that you can withdraw $40 times the contract size from your margin account? D) telling you that you can withdraw $50 times the contract size from your margin account? Answer: A Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 48) Which one of the following would not be regulated in a standardized futures contract? A) Quantity of asset to be traded B) Quality of asset to be traded C) The spot price D) Date of settlement Answer: C Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 14

49) The purpose of a margin account for a futures contract is to: A) guarantee a minimum margin of profit for the contract holder. B) allow futures traders to have more than one contract simultaneously. C) provide a cushion for the exchange against defaults on the contract. D) hold interest payments until expiration. Answer: C Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 50) The process of marking a futures contract to market means that: A) the profitability of the contract is locked in from the onset of the contract. B) the amount of commodity to be delivered changes as prices change. C) contracts are closed out as soon as they become unprofitable. D) profits or losses are settled daily. Answer: D Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 51) A futures contract calls for delivery of 60,000 pounds of soybean oil. What happens to the seller of a soybean oil futures contract at 41 cents per pound if the futures price closes the next day at 42 cents per pound? A) The contract is marked to market with a $600 loss. B) The contract is marked to market with a $600 gain. C) Futures contracts are voided if the price increases prior to expiration. D) Nothing happens until the expiration of the contract. Answer: A Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Analytical Thinking Accessibility: Keyboard Navigation 15

52) A futures contract seller is obligated to deliver 5,000 bushels of soybeans for $12.00 per bushel at expiration. If soybean futures close at $12.10 the next day, the seller: A) has a profit of $500 thus far on the contract. B) has a loss of $500 thus far on the contract. C) has no profit or loss, but is still obligated to deliver 5,000 bushels at $12.00. D) will receive a check for $500 from the buyer of the contract. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 53) What has happened to cause a $250 loss to be marked to the margin account of a futures contract buyer? A) The commodity futures price decreased on that day. B) The commodity futures price increased on that day. C) The commodity spot price decreased on that day. D) The commodity spot price increased on that day. Answer: A Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 54) The effect of marking a futures contract to market is similar to: A) doubling the total payments by the contract buyer. B) doubling the total payments by the contract seller. C) closing the current position and opening a new position daily. D) imposing a daily fee on both buyers and sellers. Answer: C Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 16

55) The primary purpose of financial futures is to: A) benefit from increases in interest rates. B) protect against swings in interest rates or prices of financial assets. C) translate one currency into another. D) guarantee the repayment of loan principal. Answer: B Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 56) The basic difference between speculators and hedgers in futures contracts is that speculators: A) will profit regardless of the direction of price change. B) do not have an offsetting position in the underlying commodity. C) are concerned only with long-term price movements. D) take a position in more than one commodity at a time. Answer: B Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 57) If there is an excess of market participants who want to buy the futures as a hedge, then: A) speculators will come into the market to sell the futures. B) speculators will see a potential profit from also buying the futures. C) speculators will steer clear of the futures market. D) the market may have to close down until there is a balance of supply and demand. Answer: A Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

58) Which one of the following is not correct concerning forward contracts? Forward contracts: A) are not standardized. B) do not set the price until the end of the contract. C) are not traded on organized exchanges. D) are not marked to market daily. Answer: B Difficulty: 1 Easy Topic: Hedging with forward contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 59) You enter into a forward contract to take delivery of 1 million euros 3 months from now. What happens to the price you will pay at expiration if the euro depreciates during the contract period? A) Your price will increase. B) Your price will decrease. C) Your price was fixed at the onset of the contract. D) Your price was fixed but you will receive correspondingly more euros due to the depreciation. Answer: C Difficulty: 1 Easy Topic: Hedging with forward contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

60) Which one of the following is a reason for firms to engage in currency swaps? A) They will be required to repay only the interest. B) They can obtain more favorable terms by borrowing in a different currency. C) The debt will not show on their balance sheets. D) You can borrow in the currency with the lowest interest rate without taking on any currency risk. Answer: B Difficulty: 2 Medium Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 61) When two borrowers engage in a currency swap, they agree to: A) a one-time currency exchange equal to the principal amount borrowed. B) make payments to each other in a different currency. C) pay to each other any depreciation or appreciation of the currency. D) exchange fixed-rate interest payments for variable-rate interest payments. Answer: B Difficulty: 2 Medium Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 62) In an interest rate swap, borrowers typically exchange fixed-rate payments in one currency for: A) fixed-rate payments in another currency. B) variable-rate payments in another currency. C) fixed-rate payments in the same currency. D) variable-rate payments in the same currency. Answer: D Difficulty: 1 Easy Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 19

63) ABC Corp. borrows $5 million at 10% from a bank and swaps this loan for a 12% yen loan. The spot exchange rate is JPY105 = USD1. How much does ABC pay annually to the bank? A) ¥1.26 million B) ¥5.71 million C) ¥52.50 million D) ¥63.00 million Answer: D Explanation: Annual interest payment = ($5 million × 105) × 0.12 = ¥63 million Difficulty: 2 Medium Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 64) Which of the following statements is correct? A) Futures contracts and options contracts are economically similar, but vary in how they are traded. B) Forward contracts and futures contracts are economically similar, but vary in how they are traded. C) Forward contracts and options contracts are economically similar, but vary in how they are traded. D) Forward contracts, futures contracts, and options contracts are all economically similar, but vary in how they are traded. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

65) The term derivatives refers to: A) forwards and futures. B) swaps and options. C) forwards, futures, swaps, and options. D) forwards, futures, and swaps. Answer: C Difficulty: 2 Medium Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 66) A derivatives contract: A) increases the risk of both the hedger and speculator. B) increases the risk of the hedger and decreases the risk of the speculator. C) reduces the risk of the hedger and increases the risk of the speculator. D) reduces risk in both cases. Answer: C Difficulty: 2 Medium Topic: Hedging Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

67) Hershey's Chocolate is concerned about cocoa prices, which are currently $3,000 a ton. Analysts project that the cost of cocoa purchases could vary from $2,900 to $3,100 a ton. A September call option can be purchased with a $2,950 exercise price for $145. What is Hershey's worst-case scenario if it purchases these options? A) Cocoa prices will rise to $3,100 and Hershey is protected only to a price of $2,950. B) Cocoa prices will not change from their current level and Hershey will have wasted the cost of the option. C) Cocoa prices will not rise above Hershey's break-even price of $3,095, which equals the sum of the exercise price plus the cost of the option. D) Cocoa prices will fall below $2,950 and Hershey will lose the $145 cost of the option. Answer: D Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 68) If you buy a forward contract, you agree to buy the product: A) at a later date at a price to be set in the future. B) today at its current price. C) at a later date at a price set today. D) if and only if its price rises above its exercise price. Answer: C Difficulty: 2 Medium Topic: Hedging with forward contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

69) If you sell a forward contract, you agree to: A) deliver a product at a later date for a price set today. B) receive a product at a later date at the price on that later date. C) receive a product at a later date for a price set today. D) deliver a product at a later date for a price set on that later date. Answer: A Difficulty: 2 Medium Topic: Hedging with forward contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 70) One distinguishing difference between the buyer of a futures contract and the buyer of an option contract is that the futures buyer: A) pays a much higher up-front price than option buyers. B) has an obligation to purchase, not a choice. C) can lose no more than the initial outlay. D) has increased rather than reduced risk. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 71) In general, when deciding whether one needs to buy or sell futures contracts in order to hedge, the rule could be: A) buy futures if you have the underlying asset and sell futures if you need the underlying asset. B) sell futures if you have the underlying asset and buy futures if you need the underlying asset. C) buy futures if you want to speculate, sell futures if you want to hedge. D) buy futures if you are willing to have unlimited risk, sell futures if you want capped risk. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 23

72) As time draws closer to contract expiration, futures prices can be expected to: A) increase as the demand for delivery intensifies. B) decrease as speculators resolve the uncertainty of prices. C) move similarly to broad-based market indices, such as the S&P 500. D) converge upon the spot price. Answer: D Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 73) Why are most futures contracts not settled through delivery of the product? A) Most contracts are settled through the margin account. B) Most contracts expire with neither party having an obligation to the other party. C) Most participants cancel their futures contracts through purchase of an option contract. D) It is easier and cheaper to settle in cash or by an offsetting futures transaction. Answer: D Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 74) The price for immediate delivery of a product is called the: A) spot price. B) exercise price. C) forward price. D) the impact price. Answer: A Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

75) If you enter into an interest rate swap, the company taking the opposite side is called: A) The swap payer. B) The swap counterparty. C) The swap maker. D) The off-taker. Answer: B Difficulty: 1 Easy Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 76) A gasoline distributor buys a gasoline futures contract to receive 42,000 gallons of gasoline at $2.94 per gallon. How is the account marked to market if gasoline futures close the next day at $2.97? A) A loss of $1,260 is posted to the account. B) A gain of $1,260 is posted to the account. C) A loss of $12,600 is posted to the account. D) A gain of $12,600 is posted to the account. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

77) The seller of a pork bellies futures contract at $1.41 per pound noted that the closing price of pork bellies was $1.44 today. What will happen to this contract, which requires delivery of 40,000 pounds of pork bellies at expiration? A) A loss of $400 is posted to the account. B) A gain of $400 is posted to the account. C) A loss of $1,200 is posted to the account. D) A gain of $1,200 is posted to the account. Answer: C Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 78) The typical sequence of cash flows in a futures contract is: A) purchase price plus a margin account up-front, differences are settled at expiration. B) margin account up-front, differences are posted daily and settled in cash if margin drops too low. C) margin account up-front, all differences settled at expiration. D) all funds are paid at expiration of the contract. Answer: B Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation

79) The seller of a copper futures contract noticed that his account was marked with a $500 gain yesterday. If the standardized contract requires delivery of 25,000 pounds of copper, what happened that day to the price of copper? A) The price closed down $0.02 per pound. B) The price closed up $0.02 per pound. C) The price closed down $0.20 per pound. D) The price closed up $0.20 per pound. Answer: A Explanation: Mark to market = $500 = $x × 25,000; x = $0.02; A seller of a futures contract gains when the closing price declines. Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 80) Which of the following contracts is not a financial future? A) eurodollar deposit futures B) yen futures C) orange juice futures D) Standard & Poor's futures Answer: C Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

81) Which one of the following is not true of the financial futures markets? A) Financial futures trade on the Chicago Mercantile Exchange. B) When many financial future mature, the seller cannot deliver the asset to the buyer. C) A major use of financial futures is protection from interest rate risk. D) Trading in financial futures is significantly less than trading in financial futures. Answer: D Difficulty: 1 Easy Topic: Futures exchanges Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 82) A clothes producer hedges its future cotton purchases by buying cotton futures. The futures contract provides the producer with 50,000 pounds of cotton at a price of $0.80 per pound. By contract expiration the producer finds that cotton prices have declined to $0.73 per pound. As a result of the futures contracts, the producer will: A) lose $3,500 per contract in the futures market which offsets gains in the cash market. B) gain $3,500 per contract in the futures market which offsets losses in the cash market. C) lose $3,500 per contract in the futures market and suffer an opportunity cost in the cash market. D) gain $3,500 per contract in the futures market and gain $0.07 per pound in the cash market. Answer: A Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

83) Which one of the following futures contract holders is speculating? A) A wheat farmer who sells wheat futures B) A cattle rancher who buys live cattle futures C) A candy maker who buys sugar futures D) An oil producer who sells crude oil futures Answer: B Difficulty: 2 Medium Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 84) The activities of speculators are necessary in the futures markets in order to: A) prevent hedgers from trading options. B) provide a continual stream of profit to hedgers. C) help ensure futures prices are fair value. D) understand the direction of future price changes. Answer: C Difficulty: 1 Easy Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 85) Those who invest in derivative instruments that increase rather than reduce risk are known as: A) option traders. B) futures traders. C) hedgers. D) speculators. Answer: D Difficulty: 1 Easy Topic: Hedging Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation

86) Which one of the following characteristics is similar in both futures and forward contracts? A) Future transactions are conducted at a price agreed upon earlier. B) Contracts are sold through organized exchanges. C) Contract terms are standardized by type of commodity. D) Price changes are settled daily in a process known as mark-to-market. Answer: A Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 87) A contract to buy Japanese yen three months forward at a price of ¥105/$ will: A) insulate the buyer from changes in interest rates. B) protect the buyer from changes in exchange rates. C) lock in a profit based on current exchange rates. D) require delivery of the yen at the Nasdaq Exchange. Answer: B Difficulty: 1 Easy Topic: Hedging with forward contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 88) Zeta Corp wishes to obtain a loan denominated in Swiss francs but the U.S. market offers better credit terms. What should Zeta do? A) Borrow francs in Switzerland, exchange for dollars, and arrange a currency swap. B) Borrow francs in Switzerland, exchange for dollars, and arrange an interest rate swap. C) Borrow dollars in the United States, exchange for francs, and arrange an interest rate swap. D) Borrow dollars in the United States, exchange for francs, and arrange a currency swap. Answer: D Difficulty: 1 Easy Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

89) Currency swaps are used to: A) lock in an exchange rate for future delivery of a foreign currency. B) effectively transform loans originated in one currency to a different currency. C) transform fixed-rate loans into variable-rate loans. D) exchange foreign currencies in amounts not possible in the foreign exchange market. Answer: B Difficulty: 1 Easy Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 90) On $10 million of loans, Firm A is paying a fixed $700,000 in interest payments while Firm B is paying LIBOR plus 50 basis points. The current LIBOR rate is 6.25 percent. Firms A and B have agreed to swap interest payments. How much will be paid to which firm this year? A) A pays $750,000 to Firm B. B) B pays $25,000 to Firm A. C) B pays $50,000 to Firm A. D) A pays $25,000 to Firm B. Answer: B Difficulty: 2 Medium Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

91) Four investors buy sugar futures. Three are speculators and one is hedging. Which of the following is hedging? A) wheat farmer B) mutual fund C) soft drink producer D) none of the options Answer: C Difficulty: 1 Easy Topic: Hedging Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 92) A firm can reduce the risk of upward movement in raw material prices by: A) buying a call option. B) selling a put option. C) buying a put option. D) selling a futures contract. Answer: A Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 93) A farmer can hedge the risk of downward movement in the price of his product by: A) buying a call option. B) selling a put option. C) buying a put option. D) buying a futures contract. Answer: C Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

94) A sensible corporate risk strategy needs answers to three of these questions. Which is the odd man out? A) What are the major risks that the company faces? B) Is the company being paid for taking these risks? C) Can we spot any mispriced derivative contracts? D) Can the company reduce the probability of a bad outcome? Answer: C Difficulty: 2 Medium Topic: Risk management Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation 95) A farmer hedged his risk by buying put options on wheat with an exercise price of $6.70 at a price of $0.14 per bushel. If the price of wheat at the expiration of the contract is $6.70, what is the net revenue from each bushel of wheat? A) $6.56 B) $6.63 C) $6.70 D) $6.84 Answer: A Explanation: Net revenue = −$0.14 + 0 + $6.70 = $6.56 Net revenue = −cost of option + option payoff + price of wheat Difficulty: 2 Medium Topic: Hedging with option contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

96) Which of the following strategies does not reduce risk? A) building flexibility into the firm's operations B) increasing the proportion of the firm's costs that are fixed C) taking out an insurance policy D) hedging with derivative contracts Answer: B Difficulty: 2 Medium Topic: Risk management Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 97) Which of these statements is not true? A) Transactions to reduce risk are unlikely to add value if investors can easily undertake similar transactions. B) Hedging may reduce the costs of financial distress. C) Transactions to reduce risk always add value. D) Hedging is a zero-sum game. Answer: C Difficulty: 2 Medium Topic: Risk management Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 98) Which one of the following statements is correct? A) An option seller makes more profits than an option buyer. B) A futures seller makes more profits than a futures buyer. C) The profit realized by the buyer of futures will be equal to the loss incurred by the seller. D) Both the buyer and the seller of a futures contract can earn a profit. Answer: C Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

99) The most active trading in forward contracts is in: A) U.S. Treasury bills. B) the Standard and Poor's index. C) wheat crops. D) foreign currencies. Answer: D Difficulty: 1 Easy Topic: Hedging with forward contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 100) At the expiration of a futures contract, the futures price will be: A) greater than the spot price. B) equal to the spot price. C) less than the spot price. D) greater than the forward price. Answer: B Difficulty: 1 Easy Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation 101) Which one of the following is the major difference between forward and futures contracts? A) Futures contracts are more expensive than forward contracts. B) Forward contracts are traded on the forward exchanges. C) Futures contracts are always delivered. D) Forward contracts are not marked to market. Answer: D Difficulty: 2 Medium Topic: Hedging with forward contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation

102) Which contract is more likely to have risk associated with the other person trading the same derivative? A) Forward B) Futures C) Option D) Stock Answer: A Difficulty: 1 Easy Topic: Risk management Learning Objective: 24-01 Understand why companies hedge to reduce risk. Bloom's: Remember AACSB: Communication Accessibility: Keyboard Navigation 103) Big Corp. borrows $1 million at a fixed rate of 7% from a bank and swaps this loan for a SOFR + 1% loan. SOFR is at 2%. How much will the company receive from the bank at the annual settlement of the swap? A) $70,000 B) $40,000 C) $30,000 D) $20,000 Answer: B Explanation: Annual payment received = ($1 million × (0.07 − 0.03)) = $40,000 Difficulty: 2 Medium Topic: Hedging with swap contracts Learning Objective: 24-03 Explain how companies can use swaps to manage the risk of securities that they have issued. Bloom's: Analyze AACSB: Analytical Thinking Accessibility: Keyboard Navigation

104) A farmer plans to harvest 10,000 bushels of wheat and shorts 2 futures contracts at a price of 550 cents per bushel. At expiration of the contract the spot price and futures price are both 510 cents. How much will be the total proceeds to the farmer when she closes the contract and sells her wheat? A) $47,000 B) $51,000 C) $55,000 D) $59,000 Answer: C Explanation: Total proceeds = 10,000 × $5.50 = $55,000 Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Apply AACSB: Reflective Thinking Accessibility: Keyboard Navigation 105) To help reduce the risk associated with a futures contract to the other parties involved in the transaction, an investor will be required to provide… A) Letter of credit B) Lien on other assets C) Margin D) Personal guarantee Answer: C Difficulty: 2 Medium Topic: Hedging with futures contracts Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Bloom's: Understand AACSB: Reflective Thinking Accessibility: Keyboard Navigation