TEST BANK for Fundamentals of Corporate Finance, Enhanced eText 5th Edition Robert Parrino, David Ki by StudyGuide

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 1 The Financial Manager and the Firm 1) The financial manager is responsible for making decisions that are in the best interests of the firm's owners. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Process and Resource Management Perspectives 2) A patent is a productive asset for a technology-based firm. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 3) Intangible assets generate most of a manufacturing firm's cash flows. Answer: FALSE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives 4) The most fundamental way a business can grow in size is by reinvesting cash flows or earnings. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Process and Resource Management Perspectives

5) A firm that goes bankrupt will always be liquidated. Answer: FALSE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 6) Capital assets are generally short term in nature. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives 7) A good capital budgeting or investment decision is one in which the benefits are worth more to the firm than the cost of the project. Answer: TRUE Explanation: Regardless of the project, a good investment is one in which the benefits are worth more to the firm than the costs of the asset. Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Budget Preparation AICPA: Resource Management 8) Investment decisions determine how firms raise capital to pay for their investments. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Strategic/Critical Thinking 9) Net working capital is the dollar difference between a firm's total current assets and total liabilities. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Budget Preparation AICPA: Process and Resource Management Perspectives 2

10) A sole proprietorship is a business where ownership interest can be transferred to someone else. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 11) One of the disadvantages of a general partnership is the double taxation of profits. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 12) Unlimited liability means that the owner of a firm is responsible for paying all the bills of the firm in the event of a bankruptcy. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 13) The process of transferring ownership of a sole proprietorship is relatively easy compared to a public corporation. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 14) General partners in a business have limited liability with regard to money owed to creditors. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 3

15) The owners of C-corporations are not subject to double taxation. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 16) Privately held corporations are allowed to have stockholders. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 17) The treasurer of a corporation usually reports to the CFO of the firm. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 18) The external auditors of the firm provide an independent annual audit of the firm's financial statements and report their findings directly to the CFO of the firm. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Reporting 19) Maximizing revenue should be the goal of the firm. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Performance Measurement AICPA: Strategic/Critical Thinking

20) An agency conflict can arise when the agent of the firm does not act in the best interest of the owners. Answer: TRUE Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 21) The owners of a firm are unaffected by agency costs. Answer: FALSE Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 22) Fraudulent business practices do not affect the growth of the financial markets. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Professional Demeanor 23) To start a business, the owners need: A) wealth. B) a clear vision of what products or services they want to produce. C) employees. D) productive assets such as buildings, technology, or patents. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

24) A stakeholder is: A) someone geographically close to the firm's headquarters. B) someone who has a claim on the cash flows of the firm. C) a business organization. D) someone working for the competitor of the firm. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 25) If you have provided capital to a firm, then you are: A) a manager. B) a stakeholder. C) a partner. D) an employee. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 26) Which of the following is NOT a stakeholder? A) An employee B) A lender C) The IRS D) The owner Answer: D Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

27) A trademark is an example of: A) a liquid asset. B) an intangible asset. C) a contingent asset. D) a physical asset. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 28) Which of the following is NOT a characteristic of a shareholder? A) Expects to receive dividends B) Expects to receive a capital gain on an investment C) Expects to receive interest D) Expects to have rights as defined in the corporation's charter and bylaws Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives 29) Which of the following is a basic source of funds for a firm? A) Debt B) Equity C) Asset liquidations D) Both A and B Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives

30) The cash remaining with the firm after paying its operating expenses, making payments to creditors, and taxes is called: A) earnings per share. B) capital contributed in excess of par. C) residual cash flows. D) assets. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives 31) Cash dividends are paid out of: A) residual cash flows. B) liquidated assets. C) long-term debt. D) payroll fund. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives 32) Current liabilities are liabilities that: A) will be converted to cash within a year. B) must be paid within a year. C) will be converted to equity within a year. D) are contingent depending upon a future outcome. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives

33) Current assets are assets that: A) will be converted to cash within a year. B) must be paid within a year. C) will be converted to equity within a year. D) must be depreciated. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Budget Preparation AICPA: Process and Resource Management Perspectives 34) The capital budgeting decision process can be described as: A) how a firm's day-to-day financial matters should be managed. B) how a firm's assets should be financed. C) determining which productive assets should be purchased. D) involving purchase of short-term assets. Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Budget Preparation AICPA: Process and Resource Management Perspectives 35) Working capital management decisions help to determine: A) how a firm's day-to-day financial matters should be managed. B) how a firm's assets should be financed. C) which productive assets should be purchased. D) how to increase a company's profit. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives

36) Capital budgeting decisions generally have the most effect on: A) the asset portion of the balance sheet. B) the short-term investment portion of the balance sheet. C) the current liability portion of the balance sheet. D) the retained earnings portion of the balance sheet. Answer: A Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives 37) A good capital budgeting decision is one in which the perceived benefits of the project are: A) equal to the cost of the asset. B) less than the cost of the asset. C) more than the cost of the asset. D) not identifiable. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Strategic/Critical Thinking 38) Financial markets that trade equity and debt instruments with maturities greater than one year are called: A) money markets. B) capital markets. C) over-the-counter exchange. D) derivative markets. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives

39) Financial markets that trade equity and debt instruments with maturities less than one year are called: A) money markets. B) capital markets. C) over-the-counter exchange. D) derivative markets. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Process and Resource Management Perspectives 40) The profitability of a firm can be negatively affected by: A) too much inventory. B) too little inventory. C) Either A or B. D) Neither A nor B. Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 41) Which of the following business organizational forms subject(s) the owner(s) to unlimited liability? A) Sole proprietorship B) General partnership C) Corporation D) Both A and B Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

42) Which of the following business organizational forms create(s) a tax liability on income at the personal income tax rate? A) Sole proprietorship B) Partnership C) Corporation D) Both A and B Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 43) Which of the following business organizational forms is/are the easiest one(s) to raise capital? A) Sole proprietorship B) Partnership C) Corporation D) Both A and B Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 44) Which of the following types of owners is protected by limited liability? A) A sole proprietor B) A general partner C) Owner of a corporation D) A managing partner Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

45) Which of the following types of owners cannot be engaged in managing the business? A) A sole proprietor B) A general partner C) A limited partner D) A managing partner Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 46) Which form(s) of business organization generate(s) the majority of business revenues and profits in the United States? A) Sole proprietorship B) Partnership C) Corporation D) Both A and B Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 47) Which organizational form is best suited for a firm to sell its securities to the market? A) Sole proprietorship B) Partnership C) Private corporation D) Public corporation Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

48) Which of the following organizational forms is subject to the Securities and Exchange Commission (SEC) regulations? A) Sole proprietorship B) Partnership C) Private corporation D) Public corporation Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Governance Perspective 49) Which organizational form best enables the owners of a firm to monitor the professional conduct of other owners of the same firm? A) Sole proprietorship B) Partnership C) Private corporation D) Public corporation Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 50) Which of the following is considered a hybrid organizational firm? A) Sole proprietorship B) Partnership C) Corporation D) Limited liability partnership Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

51) In a public corporation, which of the following reports directly to the owners of a firm? A) CFO B) CEO C) Board of directors D) Audit committee Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Process and Resource Management Perspectives 52) Which of the following is primarily responsible for managing all financial aspects of a firm? A) CFO B) CEO C) Board of directors D) Audit committee Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Process and Resource Management Perspectives 53) Which of the following is responsible for performing an independent audit of a firm's financial statements? A) CFO B) CEO C) CPA firm D) Audit committee Answer: C Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Reporting; Internal Controls AICPA: Reporting; Process and Resource Management Perspectives

54) How is a CPA firm insulated from being pressured by management? A) The audit committee approves hiring, firing, and paying fees to external auditors. B) The chairman of the board of directors approves the external auditor's fees as well as the engagement letter. C) The IRS approves the external auditor's fees as well as the engagement letter. D) The CPA firm is not insulated from management. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Internal Controls; Reporting AICPA: Reporting 55) Among the following, who is typically responsible for managing a large corporation's financial function? A) The CEO B) The Chairman of the board C) The Vice-President D) The CFO Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Process and Resource Management Perspectives 56) From the owner's perspective, which of the following should be the goal of a firm? A) Profit maximization B) Revenue maximization C) Stockholders' wealth maximization D) Tax minimization Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Performance Measurement AICPA: Strategic Perspective

57) When analysts and investors determine the value of a firm's stock, they should consider all of the following EXCEPT: A) the size of the expected cash flows associated with owning the stock. B) the timing of the cash flows. C) the riskiness of the cash flows. D) the way cash flows between a firm and its stakeholders. Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 58) From the owner's perspective, which of the following should be the primary focus of managers? A) Profit maximization B) Revenue maximization C) COGS minimization D) Maximizing stock value Answer: D Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Strategic Perspective 59) Which of the following would generally NOT increase shareholders' wealth? A) Receiving cash flows sooner rather than later B) Increased government regulation C) Receiving larger cash flows D) Rapid growth in the overall economy Answer: B Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Strategic Perspective

60) Which of the following factors or activities can be controlled by a firm's managers? A) Capital budgeting decision B) The level of economic activity C) The level of market interest rates D) Stock market conditions Answer: A Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Budget Preparation AICPA: Strategic Perspective 61) One reason for the existence of agency problems between managers and stockholders is that: A) management is separate from ownership. B) managers know how to manage the firm better than stockholders. C) stockholders have unreasonable expectations about managerial performance. D) managers and stockholders agree about the direction of the company. Answer: A Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 62) Who among the following is the "principal" in the agency relationship of a corporation? A) A company engineer B) The CEO of the firm C) The stockholders D) The board of directors Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

63) Which of the following does NOT have a legal responsibility to represent stockholders' interests? A) The chairman of the board of directors B) The CEO C) The corporation's board of directors D) Employees Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Legal/Regulatory Perspective 64) An example of an agency cost is: A) a manager turning down a value-contributing project because its risks can affect his performance. B) a manager expensing a lavish dinner on the company expense report. C) a manager using too little debt within the firm's capital structure because of the additional risk associated with debt. D) Both A and B. Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 65) Which of the following mechanisms can help align the behavior of managers with the goals of stockholders? A) Having stock dispersed among many shareholders rather than having large stockholders B) Complete managerial discretion over all aspects of the firm C) Non-independent board of directors D) Well-designed management compensation Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Communication IMA: Business Economics AICPA: Leadership

66) If a firm has had an agency conflict which is reflected by a poor performing stock for a long period of time, then the firm may become a target of: A) an SEC investigation. B) a corporate raider. C) an IRS investigation. D) a bankruptcy lawyer. Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Internal Controls AICPA: Risk Assessment, Analysis and Management 67) Executives that repeatedly put their own interests before that of the firm may find that they have difficulty in finding another job after their current one. This is an example of: A) the managerial labor market disciplining managers. B) the market for corporate control. C) the board of directors affecting the prospects of a manager. D) the agency problem. Answer: A Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 68) Who among the following is responsible for setting an agenda at meetings of the board of directors? A) Chairperson of the board of directors B) President C) Nominating committee D) Manager Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Process and Resource Management Perspectives

69) A director who is from outside the firm is called: A) an executive director. B) an inside director. C) an independent director. D) an official director. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Process and Resource Management Perspectives 70) Which of the following is NOT one of the goals of the Sarbanes-Oxley Act of 2002? A) Attain greater board independence B) Establish compliance programs C) Establish ethics programs D) Dictate maximum compensation levels Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Governance Perspective 71) Which of the following is NOT an example of an agency cost? A) A lavish dinner or trip B) A missed investment opportunity C) A cost that results from a conflict of interest between the agent and the principal D) The cost of a new piece of equipment Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Reporting

72) Which of the following does the audit committee have unconditional authority to do? A) Audit the personal bank account of the CEO B) Question any person employed by the firm C) Audit the compensation files of firms in the same industry D) Decide who should be the external auditor of the firm Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Governance Perspective 73) What is the major complaint by firms about the Sarbanes-Oxley Act of 2002? A) The legal, maximum allowable compensation for a CEO B) The legal requirement to disclose project information C) The cost of compliance D) The cost of maintaining an SEC employed officer at the firm's premises Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Governance Perspective 74) Which of the following is NOT an objective of the Sarbanes-Oxley Act of 2002? A) Reducing agency costs in corporations B) Restoring ethical conduct within the business sector C) Improving the integrity of accounting reporting system within firms D) Ensuring that an IRS employee is present at the firm's headquarters Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Governance Perspective

75) A society's ideas about what actions are right and wrong are termed as: A) rules and policies. B) ethics. C) laws. D) unwritten laws. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Governance Perspective 76) The golden rule is an example of: A) a current law. B) a civil law. C) an unworkable rule in financial markets. D) an ethical norm. Answer: D Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Governance Perspective 77) An example of an economy that had trouble in establishing a stock market and attracting foreign investment is: A) Russia. B) France. C) The Czech Republic. D) Japan. Answer: A Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

78) Corruption in business: A) is remedied by having non-independent board members. B) is unaffected by internal auditing controls. C) is not likely a result of the principal-agent relationship. D) creates inefficiencies in an economy. Answer: D Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Governance Perspective 79) Which of the following corporate officers is most likely to subject the firm to heavy financial losses when he or she is guilty of serious misconduct? A) Marketing Manager B) CFO C) Chief Technology Officer D) Chief Risk Officer Answer: B Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Ethics IMA: Business Applications AICPA: Governance Perspective 80) An officer of a firm who is also a majority owner in a competing firm will probably be subject to: A) an IRS audit. B) a conflict of interest with his/her stockholders. C) arbitrage profit returns to the SEC. D) an FBI investigation. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Governance Perspective

81) ________ occur(s) when one party in a business transaction has information that is unavailable to the other parties in the transaction. A) Profits B) Information asymmetry C) Information efficiency D) Conflict of interest Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 82) With regard to information, a central idea of fairness suggests that: A) decisions should be made on a level playing field. B) insiders should be able to trade whenever they want. C) insiders should never be able to trade. D) outsiders should not be allowed to trade since, by definition, they are at a disadvantage. Answer: A Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Decision Analysis AICPA: Strategic Perspective 83) The legal system and market forces impose substantial costs on individuals and institutions that engage in unethical behavior. Which of the following would NOT be an example of these costs? A) Financial losses B) Legal fines C) Agency conflicts D) Jail time Answer: C Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Ethics IMA: Business Applications AICPA: Governance Perspective

84) Explain what should be the goal of a firm. Answer: The goal of a firm should be to maximize stockholders' wealth, which in most cases is equivalent to maximizing the price of the shares of the firm. Maximizing the stock price, however is not the same as maximizing profits, since maximizing profits can occur while taking on too much risk, which, on the other hand can lower the value of the stockholders' investment. Maximizing profits also does not take the timing of the profits into account. Profits, moreover, should not be confused with cash. Profit does not represent the actual cash available because it deducts depreciation expense and some other noncash expenses. Maximizing stockholders' wealth is also not the same as minimizing risk as managers can also increase stock values without undertaking excessive risks. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Performance Measurement AICPA: Global and Industry Perspectives 85) Explain how agency costs might be found within a firm whose CEO owns no shares in the firm and whose compensation package is unaffected by the profits (cash or accounting profits) of the firm. Answer: If the manager has no ownership interest in the firm, he/she has no incentive to make the profits of the firm as high as possible. In fact, he/she has a personal incentive to have the firm pay for as many personal luxuries as possible since his/her compensation package will be completely unaffected by the decision to purchase the luxuries. In a firm like that, we might expect the firm to expend a material amount of resources on items that the manager should probably pay for him/herself. Overall, manager with no shares in the firm will have a tendency to maximize his or her own wealth rather than shareholders' wealth. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Ethics IMA: Performance Measurement AICPA: Strategic Perspective

86) You have a friend who tells you that ethics are completely unimportant in business since a number of laws have been set up for us to know the rules of the game. Comment. Answer: Despite heavy regulation, the financial sector has a long and rich history of financial scandals. While a good many of the scandals are due to laws that have been disregarded, many of the scandals began as ethical lapses. This suggests that laws are not enough to preclude behavior that is detrimental to the well-functioning of the financial markets. Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Ethics IMA: Business Applications AICPA: Decision Making

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 2 The Financial System and the Level of Interest Rates 1) The role of the financial system is to gather money from households (individuals), businesses and government that have funds to invest and to channel that money to those who need it. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 2) The financial system only consists of a number of different types of financial markets. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 3) Without a financial market, purchasing a house would require a cash purchase. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 4) The financial markets where direct transactions take place are retail markets with a typical minimum transaction size of $1 million. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective

5) Major buyers and sellers of securities in direct financial markets include commercial banks, large corporations, the federal government, hedge funds, and some wealthy individuals. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 6) Governments are the principal lender-savers in the economy. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 7) Businesses are the principal borrower-spenders that borrow the most in the economy. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 8) Primary markets are markets where already-issued securities are resold to other investors. They provide the means for investors to sell their securities to other investors. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 9) Secondary markets are markets where the owners of securities can resell them to other investors. They provide the means for investors to convert their securities into cash. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 2

10) Direct financial markets could be broadly labeled as wholesale markets for funding. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 11) A privately held corporation that borrows from a regional commercial bank is an example of a direct market transaction. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 12) The law that prohibited commercial banks from engaging in investment banking activities is the Financial Services Modernization Act of 1999. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Legal/Regulatory Perspective 13) With the passage of Financial Services Modernization Act, major money center banks in the United States today are allowed to provide investment banking services. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Legal/Regulatory Perspective

14) When a company raises capital by issuing shares for the first time, the selling of newly issued stocks occurs in a secondary market. Answer: FALSE Explanation: A primary market is a financial market in which new security issues are sold by companies directly to investors. A secondary market is any market in which owners of outstanding securities can resell them to other investors. Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 15) Most securities that are sold on the New York Stock Exchange are secondary market transactions. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 16) An active secondary market for a security will help to enhance the price of that particular security in the primary market. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 17) The downside to a private placement transaction is that it does not require the fees and expenses associated with an SEC registration. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

18) Brokers are market specialists who do not bear the risk of owning securities. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 19) Money market instruments are financial instruments that are highly marketable and can easily be converted into cash. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 20) Equities with maturities greater than one year generally are traded in the capital markets. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 21) Most companies use indirect market funding from financial institutions to obtain financing. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 22) Most companies finance their business investments by obtaining the majority of their funds from selling equity. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management

23) The nominal interest rate is the rate of interest that is adjusted for inflation. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 24) Real rates of interest are perfectly observable in the financial markets. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 25) It is impossible for the nominal rate of interest to be lower than real rate of interest. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 26) It is difficult for individuals to participate in the direct financial markets for the following reason: A) The direct financial markets are retail markets with a typical minimum transaction size of $1 million. B) The direct financial markets are wholesale markets with a typical minimum transaction size of $1 million. C) Major buyers and sellers of securities in indirect financial markets include commercial banks, large corporations, the federal government, hedge funds, and some wealthy individuals. D) Major buyers and sellers of securities in direct financial markets do not include commercial banks, large corporations, the federal government, hedge funds, and some wealthy individuals. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective

27) An economy with a large flow of funds requires: A) a lot of gold reserves. B) a frictionless market. C) an efficient financial system. D) all of the these. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 28) Financial markets and financial institutions are both parts of: A) the U.S. Treasury. B) the financial system. C) the SEC. D) none of these answers are correct. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 29) Savings provided by ________ in small dollar amounts is the origin of much of the money that funds business loans in an economy. A) households B) the U.S. government C) small businesses D) none of these answers are correct Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective

30) The primary function of a financial system is to funnel funds from: A) wealthy individuals to non-wealthy individuals. B) lender-savers to borrower-spenders. C) borrower-spenders to lender-savers. D) the government to wealthy individuals. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 31) ________ are the principal lender-savers in the economy. A) Households B) Investment banks C) State governments D) Businesses Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 32) An important function of financial intermediation is: A) to convert financial securities with one set of characteristics into securities with a different set of characteristics. B) to direct the money from lenders to borrowers. C) to direct the money from borrowers to savers. D) for commercial banks to use consumer CD deposits to make deposits to small businesses. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

33) An important function of the financial system is: A) to direct funds from savers to the best investment opportunities in the economy. B) to allow the federal government to view all financial transactions. C) to help state governments to coordinate state tax levies. D) to direct the money from borrower-lenders to lender-savers. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 34) Direct financing occurs when: A) a lender-saver borrows directly from a borrower-spender. B) a borrower-spender borrows directly from a lender-saver. C) a lender-saver borrows from the federal government. D) a borrower-spender borrows from the federal government. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 35) Which of the following are major participants in the direct financial markets? A) Large corporations B) Wealthy individuals C) Financial Institutions D) All of these Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

36) The major players in the direct financial markets are: A) investment banks. B) money center banks. C) regional banks. D) both investment banks and money center banks. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 37) What is the typical minimum denominated transaction size in the direct financial markets? A) $10,000 B) $100,000 C) $1,000,000 D) $10,000,000 Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 38) Which of the following Acts is responsible for rolling back many of the rules prohibiting commercial banks from engaging in investment banking activities? A) The Securities Act of 1933 B) The Securities Exchange Act of 1934 C) The Glass-Steagall Act of 1933 D) The Financial Services Modernization Act of 1999 Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Legal/Regulatory Perspective

39) Which of the following is a process by which investment bankers purchase new securities directly from the issuing company and resell them to the investors? A) Agency marketing B) Underwriting C) Distribution D) Private placement Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 40) Stocks that are traded in the ________ are typically those of smaller and less well-known firms. A) National Stock Exchange B) New York Stock Exchange C) American Stock Exchange D) over-the-counter markets Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 41) The financial market where a new security is sold for the first time is called: A) a primary market. B) a secondary market. C) an indirect financial market. D) none of these answers are correct. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

42) Secondary financial markets are similar to: A) direct auction markets. B) new-car markets. C) used-car markets. D) direct financial market. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 43) If you just purchased a share of IBM through a New York Stock Exchange-based transaction, you participated in: A) a primary market transaction. B) a secondary market transaction. C) a futures market transaction. D) none of these answers are correct. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 44) The ease with which a security can be sold and converted into cash is called: A) convertibility. B) liquidity. C) marketability. D) none of these answers are correct. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management

45) The presence of a secondary market increases the marketability of a financial security by: A) insuring the price of the security. B) reducing the transaction costs from selling the security. C) guaranteeing the accuracy of information produced by the issuer of the security. D) none of these answers are correct. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 46) One of the main services provided by investment banks to companies is: A) helping companies sell new debt or equity issues in the financial markets. B) making loans to companies. C) taking deposits from companies. D) all of these. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 47) The NYSE is an example of: A) an over-the-counter market exchange. B) an organized exchange. C) a commodities exchange. D) all of these. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

48) Which of the following markets has no central trading location? A) A futures and options market B) An over-the-counter market C) An auction market D) None of these answers are correct Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 49) A highly liquid financial instrument with a maturity of 90 days would be traded in: A) the money market. B) the bond market. C) the stock market. D) none of these answers are correct. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 50) Money market instruments are generally issued by: A) firms in dire need of cash to maintain their credit rating. B) firms with the highest credit rating. C) firms with lower credit ratings. D) all of these. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

51) The term money market is used because: A) firms that issue securities in this market are in dire need of cash. B) it is a market where stocks are converted into money. C) the instruments traded in this market are close substitutes for cash. D) none of these answers are correct. Answer: C Diff: 3 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 52) If a firm needs to adjust its liquidity position, then it would participate in: A) the money market. B) the bond market. C) the stock market. D) the auction market. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 53) If a firm needs to finance a new corporate headquarters building, then it would most likely seek the funds in the: A) money market. B) capital market. C) futures market. D) all of these. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management

54) Which of the following statements about the OTC market is true? A) Securities that are listed on an organized exchange are bought and sold in the OTC market. B) An OTC market is an organized exchange where there is a central trading location. C) OTC security transactions are made on the floor of an exchange by traders. D) Securities that are not listed on an organized exchange are bought and sold on the OTC market. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 55) The most common reason that corporate firms use the futures and options markets is to: A) hedge risk. B) take risk. C) make deposits. D) none of these answers are correct. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 56) Which of the following theories states that security prices reflect all public information, but not all private information? A) Weak-form efficiency B) Semistrong-form efficiency C) Strong-form efficiency D) Nominal-form efficiency Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

57) Which of the following theories states that security prices reflect all information, whether public or private? A) Weak-form efficiency B) Semistrong-form efficiency C) Strong-form efficiency D) Nominal-form efficiency Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 58) If your firm obtains most of its financing from commercial banks, then it primarily accesses the capital markets through: A) direct financing. B) indirect financing. C) a legal loophole that allows all commercial banks the ability to underwrite securities. D) none of these answers are correct. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 59) The process of converting financial securities with one set of characteristics into securities with another set of characteristics is called: A) financial bundling. B) financial intermediation. C) financial disintermediation. D) none of these answers are correct. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management

60) A line of credit to a corporation is like ________ to an individual. A) a term loan B) a bond C) a credit card D) a debit card Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 61) Which of the following can be a primary investment vehicle(s) for the funds in which life insurance companies must invest? A) CDs B) Equity securities C) Long-term corporate bonds D) Both equity securities and long-term corporate bonds Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 62) Casualty insurance companies sell: A) protection against loss of income in the event of the death of the insured. B) protection against loss of property from fire, theft, accidents, and other predictable causes. C) protection against a loss of pension revenue for retirees. D) all of these. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

63) Which of the following is least likely to be included in a pension fund's investment portfolio? A) Commercial paper B) Long-term corporate bonds C) Stocks D) Long-term government securities Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64) A mutual fund is an example of: A) a line of credit. B) an endowment fund. C) an investment fund. D) a pension fund. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 65) Large firms are most likely to use money markets: A) to finance long term investments. B) to adjust their liquidity position. C) to make long term investments. D) to buy commercial paper at lower interest rates than it could sell through a bank. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

66) If a small business chooses not to borrow funds from a commercial bank, then what will probably be its next best alternative source of capital? A) An insurance company B) A pension C) An investment fund D) A business finance company Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 67) The cost of borrowing money is called: A) inflation. B) return. C) interest. D) all of these. Answer: C Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 68) Which of the following statements best describes the relationship between interest rates and the business cycle? A) Typically, the Fed tightens credit to stimulate the economy, which puts further downward pressure on interest rates. B) Interest rates tend to rise during economic expansion and decline during economic contraction. C) During an expansion, there is downward pressure on interest rates as businesses begin to grow and borrow more money. D) During a recession, the demand for goods and services is lower, businesses borrow more, and as a result the economy slows down and the interest rates decline. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management

69) The nominal rate of interest is comprised of: A) the real rate of interest. B) inflation expectation. C) a commodity cross-index return. D) both the real rate of interest and inflation expectation. Answer: D Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 70) The real rate of interest can be fundamentally determined by: A) compensation for inflation. B) compensation for deferring consumption. C) compensation for the level of international borrowing. D) all of these. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 71) If you are a borrower, which would you prefer to occur during the life of your loan? A) A level of inflation that is higher than that anticipated at the outset of the loan B) A level of inflation that is lower than that anticipated at the outset of the loan C) A level of inflation that is exactly the same as anticipated at the outset of the loan D) No inflation at all Answer: A Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Reflective Thinking IMA: Corporate Finance AICPA: Resource Management

72) If inflation is anticipated to be 6 percent during the next year, while the real rate of interest for a one-year loan is 5 percent, then what should the nominal rate of interest be for a risk-free one-year loan? A) 6% B) 11% C) 5% D) 12% Answer: B Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 73) If inflation is anticipated to be 5 percent during the next year, while the nominal rate of interest for a risk-free one-year loan is 10 percent, then what should the real rate of interest for a one-year loan be? A) 5 percent B) 10 percent C) 15 percent D) 25 percent Answer: A Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74) The general level of interest rates tends to follow: A) deflation. B) the business cycle. C) the default cycle. D) all of these. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

75) During an economic expansion, we would expect: A) interest rates to increase. B) interest rates to decrease. C) interest rates to remain the same. D) the cost of money to decrease. Answer: A Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 76) In the United States, the real rate of interest has historically been around: A) 1 percent. B) 3 percent. C) 5 percent. D) 7 percent. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 77) You loaned $100 to a friend for one year at a nominal rate of interest of 3 percent. Inflation during that year was 2 percent. Has the purchasing power of your money increased or decreased and by how much? A) Increased by 1 percent. B) Decreased by 1 percent C) Increased by 5 percent. D) Decreased by 5 percent Answer: A Diff: 2 Learning Objective: LO 6 Bloomcode: Analysis AACSB: Analytic IMA: Business Economics AICPA: Resource Management

78) You loaned $100 to a friend for one year at a nominal rate of interest of 5 percent. Inflation during that year was 8 percent. Has the purchasing power of your money increased or decreased and by how much? A) Increased by approximately 3 percent B) Decreased by approximately 3 percent C) Increased by approximately 13 percent D) Decreased by approximately 13 percent Answer: B Diff: 2 Learning Objective: LO 6 Bloomcode: Analysis AACSB: Analytic IMA: Business Economics AICPA: Resource Management 79) If the supply of loanable funds decreases relative to the demand for those loanable funds, then we would expect: A) interest rates to remain unchanged. B) interest rates to increase. C) interest rates to decrease. D) the cost of money to remain unchanged. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 80) Which of the following terms relates to the process in which a firm sells common stocks to the public for the very first time? A) An underwriting B) An initial public offering C) A financial intermediation D) An origination Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

81) Explain why secondary markets are so important to businesses that need to raise capital. Answer: Secondary markets provide liquidity to the buyers of securities. They facilitate the sale of securities because they enable investors to buy and sell securities as frequently as they want. Secondary markets are important to corporations because investors are willing to pay higher prices for securities in primary markets if the securities are expected to have active secondary markets. This lowers the cost of capital for the corporations that issue securities. Diff: 3 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 3 Financial Statements, Cash Flows, and Taxes 1) A firm's annual report contains audited financial statements (balance sheet, income statement, statement of cash flows, and statement of retained earnings). Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Measurement 2) Generally accepted accounting principles (GAAP) are a set of authoritative guidelines that define accounting practice at a particular point in time. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Measurement 3) Generally accepted accounting principles determine the rules for how a company can issue equity to raise money. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Reporting AICPA: Measurement 4) The realization principle assumes that the parties to a transaction are economically rational and are free to act independently of each other. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

5) The realization principle implies that revenue should be recognized only at the time of the sale. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6) The cost principle calls for the recognition of all accounting transactions at their current market value. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7) The cost principle assumes that the parties to a transaction are economically rational and are free to act independently of each other. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8) The going concern assumption states that a business will be shutting down its operation in the near future. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

9) The balance sheet identifies the productive resources (assets) that a firm uses to generate income, as well as the sources of funding from creditors (liabilities) and owners (shareholders' equity) that were used to buy the assets. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 10) The balance sheet identity can be stated as: Total assets = Total liabilities + Total stockholders' equity. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Communication IMA: Reporting AICPA: Reporting 11) Any shares repurchased by the company in the open market are recorded as treasury stock in the shareholders' equity account in the balance sheet. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Communication IMA: Reporting AICPA: Measurement 12) The most common reason for firms to repurchase stock is to increase the number of shares outstanding in the market when the management believes that its firm's stock is undervalued. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

13) Companies repurchase their shares in the open market in the hope that it would boost the share price. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 14) In a balance sheet, assets are listed in order of their liquidity. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 15) During rising prices, a company using the LIFO method assumes that the sale is from the newest, highest-cost inventory. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 16) During rising prices, a company using the FIFO method will sell its newest, highest-cost inventory first. Answer: FALSE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 17) Book value is the amount a firm paid for its assets at the time of purchase. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Reporting 4

18) The net book value of an asset is the historical cost less the accumulated depreciation. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Measurement 19) The market value of an asset is the amount that a firm would receive for the asset if it were sold on the open market. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 20) Preparing a marked-to-market balance sheet is rather straightforward because it is easy to obtain market values for all assets and liabilities. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 21) The income statement identifies the major sources of revenues generated by the firm and the corresponding expenses that were required to generate those revenues. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Reporting 22) Depreciation expense is the amount by which a firm's fixed assets are reduced in value after the assets have been used to produce the firm's cash flows for a given year. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Reporting AICPA: Measurement 5

23) Amortization is the amount by which intangible assets like goodwill, patents, licenses, copyrights, and trademarks are reduced in value in any period that they are utilized by the firm to generate benefits. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Communication IMA: Reporting AICPA: Reporting 24) Both depreciation and amortization are cash expenses that will serve to boost the firm's aftertax cash flows. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 25) Depreciation and amortization are examples of prepaid expenses. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 26) The net cash provided by operating activities is another term used for net income. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting

27) Cash flows from operations are the net cash flows that support a firm's principal business activities. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Reporting AICPA: Measurement 28) Cash flows from operating activities involve buying and selling of long-term assets. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Reporting AICPA: Measurement 29) Making and collecting loans, issuing and paying out on insurance contracts, and buying and selling debt or equity instruments of other firms are examples of financing activities. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 30) Typical financing activities include cash payments on the principal of long-term debt, cash payments of dividends to shareholders, and cash purchases of treasury stock. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management

31) The key financial statement that ties the other three statements together is the statement of cash flows, which summarizes changes in the balance sheet from the beginning of the year to the end. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 32) Rent and insurance are examples of depletion expenses. Answer: FALSE Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 33) The average tax rate is the total tax payment divided by the taxable income. Answer: TRUE Diff: 2 Learning Objective: LO 8 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Measurement 34) Which of the following sections do annual reports typically contain? A) Financial summary related to the past year's performance B) Information about the company, its products, and its activities C) Audited financial statements, including limited historical financial data D) All three of these sections are included in the annual report. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Communication IMA: Reporting AICPA: Reporting

35) Annual reports are prepared by a firm's management to: A) communicate to its shareholders the firm's failures in the previous year. B) provide a broad overview of the firm's financial and operating performance. C) highlight the performance of its chief competitors. D) provide a forecast of the economy in the coming years. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 36) The generally accepted accounting principles (GAAP) are rules: A) that outline how a firm can operate ethically. B) on how the firm will be valued in the event of a merger. C) that define how companies are to maintain financial records and prepare financial statements. D) for how a company can issue stock to raise money. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Measurement 37) Accounting standards prescribed by generally accepted accounting principles (GAAP) are important because they: A) make the financial statements of all firms standardized. B) allow one to examine a firm's performance with ease over a period of time. C) make it possible for management or analysts to compare a firm's performance with that of other competitors. D) All of these are correct. Answer: D Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Reporting AICPA: Measurement

38) The assumption of arm's-length transaction states that: A) both parties to a transaction can act independently of each other and make economically rational decisions. B) both parties to a transaction must have had previous transactions. C) one of the parties to the transaction is a bank that has full knowledge of the firm's creditworthiness. D) None of these are correct. Answer: A Diff: 2 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39) Your uncle is planning to sell his second home in Bethany Beach, Delaware in the next few weeks. You are interested in buying this beachside property, so your agent negotiates a price for the house with your uncle's agent. This transaction is an example of the: A) cost principle. B) assumption of arm's-length transactions. C) realization principle. D) going concern assumption. Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 40) The going concern assumption implies that a firm will: A) continue to be in business at least for the next 12 months. B) be going out of business in the near future. C) continue to operate in the near future, but only after being acquired by another firm. D) None of these are correct. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Budget Preparation AICPA: Industry/Sector Perspective

41) The matching principle calls for the accountant of a firm to: A) identify an asset with each liability of the firm. B) associate the revenue generated from a sale to the costs or expenses incurred to generate the revenue. C) match each item of inventory with the historical cost at which it was acquired. D) None of these are correct. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Cost Management AICPA: Strategic/Critical Thinking 42) Tyson Corporation bought raw materials on April 23, 2022 and also on July 2, 2022. Products produced during the month of May were sold in July. The firm uses FIFO to value its inventory. According to the matching principle, the firm's accountant should associate: A) the inventory acquired on July 2 with the products sold. B) the inventory acquired on April 23 with the products sold. C) Neither of these dates is valid because the products were sold in July. D) None of these are correct. Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Measurement 43) According to the realization principle, revenue from a sale of a firm's products are recognized when the: A) products are shipped to the buyer. B) buyer orders the goods. C) cash is collected from the sale of the products. D) sale occurs whether or not cash is actually received. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting

44) On June 23, 2022, Mikhal Cosmetics sold $250,000 worth of its products to Rynex Corporation, with the payment to be made in 90 days on September 20. The goods were shipped to Rynex on July 2. The firm's accountants should recognize the sale on: A) June 23, 2022. B) July 2, 2022. C) September 20, 2022. D) None of these are correct. Answer: A Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Communication IMA: Reporting AICPA: Reporting 45) The cost principle states that an asset should be recognized on the balance sheet at the: A) market value of the asset. B) market value less the accumulated depreciation on the asset. C) historical cost. D) historical cost plus the accumulated depreciation on the asset. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 46) Trekkers Footwear bought a piece of machinery on January 1, 2020 at a cost of $2.3 million, and the machinery is being depreciated annually at an amount of $230,000 for 10 years. Its market value on December 31, 2022 is $1.75 million. The firm's accountant is preparing its financial statement for the fiscal year end on December 31, 2022. The net value of the asset that should be reported on the balance sheet is: A) $2.3 million. B) $1.61 million. C) $230,000. D) $1.75 million. Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Measurement

47) The conventional way of preparing a balance sheet is to list all assets in the order of their: A) market value. B) risk. C) liquidity. D) historical cost. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Communication IMA: Reporting AICPA: Reporting 48) Petra, Inc., has $400,000 as current assets, $1.225 million as plant and equipment, and $250,000 as goodwill. In preparing the balance sheet, these assets should be listed in which of the following orders? A) Current assets, goodwill, and plant and equipment B) Current assets, plant and equipment, and goodwill C) Goodwill is not an asset and is not listed here D) None of these are correct Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Reporting 49) When prices are rising, the value of ending inventory using the FIFO method rather than LIFO gives: A) inventory a higher value but lowers net income. B) inventory a lower value and also lowers net income. C) both inventory and net income a higher value. D) inventory a lower value and net income a higher value. Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Reporting AICPA: Measurement

50) When prices are falling, the value of inventory using the LIFO method rather than FIFO gives inventory a: A) higher value but lowers net income. B) lower value and also lowers net income. C) higher value and net income a higher value. D) lower value and net income a higher value. Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Reporting AICPA: Measurement 51) Which of the following is NOT true about goodwill? A) It is an intangible asset. B) It represents the value of all unrecorded assets acquired in a merger. C) It equals the premium paid over the fair market value of the assets acquired in a merger. D) It reduces the firm's net worth by that amount. Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Communication IMA: Reporting AICPA: Reporting 52) Which of the following is NOT true about treasury stock? A) It is a firm's own shares repurchased in the market by the firm. B) It can be reissued under stock option and other employee benefit plans. C) It lowers the value of the company. D) It increases the net worth of the company. Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management

53) Maddux, Inc., has completed its fiscal year and reported the following information. The company had current assets of $153,413, net fixed assets of $412,331, and other assets of $7,822. The firm also has current liabilities worth $65,314, long-term debt of $178,334, and common stock of $162,000. What is the amount of retained earnings? A) $405,648 B) $243,648 C) $167,918 D) $573,566 Answer: C Explanation: Total assets = $153,413 + $412,331 + $7,822 = $573,566 Total liabilities = $65,314 + $178,334 = $243,648 Total stockholders' equity = Total assets - Total liabilities Total stockholders' equity = $573,566 - $243,648 = $329,918 Retained earnings = Total stockholders' equity - Common stock Retained earnings = $329,918 - $162,000 = $167,918 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 54) Shane, Inc., has completed its fiscal year and reported Total Assets of $1,000,000 and Total Liabilities of $300,000. Calculate the value of common equity. A) $1,300,000 B) $700,000 C) $600,000 D) $800,000 Answer: B Explanation: Common Equity = Total Assets - Total Liabilities Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Reporting AICPA: Measurement

55) Galan Associates prepared its financial statement for 2017 based on the information given here. The company had cash worth $1,234, inventory worth $13,480, and accounts receivables worth $7,789. The company's net fixed assets are $42,331, and other assets are $1,822. It had accounts payables of $9,558, notes payables of $2,756, common stock of $22,000, and retained earnings of $14,008. How much long-term debt does the firm have? A) $54,342 B) $76,342 C) $12,314 D) $18,334 Answer: D Explanation: Current assets = $1,234 + $7,789 + $13,480 = $22,503 Total assets = $22,503 + $42,331 + $1,822 = $66,656 Current liabilities = $9,558 + $2,756 = $12,314 Total stockholders' equity = $22,000 + $14,008 = $36,008 Long-term debt = Total assets - Current liabilities - Total stockholders' equity Long-term debt = $66,656 - $12,314 - $36,008 = $18,334 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 56) Tumbling Haven, a gymnastic equipment manufacturer, provided the following information to its accountant. The company had net fixed assets of $356,190, and other assets of $4,176. The firm has current liabilities of $94,792, long-term debt of $76,445, common stock of $200,000, and retained earnings of $134,461. What amount of current assets did this firm have? A) $145,332 B) $505,698 C) $171,217 D) $237,332 Answer: A Explanation: (Total Assets - Current Assets) = Net Fixed Assets + Other Assets = $356,190 + $4,174 = $360,366 Total Liabilities and Equity = $94,792 + $76,445 + $200,000 + $134,461 = $505,698 = Total Assets Current Assets = Total Assets - (Total Assets - Current Assets) = $505,698 - $360,366 = $145,332 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

57) Tumbling Haven, a gymnastic equipment manufacturer, provided the following information to its accountant. The company had current assets of $145,332, net fixed assets of $356,190, and other assets of $4,176. The firm had long-term debt of $76,445, common stock of $200,000, and retained earnings of $134,461. What amount of current liabilities did this firm have? A) $94,792 B) $505,678 C) $171,217 D) None of these are correct. Answer: A Explanation: Total assets = $145,332 + 356,190 + $4,176 = $505,698 Total stockholders' equity = $200,000 + $134,461 = $334,461 Current liabilities = Total assets - Long-term debt - Total stockholders' equity Current liabilities = $505,698 - $76,445 - $334,461 = $94,792 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 58) Teakap, Inc., has current assets of $1,456,312 and total assets of $4,812,369 for the year ending September 30, 2016. It also has current liabilities of $1,041,012, common equity of $1,500,000, and retained earnings of $1,468,347. What is the value of long term debt? A) $1,844,022 B) $2,303,010 C) $2,123,612 D) $803,010 Answer: D Explanation: Total Stockholders' equity = $1,500,000 + $1,468,347 = $2,968,347 Long-term debt = Total assets - Current liabilities - Total Stockholders' equity Long-term debt = $4,812,369 - $1,041,012 - $2,968,347 = $803,010 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

59) Chandler Sporting Goods produces baseball and football equipment and lines of clothing. This year the company had cash and marketable securities worth $335,485, accounts payables worth $1,159,357, inventory of $1,651,599, accounts receivables of $1,488,121, short-term notes payable worth $313,663, and other current assets of $121,427. What is the company's net working capital? A) $3,596,632 B) $1,801,784 C) $2,123,612 D) $1,673,421 Answer: C Explanation: Total current assets = $335,485 + 1,488,121 + $1,651,599 + $121,427 = $3,596,632 Total current liabilities = $1,159,357 + $313,663 = $1,473,020 Net working capital = $3,596,632 - $1,473,020 = $2,123,612 Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Reporting AICPA: Measurement 60) What is the difference between FIFO (first in, first out) and LIFO (last in, first out) accounting? A) FIFO refers to the practice of firms, when making sales, assuming that the inventory that came in first (at a higher price) is being sold first. B) During a period of rising prices, LIFO implies that a firm is selling the higher cost, newer inventory first, leaving the lower cost, older inventory on the balance sheet. C) During a period of falling prices, LIFO implies that a firm is selling the higher cost, newer inventory first, leaving the lower cost, older inventory on the balance sheet. D) LIFO refers to the practice of firms, when making sales, assuming that the inventory that came in last is being sold first (at a higher price). Answer: B Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

61) Tre-Bien Bakeries generated net income of $233,412 this year. At year end, the company had accounts receivables of $47,199, inventory of $63,781, and cash of $21,461. It also had accounts payables of $51,369, short-term notes payables of $11,417, and accrued taxes of $6,145. The net working capital of the firm is: A) $68,931. B) $63,510. C) $69,655. D) None of these are correct. Answer: B Explanation: Total current assets = $21,461 + $47,199 + $63,781 = $132,441 Total current liabilities = $51,369 + $11,417 + $6,145 = $68,931 Net working capital = $132,441 - $68,931 = $63,510 Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Reporting AICPA: Measurement 62) Spartan, Inc., is a manufacturer of automobile parts located in Greenville, South Carolina. At the end of the current fiscal year, the company had net working capital of $157,903. The company showed accounts payables of $94,233, accounts receivables of $83,112, inventory of $171,284, and cash and marketable securities of $12,311. Calculate the amount of notes payables. (Assume that notes payable and accounts payable are the only two current liabilities of the company.) A) $14,571 B) $26,882 C) $15,471 D) None of these are correct Answer: A Explanation: Total current assets = $12,311 + $83,112 + $171,284 = $266,707 Net working capital = $266,707 - Total current liabilities = $157,903 Total current liabilities = $266,707 - $157,903 = $108,804 Total current liabilities = $108,804 = Accounts payable + Notes payable Notes payable = $108,804 - $94,233 = $14,571 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

63) The major disadvantages of market-value accounting include: A) the difficulty in estimating the current value for some assets. B) the difficulty in applying some of the valuation models used to estimate market values. C) the resulting numbers are potentially open to abuse. D) All of these choices are disadvantages of market-value accounting. Answer: D Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 64) Which of the following is the best example of how a market-value balance sheet item differs from the firm's book-value balance sheet item? A) A firm issued long-term bonds five-years ago that currently sell for par value. B) A firm sold common stock twenty-years ago for $20.00 a share. The firm's common stock is currently selling for $96.50 per share. C) A firm has $5 million of accrued liabilities on the books. D) A firm issued preferred stock ten-years ago. These shares of preferred stock currently are selling for par value. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 65) Which of the following statements is NOT a limitation associated with market valuation of balance sheet accounts? A) It can be difficult to identify the market value of an asset, particularly if there are few transactions involving comparable assets. B) The estimates of market value can involve complex financial modeling, and the resulting numbers can be open to manipulation and abuse. C) Marking to market provides decision makers with a better chance of making the correct economic decision, given the information available. D) Mark-to-market accounting can become inaccurate if market prices deviate from the "fundamental" values of assets and liabilities. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Reporting AICPA: Measurement

66) Which of the following does NOT belong to an income statement? A) Depreciation expense B) Goodwill C) Extraordinary items D) Amortization expense Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Communication IMA: Reporting AICPA: Reporting 67) Which of the following is NOT a noncash item? A) Depreciation B) Taxes C) Prepaid expenses D) Prepaid taxes Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Budget Preparation AICPA: Measurement 68) Centennial Brewery produced revenues of $1,145,227 in 2022. It has expenses (excluding depreciation) of $812,640, depreciation of $131,335, and interest expense of $81,112. It pays an average tax rate of 34 percent. What is the firm's net income after taxes? Round your final answer to the nearest dollar. A) $120,140 B) $248,475 C) $79,292 D) $40,848 Answer: C Explanation: Earnings before taxes = $1,145,227 - ($812,640 + $131,335 + $81,112) = $120,140 Net income = $120,140 (1 - 0.34) = $79,292 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Measurement

69) Simplex Healthcare had net income of $5,411,623 after paying taxes at 34 percent. The firm had revenues of $20,433,770.Its interest expense for the year was $1,122,376, while depreciation expense was $2,079,112. What was the firm's operating expenses excluding depreciation? Round your intermediate calculations and final answer to the nearest dollar. A) $8,199,429 B) $9,032,853 C) $9,321,805 D) None of these are correct. Answer: B Explanation: Earnings before taxes = Net income/(1 - Tax rate) = $5,411,623 / (1 - 0.34) = $8,199,429 EBIT = EBT + Interest expense = $8,199,429 + $1,122,376 = $9,321,805 Revenues - Operating expenses - Depreciation = EBIT Operating expenses = Revenues - Depreciation - EBIT = $20,433,770 - $2,079,112 - $9,321,805 = $9,032,853 Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 70) Triumph Trading Company provided the following information to its auditors. For the year ended March 31, 2022, the company had revenues of $1,122,878, operating expenses (excluding depreciation and leasing expenses) of $612,663, depreciation expenses of $231,415, leasing expenses of $126,193, and interest expenses of $87,125. If the company's average tax rate was 34 percent, what is its net income after taxes? Round your final answer to the nearest dollar. A) $43,218 B) $65,482 C) $152,607 D) None of these are correct. Answer: A Explanation: EBIT = $1,122,878 - ($612,663 + $231,415 + $126,193) = $152,607 Earnings before taxes = ($152,607 - $87,125) = $65,482 Net income = $65,482 (1 - 0.34) = $43,218 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Measurement

71) Parrino Corporation has announced that its net income for the year ended June 30, 2022, is $1,824,214. The company had an EBITDA of $5,174,366, and its depreciation and amortization expense was equal to $1,241,790. The company's average tax rate is 34 percent. What is the amount of interest expense for the firm? A) $2,763,961 B) $939,747 C) $1,187,720 D) $1,168,615 Answer: D Explanation: Amount EBITDA $5,174,366.00 Less: Depreciation and amortization 1,241,790.00 EBIT $3,932,576.00 Less: Interest 1,168,615.39** EBT $2,763,960.61* Less: Taxes (34%) 939,746.61 Net income $1,824,214.00 *EBT = Net income/(1 - Tax rate) = $1,824,214/0.66 = $2,763,960.61 **Interest = EBIT - EBT = $3,932,576 - $2,763,960.61 = $1,168,615.39 Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

72) The Brick Company has announced the following financial information for the period ending March 31, 2022: sales of $1.4 million, cost of goods sold of $800,000, depreciation expenses of $175,000, and interest expenses of $90,000. Assume that the firm has an average tax rate of 40 percent. What is the company's net income? A) $204,000 B) $201,000 C) $203,000 D) $220,000 Answer: B Explanation: The Brick Company Income Statement For the period ended on March 31, 2022 Amount Revenues $1,400,000 COGS 800,000 EBITDA $ 600,000 Depreciation 175,000 EBIT $ 425,000 Interest 90,000 EBT $ 335,000 Taxes (40%) 134,000 Net income $ 201,000 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Measurement

73) Arco Steel, Inc. generated total sales of $45,565,200 during fiscal 2022. Depreciation and amortization for the year totaled $2,278,260, and cost of goods sold was $27,339,120. Interest expense for the year was $9,641,300 and selling, general, and administrative expenses totaled $4,556,520 for the year. What is Arco's EBIT for 2022? A) $9,641,300 B) $11,391,300 C) $13,275,030 D) $18,490,000 Answer: B Explanation: Net sales $ 45,565,200 Cost of goods sold 27,339,120 Gross Profit $ 18,226,080 Selling, general and administrative expenses 4,556,520 Depreciation and amortization 2,278,260 Earnings Before Interest and Taxes (EBIT) $ 11,391,300 Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 74) Which of the following is an income statement item? A) Accounts payable B) Accrued taxes C) Retained earnings D) Selling and administrative expenses Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Communication IMA: Reporting AICPA: Reporting 75) Which of the following is NOT a cash flow from operating activities? A) Cash payments on the principal of long-term debt B) Payments for utilities and rent C) Payments to purchase raw materials D) Cash receipts from selling goods and services Answer: A Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Communication IMA: Reporting AICPA: Reporting 25

76) Cash flows from financing activities include all but one of the following: A) Cash payments on the principal of long-term debt B) Buying and selling bonds or stock of other firms C) Cash purchases of treasury stock D) Cash proceeds from a bank loan Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Measurement 77) Which of the following is NOT a cash flow from investing activities? A) Buying and selling bonds of other firms B) Buying or selling of land, buildings, and plant and equipment C) Cash payments of dividends to shareholders D) Buying and selling stocks of other firms Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Reporting AICPA: Measurement 78) Trident Corporation had the following cash flows in the current year. Which of the following will be categorized under the financing activities section of the statement of cash flows? A) Rent on a warehouse amounting to $1.1 million B) Purchase of $125,000 worth of five-year bonds issued by Towson Utilities C) Preferred dividends of $330,000 paid to shareholders D) Lease income received on a piece of land Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Communication IMA: Reporting AICPA: Reporting

79) During 2022, Towson Recording Company increased its investment in marketable securities by $36,845, funded fixed assets acquisition by $109,455, and had marketable securities of $14,215 mature. What is the net cash provided by (used in) investing activities? A) $132,085 B) $145,940 C) -$132,085 D) -$145,940 Answer: C Explanation: Cash inflows from investing activities = $14,215 Cash outflows from investing activities = $36,845 + $109,455 = $146,300 Net cash flows used in investing activities = $14,215 - $146,300 = $(132,085) Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 80) Trident Manufacturing Company's treasurer identified the following cash flows during this year as significant. The company repaid existing debt of $425,110, while raising additional debt capital of $750,000. It also repurchased stock in the open markets for a total of $63,250 and paid $233,144 in dividends to its shareholders. What is the net cash provided by (used in) financing activities? A) $28,496 B) $91,746 C) -$28,496 D) -$91,746 Answer: A Explanation: Cash inflows from financing activities = $750,000 Cash outflows from financing activities = $425,110 + $63,250 + $233,144 = $721,504 Net cash flows from financing activities = $750,000 - $721,504 = $28,496 Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

81) Super Grocers, Inc., provided the following financial information for the quarter ending September 30, 2022: Depreciation and amortization - $133,414 Increase in receivables - $112,709 Increase in accounts payables - $62,411 Decrease in marketable securities - $31,225

Net income - $341,463 Increase in inventory - $81,336

What is the cash flow from operating activities generated during this quarter by the firm? A) $308,458 B) $374,468 C) -$374,468 D) -$308,458 Answer: B Explanation: Statement of Cash Flows For the quarter ended on September 30, 2022 Operating Activities Net income $341,463 Additions (sources of cash) Depreciation and amortization 133,414 Increase in accounts payable 62,411 Decrease in marketable securities 31,225 Subtractions (uses of cash) Increase in accounts receivable (112,709) Increase in inventories (81,336) Net cash provided by operating activities $374,468 Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

Reference 3-1 Use the following information to answer the questions below: Thunderbird Amusement Park–Balance Sheet as of June 30 Assets 2021 2022 Cash $ 13,221 $ 11,729 Accounts receivables 31,323 37,909 Inventory 77,244 91,617 Total current assets $121,788 $141,255 Fixed assets 444,712 563,323 Less: Accumulated depreciation (100,000) (172,487) Net fixed assets 344,712 390,836 Total assets $466,500 $532,091 Liabilities and Stockholders' Equity Accounts payable Notes payable Deferred taxes Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and stockholders' equity

$ 38,549 12,004 21,934 $ 72,487 78,445 125,000 190,568 $466,500

$ 42,881 16,753 16,788 $ 76,422 61,290 175,000 219,379 $532,091

The company had a net income of $248,462, and depreciation expenses were equal to $72,487.

82) Refer to Reference 3-1. What is the firm's net cash flow from operating activities? A) $304,322 B) $299,176 C) $192,602 D) None of these are correct Answer: B Explanation: Operating Activities Net income $248,462 Additions (sources of cash) Depreciation and amortization 72,487 Increase in accounts payable 4,332 Subtractions (uses of cash) Increase in accounts receivable (6,586) Increase in inventories (14,373) Decrease in deferred taxes ( 5,146) Net cash provided by operating activities $299,176 Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 83) Refer to Reference 3-1. What is the firm's net cash flow provided by (used in) investing activities? A) $0 B) $46,124 C) -$46,124 D) None of these are correct Answer: C Explanation: Cash inflows from investing activities = $0 Cash outflows from investing activities = $390,836 - $344,712 = $46,124 Net cash flows from investing activities = -$46,124 Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

84) Refer to Reference 3-1. What is the firm's cash flow from financing activities? A) -$66,405 B) $61,656 C) -$61,656 D) -$182,057 Answer: D Explanation: Cash inflows from financing activities = Increase in notes payable + Increase in common stock = $4,749 + $50,000 = $54,749 Net income - Dividends = Increase in retained earnings Increase in retained earnings = $219,379 - $190,568 = $28,811 Cash dividends = $248,462 - $28,811 = $219,651 Cash outflows from financing activities = Decrease in long-term debt + Cash dividends paid = $17,155 + $219,651 = $236,806 Net cash flows from financing activities = $54,749 - $236,806 = $(182,057) Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 85) Which of the following is a cash flow from investing activities? A) Cash payment of dividends to shareholders B) Cash from sale of products C) Purchase of plant and equipment D) Rent received from industrial property owned Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting

86) Natural Lite, Inc. reported the following items during fiscal 2022. The firm purchased marketable securities of $87,500, paid down a long-term loan in the amount of $650,000, purchased $4,250,000 of new equipment. The firm also issued $6,250,000 of common stock, paid $350,225 in dividends to its common shareholders, and repurchased $1,250,000 of common stock in the open market. What is the net cash provided by financing activities? A) $4,575,210 B) $1,733,285 C) $3,999,775 D) $2,467,915 Answer: C Explanation: Cash inflows from financing activities = $6,250,000 Cash outflows from financing activities = $650,000 + $1,250,000 + $350,225 = $2,250,225 Net cash flows from financing activities = $6,250,000 - $2,250,225 = $3,999,775 Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 87) Which of the following presents a summary of the changes in a firm's balance sheet from the beginning of an accounting period to the end of an accounting period? A) The statement of retained earnings B) The statement of working capital C) The statement of cash flows D) The statement of net worth Answer: C Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting

88) Trimeton Corporation announced that in the year ended June 30, 2021, its earnings before taxes amounted to $2,367,045. Calculate its taxes using the following table. Round your final answer to the nearest dollar. Tax Rate Taxable Income 15% $0 to $50,000 25 50,001 - 75,000 34 75,001 - 100,000 39 100,001 - 335,000 34 335,001 - 10,000,000 35 10,000,001 - 15,000,000 38 15,000,001 - 18,333,333 35 More than $18,333,333 A) $804,795 B) $690,895 C) $713,145 D) None of these are correct Answer: A Explanation: Earnings before tax = $2,367,045 Tax rate

Income

Tax

15% 25 34 39 34

$50,000 $25,000 $25,000 $235,000 $2,032,045

$ 7,500 6,250 8,500 91,650 690,895

Total taxes payable Diff: 3 Learning Objective: LO 7 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

$804,795

89) Chartworth Associates' financial statements indicated that the company had EBITDA of $3,145,903. It had depreciation of $633,000, and its interest rate on debt of $1.25 million was 7.5 percent. Calculate the amount of taxes the company is likely to owe. Round your final answer to the nearest dollar. Tax Rate Taxable Income 15% $0 to $50,000 25 50,001 - 75,000 34 75,001 - 100,000 39 100,001 - 335,000 34 335,001 - 10,000,000 35 10,000,001 - 15,000,000 38 15,000,001 - 18,333,333 35 More than $18,333,333 A) $1,069,607 B) $1,037,732 C) $822,512 D) none of these answers are correct Answer: C Explanation: EBITDA $3,145,903 Depreciation (633,000) Interest (93,750) EBT $2,419,153 Tax rate

Income Range

Tax

15% 25 34 39 34

$0 to $50,000 50,001 - 75,000 75,001 - 100,000 100,001 - 335,000 335,001 - 10,000,000 Total taxes payable

$ 7,500 6,250 8,500 91,650 708,612 $822,512

Diff: 3 Learning Objective: LO 7 Bloomcode: Evaluation AACSB: Analytic IMA: Budget Preparation AICPA: Measurement

90) Chartworth Associates' financial statements indicated that the company has EBITDA of $3,145,903. It had depreciation of $633,000, and its interest rate on debt of $1.25 million was 7.5 percent. The company is likely to owe $822,512 in taxes. What are the marginal and average tax rates for this company? Tax Rate Taxable Income 15% $0 to $50,000 25 50,001 - 75,000 34 75,001 - 100,000 39 100,001 - 335,000 34 335,001 - 10,000,000 35 10,000,001 - 15,000,000 38 15,000,001 - 18,333,333 35 More than $18,333,333 A) 34%, 35% B) 35%, 34% C) 34%, 34% D) none of these answers are correct Answer: C Explanation: Marginal tax rate = 34% Average tax rate = Total taxes payable ÷ Total Taxable income = $822,512 ÷ $2,419,153 = 34% Diff: 3 Learning Objective: LO 7 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 91) Which of the following best represents cash flows to investors? A) Cash flow from operating activity, plus cash flow generated from net working capital B) Earnings before interest and taxes times 1 minus the firm's tax rate C) Net income minus dividends paid to preferred stockholders D) Cash flow from operating activity minus cash flow invested in net working capital minus cash flow invested in long-term assets Answer: D Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Reporting AICPA: Measurement

92) Clarity Music Company has a marginal tax rate of 34 percent and an average tax rate of 32 percent this year. It is planning to construct a new recording studio next year. The appropriate tax rate to be applied on the income generated from the new studio is: A) the average tax rate. B) the marginal tax rate. C) either the average tax rate or the marginal tax rate. D) neither the average tax rate or the marginal tax rate. Answer: B Diff: 2 Learning Objective: LO 8 Bloomcode: Application AACSB: Analytic IMA: Budget Preparation AICPA: Measurement 93) The London Bridge Company had $630,125 in taxable income in the year ending September 30, 2022. Calculate the company's tax using the following tax schedule. Tax rate 15% 25 34 39 34 A) $215,263 B) $214,243 C) $213,223 D) $211,435 Answer: B Explanation: Tax Rate 15% 25 34 39 34

Income Range (0 - $50,000) (50,001 - 75,000) (75,001 - 100,000) (100,001 - 335,000) (335,001 - 633,125)

Income Range $50,000 (75,000 - 50,000) (100,000 - 75,000) (335,000 - 100,000) (630,125 - 335,000) Total taxes payable

Tax $7,500 6,250 8,500 91,650 100,343 $214,243

Diff: 2 Learning Objective: LO 8 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

94) The London Bridge Company had $630,125 in taxable income in the year ending September 30, 2022. Calculate the company's marginal tax rate using the following tax schedule. Tax rate Income Range 15% (0 - $50,000) 25 (50,001 - 75,000) 34 (75,001 - 100,000) 39 (100,001 - 335,000) 34 (335,001 -633,125) A) 15% B) 25% C) 34% D) 39% Answer: C Explanation: The next dollar of income will be taxed at the rate in the schedule of 34% until income exceeds $10,000,000. Diff: 3 Learning Objective: LO 8 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

95) The London Bridge Company had $630,125 in taxable income in the year ending September 30, 2017. Calculate the company's average tax rate using the following tax schedule. Tax rate 15% 25 34 39 34 A) 15% B) 25% C) 34% D) 30% Answer: C Explanation: Tax Rate 15% 25 34 39 34

Income Range (0 - $50,000) (50,001 - 75,000) (75,001 - 100,000) (100,001 - 335,000) (335,001 - 633,125)

Income Range $50,000 (75,000 - 50,000) (100,000 - 75,000) (335,000 - 100,000) (630,125 - 335,000) Total taxes payable Average Tax = $214,343 / $630,125 = 34% Diff: 3 Learning Objective: LO 8 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

Tax $ 7,500 6,250 8,500 91,650 100,343 $214,243

96) Which of the following statements is true? A) Only 20 percent of interest income is taxable for a corporation. B) Dividend income is fully taxable. C) Interest paid on debt obligations is a tax-deductible business expense. D) Dividends paid to stockholders are a tax-deductible business expense. Answer: C Diff: 1 Learning Objective: LO 8 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

97) United Brands Corp. just completed their latest fiscal year. The firm had sales of $16,650,000. Depreciation and amortization was $832,500, interest expense for the year was $825,000, and selling general and administrative expenses totaled $1,665,000 for the year, and cost of goods sold was $9,990,000 for the year. Assuming a federal income tax rate of 34 percent, what was the United Brands net income after-tax? A) $2,202,750 B) $1,745,325 C) $3,505,100 D) $2,813,000 Answer: A Explanation: United Brands Corp. Net sales $ 16,650,000 Cost of goods sold 9,990,000 Gross Profit $ 6,660,000 Selling, general and administrative expenses 1,665,000 Depreciation and amortization 832,500 Earnings Before Interest and Taxes (EBIT) $ 4,162,500 Interest expense 825,000 Earnings Before Taxes (EBT) $ 3,337,500 Income Taxes 1,134,750 Net Income after-tax $ 2,202,750 Diff: 2 Learning Objective: LO 8 Bloomcode: Analysis AACSB: Analytic IMA: Reporting AICPA: Measurement

98) Identify and explain the five fundamental principles that form the basis of accounting standards in the United States. Answer: The U.S. GAAP is based on a set of five principles. These are the assumption of arm's-length transaction, the cost principle, the realization principle, the matching principle, and the going concern assumption. • The assumption of arm's-length transaction assumes that the two parties involved in a transaction have the ability to make economic decisions independently and rationally without having any influence on the other party's decision making. • The cost principle calls for recording the value of an asset at its cost at the time of acquisition. At any point in time, the book value represents a fair value of the asset. This book value is determined by depreciating the cost of the asset over its estimated useful life. • The realization principle reflects the fact that the revenue from a sale is recognized only when the sale of a firm's product or service is virtually completed and can be reliably confirmed. • The matching principle requires that any revenue generated from a sale is matched with the costs associated with producing the revenue. • The going concern assumption refers to the idea that a firm is expected to continue functioning at least for the next 12 months. Diff: 3 Learning Objective: LO 1 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Reporting 99) Explain the differences from using FIFO versus LIFO method of valuation in accounting for inventory. Answer: There are two common approaches that firms can use to value inventory. The first one is referred to as FIFO, or first-in, first-out, which requires a firm making a sale to associate the sale with the oldest inventory on the balance sheet. The second method is called LIFO, or last-in, first-out, and the firm using this approach is required to associate any sale with the newest inventory on the balance sheet. Although firms may switch from one approach to another, the switch cannot occur except under extraordinary circumstances. Choosing one approach over the other has an impact on a firm's balance sheet and the income statement, especially during the time of changing prices. When prices are rising, a firm using FIFO accounting has a lower cost of goods sold and a higher net income. In addition, the ending inventory will be valued at the more recent cost, which will result in a higher inventory value on the balance sheet. When prices are declining, firms using LIFO will benefit because LIFO provides the highest inventory valuation and net income. Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement

100) Explain the following income statement items. What are the advantages and disadvantages of using market-value accounting? Answer: Using market-value method of accounting to prepare financial statements has several advantages. Having current information about a firm's financial condition, and the information about expected cash flows a company can generate, will allow a firm's management to make better decisions. It allows investors and creditors to better evaluate the firm, and it improves its ability to raise capital. There are also some negatives associated with market-value accounting. First of all, assessing the market value of some of the assets becomes quite difficult, and accountants would wary of making estimates. Second, the valuation models used in practice are not easy to use and could result in unreliable values. Third, unscrupulous executives could very well use these estimates to their advantage. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Measurement 101) Explain the following income statement items. a. Amortization expense b. Extraordinary items c. EBITDA Answer: a. Amortization expense is similar to depreciation; however it is concerned with intangible assets. Just as depreciation is used to write off the cost of real assets such as plant and equipment, amortization is used for writing off expenses for intangible assets—such as patents, licenses, copyrights, trademarks, and goodwill. The costs are assigned to the fiscal periods in which the firm is assumed to have benefited from these intangible assets. b. Extraordinary items are unusual and unlikely to occur frequently. These are gains or losses that do not arise from operations, but because of occurrences such as floods, fires, and earthquakes. c. EBITDA is the acronym of earnings before interest, taxes, depreciation, and amortization. It represents a firm's earnings after accounting for cost of goods sold, but not expenses related to the asset base that was used to produce the revenues for the firm. The higher the value of the EBITDA, the more efficient the firm's operations are. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Communication IMA: Reporting AICPA: Reporting

102) Explain the following income statement items. Identify the noncash items that a firm may have on its financial statements and explain their impact on the shareholders of the firm. Answer: Several noncash items can be found on a firm's financial statement. Although some firms may have all of these items, others may not. One noncash item that most firms will have is the depreciation. This is typically the largest noncash item. Another noncash item is amortization. Other noncash items include the following: • Depletion charges, which are similar to depreciation but apply to extractive natural resources, such as crude oil, natural gas, timber, and mineral deposits. • Deferred taxes, which are the portion of a firm's income tax expense that is postponed because of differences in the accounting policies adopted for management financial reporting and tax reporting. • Prepaid expenses, such as prepaid rent and insurance. • Deferred revenues, which are revenues received as cash but not yet earned. An example of deferred revenue would be subscriptions received in advance towards magazines by a publishing company. The noncash expenses on a firm's income statement reduce the taxable income and hence the tax paid by the firm. This in turn increases the cash flow available to its shareholders. Noncash revenue items reduce the cash flow available to the firm but are typically nowhere near the magnitude of the largest noncash expenses. Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Reporting AICPA: Reporting

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 4 Analyzing Financial Statements 1) Financial statement analysis can help us determine why a firm's cash flows are increasing or decreasing. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 2) Trend analysis is a method of analyzing financial data to discover changes in a firm's performance over time. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 3) Stockholders of a firm are primarily concerned about the value of their shares but not about how much cash they expect to receive from dividends and/or capital appreciation over time. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 4) The shareholders of a firm are most interested in knowing if the firm is generating enough cash flows to meet all of its required obligations. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement

5) Financial statements reflect managers' decisions regarding financing, investment, and working capital. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 6) A financial statement analysis conducted over a period of time is called trend analysis. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 7) A typical way in which a common-size income statement is constructed is by dividing all expense items by net income reported in an income statement. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 8) Common-size balance sheets are those that are prepared with each item reflecting the common measures of a firm's revenues. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 9) A balance sheet can be standardized by expressing each asset and liability as a percentage of total assets. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 2

10) The most frequent method used for creating a common-size balance sheet is to divide each of the accounts by fixed assets. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 11) Liquidity ratios illustrate the firm's ability to generate sufficient cashflow from operations to meet its short-term obligations without putting the firm in financial difficulty. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 12) Efficiency ratios or asset turnover ratios (such as inventory and asset turnover ratios) measure how efficiently a firm uses its assets. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 13) Leverage ratios measure the extent to which a firm uses equity rather than debt financing and show the firm's ability to meet its short-term obligations without making the firm insolvent. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

14) A firm's current ratio changed from 1.4 times in the previous year to 1.6 times in the current year. Based on this information, we can conclude that the firm's liquidity has improved. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 15) A company can improve its liquidity by increasing its accounts payable, while maintaining the other accounts constant. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 16) A company can increase its equity multiplier by increasing its debt-to-equity ratio, holding everything else constant in the balance sheet. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 17) When a firm finances the purchases of additional inventory with accounts payable, the firm's quick ratio should decrease. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

18) Asset turnover ratios are useful for managers in identifying how efficient management is in using current and long-term assets to generate sales. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 19) A firm increased its days' sales outstanding from 35 days to 43 days. This implies the firm is more efficient in converting credit sales into cash. Answer: FALSE Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 20) Total asset turnover is more relevant for service-industry firms, while the fixed asset turnover ratio is more relevant for manufacturing-industry firms. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 21) Financial leverage refers to the use of preferred stocks in a firm's capital structure. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 22) The equity multiplier can be determined by dividing a firm's total equity by its total assets. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 5

23) The higher the times interest earned ratio, the greater the ability the firm has in meeting its interest payment obligations. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 24) For a given share price of a firm's stock, a lower EPS will lead to a lower price-to-earnings ratio. Answer: FALSE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 25) A firm with no debt will have its return on assets (ROA) equal to its return on equity (ROE). Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 26) One of the three major shortcomings of return on equity is that it ignores risk. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 27) For a given level of after-tax income, the lower the level of equity a firm has, the higher the return on equity its shareholders will earn. Answer: TRUE Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 6

28) A firm's ROE can be determined by the firm's ROA and its use of financial leverage. Answer: TRUE Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 29) The DuPont equation relates a firm's net profit margin, total asset turnover ratio, and equity multiplier with its return on equity. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 30) The DuPont equation shows the combined impact of a firm's efficiency in operation and in asset and debt utilizations on its return on equity. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 31) Firms with a lower return on assets (ROA) but higher leverage will always have a lower return on equity (ROE) than firms with a higher return on assets (ROA) but lower leverage. Answer: FALSE Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

32) In a peer group analysis, the benchmark for financial statement analysis for a particular firm is the performance of a competitor that is roughly the same size and that offers a similar range of products. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 33) To establish a benchmark for an industry group analysis, a comparison group is formed by choosing firms that are larger than the firm being compared. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 34) The Standard Industrial Classification (SIC) codes are four-digit numbers in which the last two digits describe the type of business or industry the firm is engaged in. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 35) The three different perspectives on financial statement analysis are those of the: A) managers, regulators, and bondholders. B) managers, shareholders, and creditors. C) regulators, shareholders, and creditors. D) bondholders, creditors, and regulators. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement

36) Shareholders analyze financial statements in order to: A) determine the ability of the firm to pay interest rather than dividends. B) perform their fiduciary responsibilities to management. C) determine the best board structure for the firm. D) determine the total cash dividend distribution they are likely to receive. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 37) Bondholders primarily analyze financial statements to: A) assess the cash flows that the firm will generate from its financing activities. B) determine the firm's profitability. C) focus on the value of the company stock. D) determine the likelihood that the firm will have sufficient cash to pay their interest and principal at maturity. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 38) The creditors of a firm analyze financial statements so that they can better understand the firm's: A) commitment to paying interest rather than principal on debt. B) ability to generate sufficient cash flows to meet its legal obligations first and still have sufficient cash flows to pay dividends. C) ability to meet only its long-term debt obligations. D) ability to meet its short-term obligations. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

39) A firm's management analyzes financial statements so that they can: A) get feedback on their investing, financing, and working capital decisions by identifying trends in the various accounts that are reported in the financial statements. B) focus on profitability, dividend, capital appreciation, and return on investment. C) get more stock options. D) get feedback on their investing, financing, and working capital decisions by identifying trends in the various accounts that are reported in the financial statements, and focus on profitability, dividend, capital appreciation, and return on investment. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 40) Anyone analyzing a firm's financial statements should: A) ignore trends, because the future is unpredictable. B) ignore benchmarks because firms are unique. C) not consider competitors performance and focus on the firm. D) use audited financial statements. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 41) An individual analyzing a firm's financial statements should do all of the following except: A) use unaudited financial statements. B) perform a trend analysis. C) perform a benchmark analysis. D) compare the firm's performance to that of its direct competitors. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

42) Which of the following would be unrelated to analyzing a firm's trend over time? A) The relative ratios of the major competitors B) The sales growth C) The control of the firm's expenses D) The efficient use of the firm's assets Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 43) Which of the following is NOT true of common-size balance sheets? A) Each asset and liability item on the balance sheet is standardized by dividing it by total assets. B) Balance sheet accounts are represented as percentages of total assets. C) Each asset and liability item on the balance sheet is standardized by dividing it by sales. D) Common-size balance sheets allow us to make meaningful comparisons between the balance sheets of two firms that are different in size. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 44) Which of the following is NOT true of common-size income statements? A) Each income statement item is standardized by dividing it by total assets. B) Income statement accounts are represented as percentages of net sales. C) Each income statement item is standardized by dividing it by net sales. D) Common-size income statements analysis is a specialized application of ratio analysis. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

45) Common-size financial statements: A) are not related to ratio analysis. B) prevent comparisons between different sized firms. C) are prepared by having each financial statement item expressed as a percentage of total equity. D) are prepared by having each financial statement item expressed as a percentage of some base number, such as total assets or total revenues. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 46) Which of the following is the best advantage of a common-size income statement? A) It is very useful to assess how effectively a firm collected its accounts receivable. B) It reveals a great deal of information about the adequacy of a firm's net working capital. C) It can tell the analyst a great deal about a firm's efficiency and profitability. D) It reveals how effectively a firm has increased its assets. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 47) Which of the following is the best advantage of a common-size balance sheet? A) It is very useful to assess how effectively a firm collected its accounts receivable. B) It reveals a great deal of information about how the firm is controlling its expenses. C) It can tell the shareholders how dividends have changed over time. D) It reveals how the firm has managed its tax payments. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

48) Which of the following is true of ratio analysis? A) Ratios are not generally used to analyze profitability. B) The choice of the scale has no affect on the information garnered from the ratio. C) Ratios are not adjustable for different types of firms. D) A ratio is computed by dividing one balance sheet item or income statement item by another. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 49) Which of the following actions would increase a firm's quick ratio? A) Offer price reductions that would enable the firm to sell some of its inventory. B) Issue new common stocks and use the proceeds to increase inventories. C) Speed up the collection of receivables and use the cash generated to increase inventories. D) Use some of its cash to purchase additional inventories. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 50) A company's current ratio is 2.0. Which of the following actions would lower the company's current ratio, assuming everything else remains the same? A) Borrow using short-term notes payable and use all of the proceeds to reduce accruals. B) Borrow using short-term notes payable and use part of the proceeds to reduce long-term debt. C) Use cash to reduce accruals. D) Use cash to reduce accounts payable. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

51) You observe that a firm's ROE has increased from the previous year, but both its profit margin and equity multiplier are below the previous year's levels. Which of the following statements is CORRECT? A) Its total assets turnover must be higher than the previous year. B) Its return on assets must be lower than the previous year. C) Its TIE ratio must be higher than the previous year. D) Its total assets turnover must be lower than the previous year. Answer: A Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 52) Which of the following is NOT true of liquidity ratios? A) They measure the ability of a firm to meet short-term obligations with short-term assets without putting the firm in financial trouble. B) There are two commonly used ratios to measure liquidity—current ratio and quick ratio. C) For manufacturing firms, quick ratios will tend to be much higher than current ratios. D) The higher the liquidity ratios, the more liquid the firm and the better its ability to pay its short-term bills. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 53) Which of the following is TRUE about the quick ratio? A) The quick ratio is calculated by dividing the least liquid of current assets by current liabilities. B) Service firms that tend not to carry too much inventory will have significantly higher quick ratios than current ratios. C) Inventory, not being very liquid, is subtracted from total current assets to determine the most liquid assets for a quick ratio calculation. D) Quick ratios will tend to be much larger than current ratio for manufacturing firms or other industries that have a lot of inventory. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

54) Which of the following does NOT change a firm's current ratio? A) The firm collects its accounts receivables. B) The firm purchases inventory by taking a short-term loan. C) The firm pays down its accounts payables. D) The firm accrues expenses by the end of the reporting period. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 55) All else being equal, which of the following will decrease a firm's current ratio? A) A decrease in the net fixed assets B) A decrease in depreciation expense C) An increase in accounts payable D) An increase in prepaid expense Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 56) Which of the following is NOT true about the inventory turnover ratio? A) It is calculated by dividing inventory by cost of goods sold. B) It measures how many times the inventory is turned over into saleable products. C) The more times a firm can turn over its inventory, the better. D) Too high or too low an inventory turnover could be a warning sign. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

57) Which one of the following statements is NOT true? A) The accounts receivable turnover ratio measures how quickly the firm collects its credit sales. B) One ratio that measures the efficiency of a firm's collection policy is days' sales outstanding. C) The more days that it takes a firm to collect its receivables, the more efficient the firm is. D) Days' sales outstanding measures how many days a firm takes to convert its receivables into cash. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 58) Which of the following statements is NOT true of the asset turnover ratio? A) Asset turnover ratio measures the dollar amount of sales per dollar of assets that the firm has. B) The fixed assets turnover ratio is less significant for equipment-intensive manufacturing industry firms than the total assets turnover ratio. C) The higher the total asset turnover, the more efficiently management is using total assets. D) The ratio is quite useful in identifying the inefficient use of current and long-term assets. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 59) Which of the following statements is correct? A) The lower the level of a firm's debt, the higher the firm's leverage. B) The lower the level of a firm's debt, the lower the firm's equity multiplier. C) The lower the level of a firm's debt, the higher the firm's equity multiplier. D) The tax benefit from using debt financing reduces a firm's risk. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

60) If firm A has a higher debt-to-equity ratio than firm B, then: A) firm A has a lower equity multiplier than firm B. B) firm B has a lower equity multiplier than firm A. C) firm B has higher financial leverage than firm A. D) firm B does not have any financial leverage. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 61) Which one of the following statements is NOT correct? A) A leveraged firm is riskier than a firm that has no leverage. B) A leveraged firm is less risky than a firm that has no leverage. C) A firm that uses debt magnifies the return on equity ratio. D) A firm that does not use debt incurs an opportunity cost of increasing the value of shares. Answer: B Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 62) Coverage ratios, like times interest earned and cash coverage ratio, allow a firm's: A) management to assess how well they meet short-term liabilities. B) shareholders to assess how well the firm will meet its short-term liabilities. C) creditors to assess how well the firm will meet its interest obligations. D) creditors to assess how well the firm will meet its short-term liabilities other than interest expense. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

63) Lionel, Inc., has current assets of $623,122, including inventory of $241,990, and current liabilities of $378,454. What is the quick ratio? Round your final answer to two decimal places. A) 1.65 B) 0.64 C) 1.01 D) 0.99 Answer: C Explanation: Current assets = $623,122 Current liabilities = $378,454 Inventory = $241,990 Quick ratio = = = 1.01 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 64) Bathez Corp. has receivables of $334,227, inventory of $451,000, cash of $73,913, and accounts payables of $469,553. What is the firm's current ratio? Round your final answer to two decimal places. A) 1.83 B) 0.73 C) 1.67 D) 0.55 Answer: A Explanation: Current assets = $73,913 + $451,000 +$334,227 = $859,140 Current liabilities = $469,553 Current ratio = = = 1.83 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 18

65) Zidane Enterprises has a current ratio of 1.92, current liabilities of $272,934, and inventory of $197,333. What is the firm's quick ratio? Round your final answer to two decimal places. A) 0.72 B) 1.20 C) 1.92 D) 0.84 Answer: B Explanation: Current ratio = 1.92 times Current liabilities = $272,934 Inventory = $197,333 Current ratio = 1.92 =

Current assets = 1.92 × $272,934 = $524,033 Quick ratio = = = 1.20 Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

66) The firm's current ratio now is 2.1. The firm plans to acquire additional inventory to meet a surge in the demand for its products and will pay for the inventory with short-term debt. How much inventory can the firm purchase without violating its debt agreement, to maintain current ratio of 1.75 if their total current assets equal $3.5 million? Round your final answer to the nearest dollar. A) $0 B) $777,777 C) $1 million D) $437,500 Answer: B Explanation: Let X represent the additional borrowing against the firm's line of credit (which also equals the addition to current assets). We can solve for the level of X that forces the firm's current ratio to be at 1.75. $3,500,000/Current liabilities = 2.1 Current liabilities = $1,666,667 1.75 = ($3,500,000 + X)/($1,666,667 + X) (1.75 × $1,666,667) + 1.75X = $3,500,000 + X 0.75X = $3,500,000 - $2,916,667 X = $777,777 Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement 67) A company's current ratio is 0.5. Everything else held constant, which of the following actions would increase the company's current ratio? A) Borrow long-term debts to reduce accounts payable B) Use cash to reduce accruals C) Use cash to reduce accounts payable D) Use cash to reduce short-term notes payable Answer: A Explanation: All of the other actions decrease both the numerator and denominator. Increasing long-term debt does not change current assets but reducing accounts payable will decrease the total current liabilities, causing the current ratio to increase. Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

68) Pedro & Co. has $720,000 of assets and is all-equity financed. The new CFO wants to use enough debt to raise the total debt to total capital ratio to 40 percent, using the proceeds from borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio? A) $273,600 B) $288,000 C) $302,400 D) $317,520 Answer: B Explanation: Total assets = Total Common Equity = $720,000 Target debt to total capital ratio = TD/TA = 40% Debt to achieve target ratio = Amount borrowed = Target % × Total Assets = (40% × $720,000) = $288,000 Diff: 1 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 69) Pedro & Son's total common equity at the end of last year was $405,000 and its net income was $70,000. What was its ROE? A) 14.82% B) 15.60% C) 16.42% D) 17.28% Answer: D Explanation: Common equity $405,000 Net income $70,000 ROE = NI/Equity = $70,000 / $405,000 = 17.28% Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement

70) If Randolph Corp. has accounts receivables of $654,803 and net sales of $1,932,349, what is its accounts receivable turnover? Round your final answer to two decimal places. A) 0.34 times B) 1.78 times C) 2.95 times D) 2.50 times Answer: C Explanation: Accounts receivables = $654,803 Net sales = $1,932,349 Accounts receivable turnover = = = 2.95 times Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 71) If Viera, Inc., has an accounts receivable turnover of 3.9 times and net sales of $3,436,812, what is its level of accounts receivables? Round your final answer to the nearest dollar. A) $881,234 B) $13,403,567 C) $1,340,357 D) $81,234 Answer: A Explanation: Accounts receivable turnover = 3.9 times Net sales = $3,436,812 Accounts receivable turnover = 3.9 = Accounts receivables

= $881,234

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement

72) Gateway Corp. has an inventory turnover ratio of 5.6. What is its days' sales in inventory? Round your final answer to nearest day. A) 65 days B) 64 days C) 61 days D) 57 days Answer: A Explanation: Inventory turnover ratio = 5.6 times Days' sales in inventory =

= 65.2 days

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 73) Viera Industries has net sales of $200,000, accounts receivable of $18,500, and gives its customers 25 days to pay. The industry average DSO is 27 days based on a 365-day year. If the company changes its credit and collection policy sufficiently to cause its DSO to change to the industry average, and if it earns 8.0 percent on any cash freed-up by this change, how would that affect its net income assuming other things are held constant? A) $241.45 B) $254.16 C) $267.54 D) $298.08 Answer: D Explanation: Rate of return on cash generated 8.0% Sales $200,000 A/R $18,500 Days in Year 365 Net Sales/day = $200,000/365 = $547.95 Company DSO = Receivables/Sales per day = 33.8 Industry DSO 27.0 Difference = Company DSO - Industry DSO = 6.8 Cash flow from reducing the DSO = Difference × Net Sales/day = 6.8 × 547.95=$3,726.06 Additional Net Income = Return on cash × Added cash flow =0.08 × 3,726.06= $298.08 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement

74) An all-equity new firm is developing its business plan. It has $615,000 of common equity and it projects $450,000 of sales and $355,000 of operating costs for the first year. Management is reasonably sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5 percent, but the bank requires it to have a TIE of at least 4.0. The firm will use debt and common equity for financing. What is the maximum debt to capital ratio (measured as debt/total common equity) the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt to capital ratio.) A) 44.15% B) 46.47% C) 48.92% D) 51.49% Answer: D Explanation: Assets = Total invested capital = $615,000 Sales = $450,000 Operating costs = $355,000 Operating income (EBIT) = $ 95,000 Target TIE = 4.00 Maximum interest expense = EBIT/Target TIE = $95,000/4 = $23,750 Interest rate = 7.50% Max. debt = Max interest expense/Interest rate = $23,750/0.075 = $316,667 Maximum debt to capital ratio = Debt/Total Common Equity = $316,667/$615,000 = 51.49% Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

75) Water Inc.'s net sales last year were $315,000, and its year-end total assets were $355,000. The average firm in the industry has a total assets turnover ratio of 2.4. The firm's new CFO believes the firm has excess assets that can be sold so as to bring the total assets turnover ratio down to the industry average without affecting sales. By how much will the assets need to be reduced to bring the total assets turnover ratio to the industry average, holding sales constant? A) $201,934 B) $212,563 C) $223,750 D) $234,938 Answer: C Explanation: Sales = $315,000 Actual total assets = $355,000 Target Total assets turnover ratio = Sales/Total assets = 2.40 Target assets = Sales/Target total assets ratio = $315,000/2.4 = $131,250 Asset reduction = Actual assets - Target assets = $355,000 - $131,250 = $223,750 Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement 76) Chang Corp. has $375,000 of assets, and it uses only common equity capital (zero debt). Its sales for the last year were $595,000, and its net income was $25,000. Stockholders recently voted in a new management team that has promised to lower costs and raise the return on equity to 15.0 percent. What profit margin would the firm need in order to achieve the 15 percent ROE, holding everything else constant? A) 9.45% B) 9.93% C) 10.42% D) 10.94% Answer: A Explanation: Total assets = Equity because zero debt = $375,000 Sales = $595,000 Net income = $25,000 Target ROE = 15.00% Net income required to achieve target ROE = Target ROE × Equity = 0.15 × $375,000 = $56,250 Profit margin needed to achieve target ROE = NI/Sales = $56,250/$595,000 = 9.45% Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

77) Jet, Inc., has net sales of $712,478 and accounts receivable of $167,435. What are the firm's accounts receivable turnover and days' sales outstanding? Round your accounts receivable turnover to two decimal places and days' sales outstanding to nearest day. A) 0.24 times; 79 days B) 4.26 times; 86 days C) 5.20 times; 61 days D) 2.50 times; 146 days Answer: B Explanation: Net sales = $712,478 Accounts receivable = $167,435 Accounts receivable turnover = =

= 4.26 times

Days' sales outstanding = 365 ÷ Accounts receivable turnover = 365 ÷ 4.26 = 85.7 days Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

78) Ellicott City Manufacturers, Inc., has sales of $6,344,210, and a gross profit margin of 67.3 percent. What is the firm's cost of goods sold? Round your final answer to the nearest dollar. A) $2,074,557 B) $2,745,640 C) $274,560 D) $4,269,653 Answer: A Explanation: Sales = $6,344,210 Gross profit margin = 67.3 Gross profit margin = 0.673 = Cost of goods sold = $6,344,210 - (0.673 × $6,344,210) = $2,074,557 Alternative solution: (1 - .673) × Sales = CGS = 0.327 × $6,344,210 = $2,074,557 Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

79) Deutsche Bearings has total sales of $9,745,923, inventories of $2,237,435, cash and equivalents of $755,071, and days' sales outstanding of 49 days. If the firm's management wanted its days' sales outstanding (DSO) to be 35 days, by how much will the accounts receivable have to change? Round your final answer to two decimal places. A) $373,816.23 B) -$373,816.23 C) -$379,008.12 D) $379,008.12 Answer: B Explanation: Sales = $9,745,923 Inventory = $2,237,435 Cash and equivalents = $755,071 DSO = 49 Days DSO =

DSO = Accounts receivable =

= $1,308,356.79 Target DSO = 35 days New accounts receivable =

= $934,540.56 △ Accounts receivable = $1,308,356.79 - $934,540.56 -$373,816.23 Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

80) Trident Corp., has debt of $3,350,000 with an interest rate of 6.875 percent. The company has an EBIT of $2,766,009. What is its times interest earned ratio? Round your final answer to nearest number. A) 13 times B) 12 times C) 11 times D) 10 times Answer: B Explanation: Debt = $3.35 million Interest Rate = 6.875 percent EBIT = $2,766,009 Interest expense = $3,350,000 × 0.06875 = $230,312.50 Times interest earned =

= 12 times Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement 81) Sectors, Inc., has EBIT of $7,221,643 and interest expense of $611,800. Its depreciation for the year is $1,434,500. What is its cash coverage ratio? Round your final answer to two decimal places. A) 15.42 times B) 18.34 times C) 14.15 times D) 11.80 times Answer: C Explanation: Depreciation = $1,434,500 Interest expenses = $611,800 EBIT = $7,221,643 Cash coverage ratios =

= = 14.15 times Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement

82) Fahr Company has depreciation expenses of $630,715, interest expenses of $112,078, and an EBIT of $1,542,833. What are the times interest earned and cash coverage ratios for this company? Round your final answers to one decimal place. A) 19.4 times; 12.7 times B) 17.3 time; 11.4 times C) 13.8 times; 19.4 times D) 12.5 times; 18.3 times Answer: C Explanation: Depreciation = $630,715 Interest expenses = $112,078 EBIT = $1,542,833 Times interest earned =

Cash coverage ratios =

= = 19.4 times Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 83) Your firm has an equity multiplier of 2.47. What is its debt-to-equity ratio? Round your final answer to two decimal places. A) 0.60 B) 1.47 C) 1.74 D) 3.47 Answer: B Explanation: Equity multiplier = 2.47 Equity multiplier = 1 + Debt-to-equity Debt-to-equity = Equity multiplier - 1 = 2.47 - 1 = 1.47 Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

84) What will be a firm's equity multiplier given a debt ratio of 0.45? Round your final answer to two decimal places. A) 1.82 B) 1.28 C) 2.22 D) 2.43 Answer: A Explanation: Debt Ratio = 0.45 Equity multiplier

= =

= 1.818 Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 85) Dreisen Traders has total debt of $1,233,837 and total assets of $2,178,990. What are the firm's equity multiplier and debt-to-equity ratio? Round your final answers to two decimal places. A) 2.31; 1.31, respectively B) 1.75; 0.75, respectively C) 0.75; 1.75, respectively D) 1.31; 2.31, respectively Answer: A Explanation: Debt = $1,233,837 Total Assets = $2,178,990 Total Equity = $2,178,990 - $1,233,837 = $945,153 D/E = $1,233,837/$945,143 = 1.31 EM = 1 + D/E = 1 + 1.31 = 2.31 Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

86) RTR Corp. has reported a net income of $812,425 for the year. The company's share price is $13.45, and the company has 312,490 shares outstanding. Compute the firm's price-earnings ratio. Round your final answer to two decimal places. A) 4.87 times B) 8.12 times C) 5.17 times D) 6.23 times Answer: C Explanation: Net income = $812,425 Share price = $13.45 Shares outstanding = 312,490 EPS = $812,425 ÷ 312,490 = $2.60 per share Price-earnings ratio =

= 5.17 times

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement 87) Perez Electronics Corp. has reported that its net income for the year is $1,276,351. The firm has 420,000 shares outstanding and a PE ratio of 11.2 times. What is the firm's share price? Round your intermediate and final answer to two decimal places. A) $34.05 B) $3.68 C) $11.20 D) $36.80 Answer: A Explanation: Net income = $1,276,351 Share outstanding = 420,000 EPS = $1,276,351 ÷ 420,000 = $3.04 per share PE ratio = 11.2 times Price-earnings ratio = Price per share ÷ EPS 11.2 = Price per share ÷ $3.04 Price per share = 11.2 × $3.04 = $34.05 Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

88) Juventus Corp. has total assets of $4,744,288, total debt of $2,912,000, and net sales of $7,212,465. Their net profit margin for the year is 18 percent. What is Juventus's return on assets (ROA)? Round intermediate calculations to nearest dollar and percentage answer to one decimal place. A) 15.6% B) 25.6% C) 27.4% D) 34.3% Answer: C Explanation: Total assets = $4,744,288 Total debt = $2,912,000 Net sales = $7,212,465 Net profit margin = 18% Net profit margin Net income

ROA =

= = 0.18 × $7,212,465 = $1,298,244 =

= 27.4%

Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

89) GenTech Pharma has reported the following information: Sales/Total assets = 2.89; ROA = 10.74%;

ROE = 20.36%

What are the firm's profit margin and equity multiplier? Round your profit margin answer to one decimal place, and equity multiplier answer to two decimal places. A) 7.1%; 0.53 B) 7.1%; 1.90 C) 3.72%; 0.53 D) 3.72%; 1.90 Answer: D Explanation: Total assets turnover = 2.89 ROA = Net profit margin × Total asset turnover = 10.74% Net profit margin = ROA/Total asset turnover = 10.74%/2.89 = 3.716% ROE = ROA × EM 0.2036 = 0.1074 × EM EM = 0.2036/0.1074 = 1.896 =1.90 Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

90) Tigger Corp. has reported the financial results for the year. Based on the information given, calculate the firm's gross profit margin and operating profit margin. Round your final answers to one decimal place. Net sales = $4,156,700 Cost of goods sold = $2,715,334

Net income = $778,321 EBIT = $1,356,098

A) 34.7%; 32.6%, respectively B) 32.6%; 18.7%, respectively C) 34.7%; 18.7%, respectively D) 32.6%; 34.7%, respectively Answer: A Explanation: Net sales = $4,156,700 Net income = $778,321 Cost of goods sold = $2,715,334 EBIT = $1,356,098 Gross profit margin = = Operating profit margin =

= 34.6757% =

= 32.6243%

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Measurement

91) Andrade Corp. has debt of $2,834,950, total assets of $5,178,235, sales of $8,234,121, and net income of $812,355. What is the firm's return on equity? Round your final answer to one decimal place. A) 7.1% B) 34.7% C) 28.1% D) 43.2% Answer: B Explanation: Debt = $2,834,950 Sales = $8,234,121 Total Assets = $5,178,235 Net Income = $812,355 Total equity = Total assets - Total liabilities = $5,178,235 - $2,834,950 = $2,343,285 Return on equity = Net income ÷ Total equity = ($812,355 ÷ $2,343,285) = 34.67% Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement 92) Why is the quick ratio considered by some to be a better measure of liquidity than the current ratio? A) The quick ratio more accurately reflects a firm's profitability. B) It leaves out the least liquid current asset from the numerator of the ratio. C) The current ratio does not include accounts receivable. D) It measures how "quickly" cash flows through the firm. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

93) In the latest year, Photon, Inc. reported $276,000 in net income. The firm maintains a debt ratio of 30 percent and has total assets of $3,000,000. What is Photon's return on equity? (Round your percentage answer to one decimal place.) A) 13.1% B) 14.6% C) 22.5% D) 18.7% Answer: A Explanation: Net Income = $276,000 Debt Ratio = 30% Total assets = $3,000,000 Total equity = Total assets × (1 - Debt ratio) = $3,000,000 × (1 - 30%) = $2,100,000 ROE =

= 13.1%

Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement 94) Which of the following is true of a firm that has no debt in its capital structure? A) Its return on equity (ROE) will be greater than its return on asset (ROA). B) Its return on equity (ROE) will be lesser than its return on asset (ROA). C) Its return on equity (ROE) will be equal to its return on asset (ROA). D) Its return on equity (ROE) will not be related to return on asset (ROA). Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 95) Which of the following is true of a firm that has both debt and equity? A) Its return on equity (ROE) will be greater than its return on asset (ROA). B) Its return on equity (ROE) will be lesser than its return on asset (ROA). C) Its return on equity (ROE) will be equal to its return on asset (ROA). D) Its return on equity (ROE) will not be related to return on asset (ROA). Answer: A Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 37

96) Which one of the following statements is NOT correct? A) The DuPont system is based on two equations that relate a firm's return on asset (ROA) and return on equity (ROE). B) The DuPont system is a set of related ratios that links the items of balance sheet and the income statement. C) Both management and shareholders can use this tool to understand the factors that drive a firm's return on equity (ROE). D) The DuPont system includes the current ratio. Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 97) The DuPont equation shows that a firm's return on equity (ROE) is determined by three factors: A) net profit margin, total asset turnover, and the equity multiplier. B) operating profit margin, return on assets (ROA), and the total assets turnover. C) net profit margin, total asset turnover, the return on assets (ROA). D) return on assets (ROA), total assets turnover, and the equity multiplier. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Measurement 98) Which of the following is a criticism of a policy of maximizing the firm's return on equity (ROE)? A) ROE is based on pre-tax earnings. B) ROE does consider risk. C) ROE is based on cash flows. D) ROE ignores the size of the initial investment as well as future cash flows. Answer: D Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

99) Which one of the following is NOT an advantage of using return on equity (ROE) as a goal? A) ROE is highly correlated with shareholder wealth maximization. B) ROE and the DuPont analysis allow management to break down the performance and identify areas of strengths and weaknesses. C) ROE does not consider risk. D) Leverage connects ROA and ROE. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 100) Last year Viera Corp had $155,000 of assets, $305,000 of sales, $20,000 of net income, and a debt to total capital ratio of 37.5 percent. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $33,000. Assets, total invested capital, sales, and the debt to capital ratio would not be effected. By how much would the cost reduction improve the ROE? A) 11.51% B) 12.11% C) 12.75% D) 13.42% Answer: D Explanation: Assets = Total invested capital = $155,000 Debt to total capital ratio = 37.5% Debt = Capital × Debt % = $155,000 × 0.375 = $58,125 Equity = Assets - Debt = $155,000 - 58,125 = $96,875 Old net income = $20,000 New net income = $33,000 New ROE = New NI/Equity = $33,000/$96,875 = 34.065% Old ROE = Old NI/Equity = $20,000/$96,875 = 20.645% Increase in ROE = New ROE - Old ROE = 13.42% Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

101) Last year Gray Corp. had net sales of $325,000 and a net income of $19,000, and its yearend assets were $250,000. The firm's total debt to total-capital ratio was 45.0 percent. The firm uses only debt and common equity as financing. Based on the DuPont equation, what was the ROE? A) 13.8% B) 14.5% C) 15.2% D) 16.0% Answer: A Explanation: Sales = $325,000 Assets = Total common equity = $250,000 Net income = $19,000 Debt to total capital ratio = 45.0% Debt = Debt % × Capital = 0.45 × $250,000 = $112,500 Equity = Assets - Debt = $250,000 - $112,500 = $137,500 Profit margin = NI/Sales = 5.85% Total assets turnover = Sales/Assets = $325,000/$250,000 = 1.30 Equity multiplier = Assets/Equity = $250,000/$137,500 = 1.82 ROE = PM × TAT × EM =.0585 × 1.3 × 1.82 = 13.84% ROE = NI/Equity = $19,000/$137,500 = 13.82% Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

102) Covent Gardens Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000, operating costs to be $265,000, assets to be $200,000, and its tax rate to be 35 percent. Under Plan A it would use 25 percent debt and 75 percent common equity. The interest rate on the debt would be 8.8 percent, but under a contract with existing bondholders the times interest earned (TIE) ratio would have to be maintained at or above 4.5. Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure? A) 3.45% B) 2.59% C) 15.85% D) 13.26% Answer: B Explanation: Work down the Plan A column, find the Max Debt, and then use it to complete Plan B and the ROEs.

Interest rate constant Tax rate constant Assets = Total capital constant Debt ratio: Plan A given, Plan B calculated Debt Equity

Plan A Target Plan B 8.80% 8.80% 35% 35% $200,000 $200,000 25% 44.19% $50,000 $88,384 $150,000 $111,616

Sales Operating costs EBIT Interest expense Taxable income Taxes (35%) Net income ROE = NI/Equity =

$300,000 $265,000 $35,000 $4,400 $30,600 $10,710 $19,890 3.26%

Constant Constant Constant

$300,000 $265,000 $35,000 $7,778 $27,222 $9,528 $17,694 15.85%

TIE = EBIT/Interest = 7.95 Minimum TIE Target 4.50 $ of Interest consistent with minimum TIE = EBIT/Min. TIE = 35,000/4.5 = $7,778 Max debt = Interest/interest rate = $88,384 Change in ROE 2.59% = 15.85% - 13.26% Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

103) Saunders, Inc., has a ROE of 18.7 percent, an equity multiplier of 2.53 times, sales of $2.75 million, and a total assets turnover of 2.7 times. What is the firm's net income? Round your final answer to two decimal places. A) $75,281.25 B) $514,250.00 C) $51,425.00 D) $7,528.10 Answer: A Explanation: ROE = 18.7 percent Equity multiplier = 2.53 times Sales = $2.75 million Total assets turnover = 2.7 times ROE = Net profit margin × Total asset turnover × Equity multiplier 0.187 = Net profit margin × 2.7 × 2.53 Net profit margin = 0.187 ÷ (2.7 × 2.53) = 0.027375 Net profit margin = Net income ÷ Sales 0.027375 = Net income ÷ $2.75 million Net income = 0.027375 × $2.75 million = $75,281.25 Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

104) Sorenstam Corp. has an equity multiplier of 2.34 times, total assets of $4,512,895, a ROE of 17.5 percent, and a total assets turnover of 3.1 times. Calculate the firm's ROA. Round your percentage answer to two decimal places. A) 6.23% B) 4.53% C) 7.48% D) 5.79% Answer: C Explanation: Equity multiplier = 2.34 times Total assets = $4,512,895 ROE = 17.5 percent Total assets turnover = 3.1 times ROE = ROA × Equity multiplier 0.175 = ROA × 2.34 ROA = 0.175 ÷ 2.34 = 0.0748 Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement 105) Which one of the following statements about trend analysis is NOT correct? A) A firm's historical performance determines the benchmark for trend analysis. B) Trend analysis allows management to examine each ratio over time and determine whether the trend is good or bad for the firm. C) Trend analysis uses the Standard Industrial Classification (SIC) System to benchmark firms. D) A ratio value that is changing typically prompts the financial manager to sort out the issues surrounding the change. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

106) Peer group analysis can be performed by: A) management choosing a set of firms that are similar in size or sales, or who compete in the same market. B) using the average ratios of this peer group, which would then be used as the benchmark. C) identifying firms in the same industry that are grouped by size, sales, and product lines in order to establish benchmark ratios. D) Only A and B relate to peer group analysis. Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 107) Which of the following is NOT a method of "benchmarking"? A) Conducting an industry group analysis B) Evaluating a single firm's performance at a point in time C) Considering similar ratios between firms D) Identifying a group of firms that compete with the company being analyzed Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement

108) Last year Camden Corp. had sales of $500,000, operating costs of $450,000, and year-end assets (which is equal to its total invested capital) of $395,000. The debt to total capital ratio was 17 percent, the interest rate on the debt was 7.5 percent, and the firm's tax rate was 35 percent. The new CFO wants to see how the ROE would have been affected if the firm had used a 50 percent debt to total capital ratio. Assume that sales, operating costs, total assets, total invested capital, and the tax rate would not be effected, but the interest rate would rise to 8.0 percent. By how much would the ROE change in response to the change in the capital structure? A) 1.71% B) 1.90% C) 2.11% D) 2.34% Answer: D Explanation: Old New Interest rate 7.5% 8.0% Tax rate 35% 35% Assets = Total capital $395,000 $395,000 Debt to capital ratio 17% 50% Debt = Capital × Debt ratio = $ 67,150 $197,500 Equity = Assets - Debt = $327,850 $197,500 Sales $500,000 Operating costs 450,000 EBIT = Sales - Operating costs = $ 50,000 Interest paid = Interest rate × Debt = 5,036 Taxable income $ 44,964 Taxes 15,737 Net income $ 29,226 ROE 8.91%

$500,000 450,000 $ 50,000 15,800 $ 34,200 11,970 $ 22,230 11.26%

Change in ROE 11.26% - 8.91% = 2.34% Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: FSA AICPA: Measurement

109) Which of the following is a limitation of ratio analysis? A) Ratios depend on current market values data rather than historical costs. B) Not being comparable between firms of different sizes. C) Trend analysis being inaccurate because it is not influenced by inflation. D) Differences in accounting practices like FIFO versus LIFO make comparison difficult. Answer: D Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Measurement 110) There are people who believe that the analysis of financial statements has limitations. Which of the statements below would qualify as a limitation of financial statement analysis? A) Ratio analysis requires the analyst to evaluate a firm's performance over a period of time. B) Proper ratio analysis requires the analyst to rely upon audited financial statements, which can be easily manipulated. C) Thorough ratio analysis requires the analyst to refer to benchmarking, which is very easy to misinterpret. D) Ratio analysis requires the analyst to utilize accounting data that is based on historical value instead of current market values. Answer: D Diff: 2 Learning Objective: LO 6 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement 111) Compare how a firm's creditor would analyze a firm's financial statements with a firm's shareholders' analysis. Answer: A firm's creditors' primary concern is the ability of the firm to repay their loans with interest on a timely manner. They analyze the firm's financial statements to gauge the ability of the firm to generate sufficient cash flows to meet not only the legal financial obligations, but also the creditors' debt obligations. Shareholders, on the other hand, want to know how much cash they can expect to receive for their stocks, what their return on investment will be, and/or how much their stock is worth in the market. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

112) What are some of the main limitations of ratio analysis? Answer: While financial ratio analysis can provide management with useful information to improve a firm's performance, there are some serious limitations to its usefulness. First, ratio analysis depends on accounting data based on historical costs. Management or investors will get a truer picture of the firm's financial condition if market value is the basis of the analysis. Second, there is no theoretical backing in making judgments based on financial statement and ratio analysis. Judgment calls made based on experience or common sense will not work all the time. Third, when doing industry or peer group analysis you are often confronted with large, diversified firms that do not fit into any one SIC code or classification. Fourth, trend analysis could be distorted by financial statements affected by inflation. Finally, multinational firms deal with many accounting standards. Financial reports that are created based on different accounting standards make it difficult to compare. Even among domestic firms, differences in accounting practices, like FIFO versus LIFO, make comparison difficult. Diff: 2 Learning Objective: LO 6 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

113) Explain the different ways that a firm's ratios can be benchmarked. Answer: Benchmark data can be obtained in three different ways—trend analysis, industry average analysis, and peer group analysis. Trend analysis involves evaluating a single firm's performance over time. This sort of analysis allows management to see whether a given ratio value has increased or decreased over time and whether there has been any significant changes in the value of the ratios being analyzed. A ratio value that is changing typically is a signal to the financial manager to take a closer look at the ratio and to make decisions depending on whether the change is favorable or unfavorable to the firm. A second way to establish a benchmark is to conduct an industry group analysis. We do this by identifying a group of firms that have the same product line, compete in the same market, and are about the same size. The average ratio values for the group will be our benchmarks. The third way to establish benchmark information is to identify a group of firms that compete with the company you are analyzing. Ideally, the firms are in similar lines of business, are about the same size, and are direct competitors of the target firm. These firms form a peer group of firms in the same industry. Once a peer group has been identified, you can obtain their annual reports and compute average ratio values and can compare its performance with the competitors'. Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: FSA AICPA: Measurement

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 5 The Time Value of Money 1) The time value of money is based on the principle that people have a positive time preference for consumption. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 2) The time value of money accounts for the fact that people place different value on money over time. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 3) The time value of money concept recognizes that people require additional compensation for deferring consumption. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 4) The further in the future you receive a dollar, the more value you place on the dollar today. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

5) The value of a dollar invested at a positive interest rate grows over time. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 6) The value of a dollar invested at a positive interest rate grows over time but at a slower rate further into the future. Answer: FALSE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 7) The value of a dollar invested at a positive interest rate grows at an increasing rate over time. Answer: TRUE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 8) Starting to invest early for retirement reduces the benefits of compound interest. Answer: FALSE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement 9) Some of the cash flows shown on a time line can be equal in size, but none can be unequal. Answer: FALSE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

10) The higher the rate of interest, the more likely you will forgo current consumption. Answer: TRUE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 11) The lower the rate of interest, the more likely you are going to consume now rather than invest money to consume later. Answer: TRUE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 12) The future value technique uses discounting to find the future value of each cash flow at the end of a project's life. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 13) The future value increases as either the interest rate or the number of periods per year increases, other things held constant. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 14) The process of converting the initial amount into future value is called discounting. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 3

15) Compounding is the process by which interest earned on an investment is reinvested so in future periods, there is interest on interest as well as the original principal. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 16) Compound interest consists of both simple interest and interest on interest. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 17) Compound interest increases as the number of years decreases. Answer: FALSE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 18) Compounding increases the growth of the total interest earned. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 19) Due to compounding effects, the growth in the future value of an investment over time is linear. Answer: FALSE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

20) The growth in the future value of an investment over time is not linear, but exponential. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 21) William invested $5,000 in an account earning 10 percent for one year. If he had left his investment in that account for another two years, he would expect the total interest earned over the three years to be higher by exactly $1,000. Answer: FALSE Explanation: Solution: PV = -5,000; I/Y = 10; N = 3; PMT = 0; CPT FV = $6,655 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 22) Suppose Randy plans to invest $1,000. He can earn an annual rate of 5 percent on Security A, while Security B has an effective annual rate of 10 percent. After 11 years, the compounded value of Security B should be somewhat less than double the compounded value of Security A. Answer: TRUE Explanation: Solution A: PV = -1,000; I/Y = 5; PMT = 0; N = 11; CPT FV = $1,710.34 Solution B: PV = -1,000; I/Y = 10; PMT = 0; N =11; CPT FV = $2,853.12 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 23) With a higher interest rate on an investment, more money is accumulated for any time period. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

24) The more frequently the interest payments are compounded, the larger the future value of $1 for a given time period. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 25) If Bank A pays interest on a monthly basis and Bank B pays the same interest rate, but on a quarterly basis, then investing $1,000 in Bank B will result in a higher future value compared to investing the same amount in Bank A. Answer: FALSE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 26) The future value of an investment of $5,000 earning an interest rate of 10 percent compounded annually equals $6,000 at the end of one year. Answer: FALSE Explanation: Solution: PV = -5,000; I/Y = 10; N = 1; PMT = 0; CPT FV = $5,500 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 27) The future value in three years of $5,000 invested today at a rate of 10 percent is $6,655. Answer: TRUE Explanation: Solution: PV = -5,000; N = 3; I/Y = 10; PMT = 0; CPT FV = $6,655 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Application IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

28) The future value factor for 10 years at 15 percent with annual compounding is calculated as (1 + 0.15)10. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 29) To calculate the present value of a future amount, we divide the future value by the future value factor. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 30) The present value is simply the current value of a future cash flow that has been discounted at the relevant discount rate. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 31) The present value technique uses discounting to find the present value of each cash flow at the beginning of a project. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 32) The present value factor increases as the number of periods decreases. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 7

33) If the discount rate increases, then the present value of a potential investment would fall. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 34) If the discount rate falls, then the present value of a potential investment would also fall. Answer: FALSE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 35) The process of calculating the present value of a future cash flow is called compounding. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 36) The present value of $3,000 to be received in two years at a discount rate of 10 percent is $3,630. Answer: FALSE Explanation: Solution: 3,000/(1.1)2 = $2,479.34 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 37) The higher the discount rate, the lower the present value of a future cash flow. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 8

38) The lower the discount rate, the lower the present value of a future cash flow. Answer: FALSE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 39) The farther in the future a dollar will be received, the less it is worth today. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 40) You need $5,000 in five years. If you could choose a discount rate of 8 percent or 10 percent, you should always choose the higher rate because you would need a higher starting amount. Answer: FALSE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 41) Future value focuses on the valuation of cash flows received over time, while present value focuses only on the valuation of cash flows received at a point in time. Answer: FALSE Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 42) The present value factor 1/(1 + i)n is the reciprocal of the future value factor (1 + i)n. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

43) The Rule of 72 allows one to calculate the return earned on an investment over six years. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 44) The Rule of 72 allows one to calculate the approximate amount of time required to double an investment. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 45) Compound growth occurs when the initial value of a number increases or decreases each period by the factor (1 + growth rate). Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 46) The compound annual growth rate (CAGR) is the average annual growth rate over a given number of years. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

47) Your bank account pays a 6 percent annual rate of interest. The interest is compounded quarterly. This implies that the periodic rate of interest is 1.5 percent and the effective annual rate of interest is greater than 6 percent. Answer: TRUE Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 48) Jane has $5,000 invested in a bank that pays 4 percent compounded annually. It will take her approximately 28 years for her funds to triple. Answer: TRUE Explanation: Solution: PV = -5,000; N = 28: I/Y = 4; PMT = 0; CPT FV = $14,993.52 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 49) Time value of money refers to the concept of: A) summing a stream of future cash flows. B) why a dollar received today is worth more than a dollar received tomorrow. C) the time required to double an amount of money assuming no application of an interest rate. D) why people prefer to consume things of equal value at some time in the future rather than today. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

50) Which of the following statements is correct? A) A time line is not meaningful unless all cash flows occur annually. B) Time lines are useful for visualizing complex problems prior to doing actual calculations. C) Time lines cannot be constructed in situations when the cash flows occur at yearly and quarterly frequencies. D) Time lines cannot be constructed for annuities where the payments occur at the beginning of the periods. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 51) Which of the following statements about the time value of money concept is true? A) It means a dollar received today is worth more than a dollar received tomorrow. B) It assumes that inflation rate remains constant at least for the next 12 months. C) It refers to the fact that higher cash flows in earlier years are less desirable. D) It assumes that people prefer to consume things at some time in the future rather than today. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 52) Which of the following statements about the time value of money is true? A) The value of a dollar invested at a positive interest rate decreases over time. B) The further in the future you receive a dollar, the less it is worth today. C) A dollar in hand today is worth less than a dollar to be received in the future. D) The higher the rate of interest, the more likely an investor will elect to consume at present and forgo invest his funds. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

53) Which of the following statements about the time value of money concept is true? A) A dollar received today is worth more than a dollar to be received in the future because future dollars are not affected by inflation. B) A dollar received today is worth less than a dollar to be received in the future because future dollars are not affected by inflation. C) A dollar received today is worth more than a dollar to be received in the future because funds received today can be invested to earn a return. D) A dollar to be received in the future is worth more than a dollar received today because it would have less risk associated with it. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 54) Future value measures: A) the value of one or more cash flows at the end of a specified period. B) what one or more cash flows that is to be received in the future will be worth today. C) the value of an investment after subtracting interest earned on it for one or more periods. D) the value of an investment in today's terms. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 55) Which of the following equations is used to compute the future value using continuous compounding? A) FV∞ = PV × e i × n B) FV∞ = PV ÷ e i × n C) FV∞ = ei ÷ PV D) FV∞ = ei × PV Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

56) The process of converting an amount given at the present time into a future value is called: A) annualizing. B) discounting. C) compounding. D) capital budgeting. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 57) Which of the following is true of the future value of an investment? A) The higher the interest rate, the higher the future value of an investment. B) The lower the interest rate, the higher the future value of an investment. C) The lower the number of compounding periods, the higher the future value of an investment. D) The lower the present value of an investment, the higher the future value of an investment. Answer: A Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 58) Which of the following statements is correct, assuming positive interest rates and holding other things constant? A) Banks A and B offer the same annual rate of interest, but A pays interest quarterly and B pays semiannually. A deposit in Bank B will have a higher value in five years. B) Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays monthly. A deposit in Bank B will have a higher value in five years. C) Banks A and B offer the same nominal annual rate of interest, but A pays interest daily and B pays semiannually. A deposit in Bank B will have a higher value in five years. D) Banks A and B offer the same nominal annual rate of interest, but A pays interest weekly and B pays quarterly. A deposit in Bank B will have a higher value in five years. Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

59) You are considering two investments (ORD and DUE) that each pay $5,000 each year for the next 10 years. Investment ORD makes each payment at the end of the year, and Investment DUE makes payments at the beginning of each year. Which of the following statements is correct? A) The present value of ORD must exceed the present value of DUE, but the future value of ORD may be less than the future value of DUE. B) The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. C) The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. D) The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD. Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 60) Which of the following investments will have the highest future value? A) $1,300 invested at an annual interest rate of 10 percent for 5 years B) $1,000 invested at a quarterly interest rate of 2.25 percent for 10 years C) $1,300 invested at a quarterly interest rate of 2.25 percent for 5 years D) $1,000 invested at an annual interest rate of 10 percent for 10 years Answer: B Explanation: Solution: 1,300(1.1)5 = $2,093.66 1,000(1.0225)40 = $2,435.19 1,300(1.0225)20 = $2,028.66 1,000(1.1)10 = $2,593.74 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 61) Which of the following statements is true? A) The longer the time period that funds are invested, the greater the future value. B) The lower the discount rate that funds are invested at, the greater the future value. C) The shorter the time period that funds are invested, the greater the future value. D) The higher the interest rate, the slower the value of an investment will grow. Answer: A Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 15

62) Joseph Ray just received an inheritance of $35,775 from his great aunt. He plans to invest the funds for retirement. If Joseph can earn 4.75 percent per year with quarterly compounding for 32 years, how much will he have accumulated? (Round to the nearest dollar.) A) $237,416 B) $71,550 C) $184,622 D) $162,113 Answer: D Explanation: Amount invested today = PV = $35,775 Frequency of compounding = m = 4 Interest rate = i = 4.75% ÷ 4 = 1.1875% Duration of investment = n = 32 years × 4 = 128 periods Value of investment after 7 years, or 128 periods = FV128 = $162,113.25 FV32 = PV ×

= $35,775

= $35,775 × (1.011875)128 = $35,775 × 4.531467 = $162,113.25 Financial Calculator Solution: PV = -35,775; I/Y = 4.75/4; N = 32 × 4; PMT = 0; CPT FV = $162,113.25 Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Applying IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 63) Your aunt is looking to invest a certain amount today. Which of the following choices will give the maximum interest? A) Three-year CD at 6.5 percent annual rate B) Three-year CD at 6.75 percent annual rate C) Three-year CD at 6.25 percent annual rate D) Three-year CD at 7 percent annual rate Answer: D Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

64) You are interested in investing $15,000, a gift from your grandparents, for the next four years in a mutual fund that will earn an annual return of 8 percent. What will your investment be worth at the end of four years? (Round to the nearest dollar.) A) $18,816 B) $20,407 C) $20,221 D) $18,089 Answer: B Explanation: Present value of the investment = PV = $15,000 Return on mutual fund = i = 8% No. of years = n = 4 0 1 2 3 4 ├───┼───┼───┼────┤ -$15,000 FV=? FV4 = PV × (1 + i)n = $15,000 × (1.08)4 = $20,407.33 Financial calculator solution: PV = -$15,000; N = 4; I/Y = 8; PMT = 0; CPT FV = $20,407.33 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

65) Juan Vinson is planning to buy a house in five years. He is looking to invest $25,000 today in an index mutual fund that will provide him a return of 12 percent annually. How much will he have at the end of five years? (Round to the nearest dollar.) A) $45,000 B) $28,000 C) $44,059 D) $28,530 Answer: C Explanation: Present value of the investment = PV = $25,000 Return on mutual fund = i = 12% No. of years = n = 5 0 1 2 3 4 5 ├───┼───┼───┼────┼───┤ -$25,000 FV =? FV5 = PV × (1 + i)n = $25,000 × (1.12)5 = $44,058.54 Financial calculator solution: PV = -$25,000; N = 5; I/Y = 12; PMT = 0; CPT FV = $44,058.54 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

66) Carlos Lopes is looking to invest for the next three years. He is looking to invest $7,500 today in a bank CD that will earn interest at 5.75 percent annually. How much will he have at the end of three years? (Round to the nearest dollar.) A) $8,870 B) $8,575 C) $8,681 D) $8,990 Answer: A Explanation: Present value of the investment = PV = $7,500 Interest rate on CD = i = 5.75% No. of years = n = 3 0 1 2 3 ├───┼───┼───┤ -$7,500 FV=? FV3 = PV × (1 + i)n = $7,500 × (1.0575)3 = $8,869.57 Financial calculator solution: PV = -$7,500; PMT = 0; I/Y = 5.75; N = 3; CPT FV = $8,869.57 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

67) Kevin Robertson would like to buy a condo in Florida in six years. He is looking to invest $75,000 today in a stock that is expected to earn a return of 18.3 percent annually. How much will he have at the end of six years? (Round to the nearest dollar.) A) $205,575 B) $157,350 C) $184,681 D) $273,620 Answer: A Explanation: Present value of the investment = PV = $75,000 Return on stock = i = 18.3% No. of years = n = 6 0 1 2 3 4 5 6 ├───┼───┼────┼───┼───┼───┤ -$75,000 FV=? FV6 = PV × (1 + i)n = $75,000 × (1.183)6 = $205,574.73 Financial calculator solution: PV = -$75,000; I/Y = 18.3; N = 6; PMT = 0; CPT FV = $205,574.73 Diff: 1 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

68) Lori Willis plans to invest for retirement, which she hopes will be in 20 years. She is planning to invest $25,000 today in U.S. Treasury bonds that will earn interest at 6.25 percent annually. How much will she have at the end of 20 years? (Round to the nearest dollar.) A) $68,870 B) $50,625 C) $84,046 D) $75,000 Answer: C Explanation: Present value of the investment = PV = $25,000 Return on Treasury bonds = i = 6.25% No. of years = n = 20 0 1 2 3 19 20 ├───┼───┼───┼……………─┼────┤ -$25,000 FV=? FV20 = PV × (1 + i)n = $25,000 × (1.0625)20 = $84,046.34 Financial calculator solution: PV = -25,000; N = 20; I/Y = 6.25; PMT = 0; CPT FV = $84,046.34 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

69) What is the future value of $1,500 after 5 years if the annual return is 6 percent, compounded semiannually? A) $1,819 B) $1,915 C) $2,016 D) $2,117 Answer: C Explanation: Present value of the investment = PV = $1,500 Return = i = 6%/2 = 3% No. of years times periods per year = n = 5 × 2 = 10 0 1 2 3 9 10 ├───┼───┼───┼……………─┼────┤ -$1,500 FV=? FV10 = PV × (1 + i)n = $1,500 × (1.03)10 = $2,015.87 Financial calculator solution: PV = -1,500; N = 10; I/Y = 3; PMT = 0; CPT FV = $2,015.87 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 70) What is the future value of $1,500 after 5 years if the annual return is 6 percent, compounded quarterly? A) $1,819 B) $2,020 C) $2,016 D) $2,117 Answer: B Explanation: Present value of the investment = PV = $1,500 Return = i = 1.5% No. of years times periods per year = n = 20 0 1 2 3 19 20 ├───┼───┼───┼……………─┼────┤ -$1,500 FV=? FV20 = PV × (1 + i)n = $25,000 × (1.015)20 = $2,020.28 Financial calculator solution: PV = -1,500; N = 20; I/Y = 1.5; PMT = 0; CPT FV = $2,020.28 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 22

71) Joseph Ray just received an inheritance of $50,000 from his great aunt. He plans to invest the funds for retirement. If Joseph can earn 6 percent per year with quarterly compounding for 30 years, how much will he have accumulated? (Round to the nearest dollar.) A) $298,466 B) $271,550 C) $284,622 D) $269,113 Answer: A Explanation: Present value of the investment = PV = $50,000 Return = i = 1.5% No. of years times periods per year = n = 120 0 1 2 3 119 120 ├───┼───┼───┼……………─┼────┤ -$50,000 FV=? FV120 = PV × (1 + i)n = $50,000 × (1.015)120 = $298,466.14 Financial calculator solution: PV = -50,000; N = 120; I/Y = 1.5; PMT = 0; CPT FV = $298,466.14 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

72) Your brother has asked you to help him to choose an investment. He has $6,000 to invest today for a period of two years. You identify a bank CD that pays an annual interest rate of 4.25 percent with the interest being paid quarterly. What will be the value of the investment in two years? A) $6,550 B) $6,529 C) $6,107 D) $6,216 Answer: B Explanation: 0 8 quarters ├────────────────────┤ PV = $6,000 FV =? Amount invested today = PV = $6,000 Interest rate on CD = i/m = 4.25%/4 = 1.0625% Duration of investment = n = 2 years Frequency of compounding = m = 4 Value of investment after 2 years = FV2 FV2 = PV × (1 + i/m)mn = $6,000 × (1 + (0.0425/4))2×4 = $6,529.37 Financial calculator solution: PV = -6,000; N = 8; I/Y = 4.25/4; PMT = 0; CPT FV = $6,529.37 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

73) Dynoxo Textiles has a cash inflow of $1 million, which it needs for a long-term investment, at the end of one year. It plans to deposit the money in a bank CD that pays daily interest at an annual rate of 4.50 percent. What will be the value of the investment at the end of the year? (Round to the nearest dollar.) A) $1,020,475 B) $1,000,103 C) $1,037,500 D) $1,046,025 Answer: D Explanation: 0 1 ├────────────────────┤ PV = $1,000,000 FV =? Amount invested today = PV = $1,000,000 Interest rate on CD = i = 4.50% Duration of investment = n = 1 year Frequency of compounding = m = 365 Value of investment after 1 year = FV1 FV1 = PV × (1 + i/m)mn = $1,000,000 × (1 + (0.0450/365))365×1 = $1,046,024.96 Financial calculator solution: PV = -1,000,000; I/Y = 4.5/365; N = 365; PMT = 0; CPT FV = $1,046,024.96 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

74) Your mother is trying to choose one of the following bank CDs to deposit $10,000. Which will have the highest future value if she plans to invest for three years? A) 3.50 percent compounded daily B) 3.25 percent compounded monthly C) 3.40 percent compounded quarterly D) 3.75 percent compounded annually Answer: D Explanation: 0 3 ├────────────────────┤ PV = $10,000 FV =? Amount invested today = PV = $10,000 Duration of investment = n = 3 years A) Interest rate on CD = i = 3.50% Frequency of compounding = m = 365 Value of investment after 3 years = FV3 FV3 = PV × (1+ i/m)m × n = $10,000 × (1+ 0.035/365)365 × 3 = $10,000 × (1.00009589)1,095 = $11,107.05 B) Interest rate on CD = i = 3.25% Frequency of compounding = m = 12 Value of investment after 3 years = FV3 FV3 = PV × (1+ i/m)m × n = $10,000 × (1+ 0.0325/12)12 × 3 = $10,000 × (1.0027908333)36 = $11,022.66 C) Interest rate on CD = i = 3.40% Frequency of compounding = m = 4 Value of investment after 3 years = FV3 FV3 = PV × (1 + i/m)m × n = $10,000 × (1+ 0.034/4)4 × 3 = $10,000 × (1.0085)12 = $11,069.06 D) Interest rate on CD = i = 3.75% Frequency of compounding = m = 1 Value of investment after 3 years = FV3 FV3= PV × (1+ i/m)m × n = $10,000 × (1+ 0.0375)3 = $10,000 × (1.0375)3 = $11,167.71 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

75) Lorene Buckley wants to invest $3,500 today in a money market fund that pays an annual rate of 5 percent paid quarterly. She plans to fund a scholarship with the proceeds at her alma mater, Towson University. How much will Lorene have at the end of seven years? (Round to the nearest dollar.) A) $5,091 B) $3,849 C) $4,956 D) $5,075 Answer: C Explanation: 0 7 ├────────────────────┤ PV = $3,500 FV =? Amount invested today = PV = $3,500 Interest rate on money market account = i = 5% Duration of investment = n = 7 years Frequency of compounding = m = 4 Value of investment after 7 years = FV7 FV7 = PV × (1 + i/m)m × n = $3,500 × (1 + 0.05/4)4 × 7 = $3,500 × (1.0125)28 = $4,955.97 Financial calculator solution: PV = -$3,500; N = 28; I/Y = 5/4; PMT = 0; CPT FV = $4,955.97 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

76) Paul Springer plans to save for a down payment for a house in 10 years. He will be able to invest $12,000 today in a money market account that will pay him an annual interest rate of 5.50 percent on a monthly basis. How much will he have at the end of 10 years? A) $12,640 B) $20,773 C) $24,859 D) $23,080 Answer: B Explanation: 0 10 ├────────────────────┤ PV = $12,000 FV =? Amount invested today = PV = $12,000 Interest rate on money market account = i = 5.50% Duration of investment = n = 10 years Frequency of compounding = m = 12 Value of investment after 10 years = FV10 FV10 = PV × (1 + i/m)m × n = $12,000 × (1 + 0.0550/4)12 × 10 = $12,000 × (1.04583)120 = $20,772.92 Financial calculator solution: PV = -12,000; N = 120; I/Y = 5.5/12; PMT = 0; CPT FV = $20,772.92 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

77) Jack Palomo has deposited $2,500 today in an account paying 6 percent interest annually. What would be the simple interest earned on this investment in five years? If the account pays compound interest, what will be the interest on interest in five years? A) $750; $95.56 B) $150; $845.56 C) $150; $95.56 D) $95.56; $845.56 Answer: A Explanation: Deposit today = PV = $2,500 Interest rate = i = 6% No. of years = n = 5 Simple interest: Simple interest per year = $2,500 × (0.06) = $150.00 Simple interest for 5 years = $150 × 5 = $750.00 Future value with compound interest: FV5 = $2,500 (1 + 0.06)5 = $3,345.56 Simple interest = $750 Interest on interest = $3,345.56 - $2,500 - $750 = $95.56 Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

78) Camille Noah is investing $5,000 in an account that pays an annually compounded rate of 6.75 percent for three years. What is the interest on interest if interest is compounded? A) $1,012.50 B) $1,082.38 C) $82.38 D) $69.88 Answer: D Explanation: Deposit today = PV = $5,000 Interest rate = i = 6.75% No. of years = n = 3 Simple interest: Simple interest per year = $5,000 × (0.0675) = $337.50 Simple interest for 3 years = $337.50 × 3 = $1,012.50 Future value with compound interest: FV3 = $5,000 (1 + 0.0675)3 = $6,082.38 Simple interest = $1,012.50 Interest on interest = $6,082.38 - $5,000 - $1,012.50 = $69.88 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

79) Richard McLean wants to invest $3,000 in an account paying annual interest of 5.25 percent compounded quarterly. What is the interest on interest after four years? A) $695.98 B) $65.98 C) $630.00 D) $157.50 Answer: B Explanation: Deposit today = PV = $3,000 Interest rate = i = 5.25% No. of years = n = 4 Frequency of compounding = m = 4 Simple interest: Simple interest per year = $3,000 (0.0525) = $157.50 Simple interest for 4 years = $157.50 × 4 = $630 Future value with compound interest: FV4 = PV ×

= $3,000 ×

= $3,000 × (1.013125)16 = $3,695.98 Simple interest = $630 Interest on interest = $3,695.98 - $3,000 - $630 = $65.98 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

80) Dat Nguyen is depositing $17,500 in an account paying an annual interest rate of 8.25 percent compounded monthly. What is the interest on interest after six years? A) $8,662.50 B) $10,925.44 C) $2,497.63 D) $1,092.48 Answer: C Explanation: Deposit today = PV = $17,500 Interest rate = i = 8.25% No. of years = n = 6 Frequency of compounding = m = 2 Simple interest: Simple interest per year = $17,500 (0.0825) = $1,443.75 Simple interest for 6 years = $1,443.75 × 6 = $8,662.50 Future value with compound interest: FV6 = PV ×

= $17,500 ×

= $17,500 × (1.006875)72 = $28,660.13 Simple interest = $8,662.50 Interest on interest = $28,660.13 - $17,500 - $8,662.50 = $2,497.63 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

81) Shawn Bowker invested $10,000 in a money market account that will pay an annual interest rate of 5.75 percent compounded daily. How much will the interest on interest be after two years? A) $1,218.63 B) $1,150.00 C) $33.06 D) $68.63 Answer: D Explanation: Deposit today = PV = $10,000 Interest rate = i = 5.75% No. of years = n = 2 Frequency of compounding = m = 365 Simple interest: Simple interest per year = $10,000 × 0.0575 = $575 Simple interest for 2 years = $575 × 2 = $1,150 Future value with compound interest: FV2 = PV ×

= $10,000 ×

= $10,000 × (1.000157534)730 = $11,218.63 Simple interest = $575 Interest on interest = $11,218.63 - $10,000 - $1,150 = $68.63 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 82) Which of the following equations is used to calculate the future value of an investment? A) FVn = PV ÷ (1 + i)n B) FVn = PV × (1 + i)n C) FVn = (1 + i)n + PV D) FVn = (1 + i)n ÷ PV Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

83) Which of the following equations is used to calculate the future value of an investment when interest is compounded m times a year? A) FVn = PV ÷ (1 + i)m × n B) FVn = PV × (1 + i/m)m × n C) FVn = (1 + i)m × n + PV D) FVn = (1 + i)m × n ÷ PV Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 84) Evelyn has invested $10,000 today for ten years at an annual interest rate of 8 percent. Beginning in the 11th year, interest rates decrease to 6 percent. Approximately how much does she have in her account after fifteen years (round to the nearest dollar)? A) $27,590 B) $28,891 C) $31,722 D) $23,966 Answer: B Explanation: Treat this problem as two timelines the first one for ten years and the second for 5 years. N = 10 I/Y = 8 PV = -10,000 PMT = 0 Compute FV = $21,589.25 Then: N=5 I/Y = 6 PV = 21,589.25 PMT = 0 Compute FV = -$28,891.29 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

85) Joseph Harris is considering an investment that pays 6.5 percent annually. How much does he need to invest today so that he will have $25,000 in seven years? (Round to the nearest dollar.) A) $17,474 B) $18,850 C) $16,625 D) $16,088 Answer: D Explanation: 0 7 years ├────────────────────┤ PV =? i = 6.5% FV = $25,000 Value of investment after 7 years = FV7 = $25,000 Return expected from investment = i = 6.5% Duration of investment = n = 7 years Amount to be invested today = PV PV =

= $16,087.66

Financial calculator solution: FV = 25,000; N = 7; I/Y = 6.5; PMT = 0; CPT PV = $16,087.66 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 86) Which of the following statements is true? A) Present value calculations involve converting the initial amount into a future amount. B) The present value (PV) is often called the compounded value of future cash payments. C) The present value is calculated by using the discount factor. D) The future value of an investment is the reciprocal of its present value. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

87) When the discount rate: A) decreases, the present value of the future cash flow does not change. B) decreases, the present value of any future cash flow increases. C) increases, the present value of any future cash flow increases. D) increases, the present value of any future cash flow does not change. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 88) When the discount rate: A) increases, the present value of a future cash flow decreases. B) increases, the present value of a future cash flow increases. C) decreases, the present value of a future cash flow will remain the same. D) decreases, the present value of a future cash flow decreases. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 89) Which of the following statements is true with respect to the present value of a future amount? A) The higher the discount rate, the higher the present value of a single sum for a given time period. B) The relationship between present value and time is exponential. C) The greater the time period, the higher the present value of a single sum for a given interest rate. D) The lower the discount rate, the lower the present value of a single sum for a given time period. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

90) Juan and Rachel Burpo plan to buy a time-share in six years of $16,860. In order to have adequate funds to do so, the Burpo want to make a deposit to their money market fund today. Assume that they will be able to earn an investment rate of 5.75 percent, compounded annually. How much will Juan and Rachel need to deposit today to achieve their goal? (Round to the nearest dollar.) A) $11,138 B) $8,885 C) $12,055 D) $14,243 Answer: C Explanation: Amount needed = FV = $16,860 Interest rate = i = 5.75% Duration of investment = n = 6 years Present Value = PV6 = $12,055.22 PV6 =

= = $12,055.22 Financial calculator solution: FV = 16,860; N = 6; I/Y = 5.75; PMT = 0; CPT PV = $12,055.22 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

91) Steve Fisher is saving for a new car. He needs to have $ 21,000 for the car in three years. How much will he have to invest today in an account paying 8 percent annually to achieve his target? (Round to nearest dollar.) A) $22,680 B) $26,454 C) $16,670 D) $19,444 Answer: C Explanation: 0 3 years ├────────────────────┤ PV =? i = 8% FV = $21,000 Value of investment after 3 years = FV3 = $21,000 Return expected from investment = i = 8% Duration of investment = n = 3 years Amount to be invested today = PV PV =

= $16,670.48

Financial calculator solution: FV = 21,000; N = 3; I/Y = 8; PMT = 0; CPT PV = $16,670.48 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

92) Albert borrows money from Jacob today with a promise to repay $7,418.87 in four years. If Jacob could earn 5.45 percent annually on the any investment he makes today, how much would he be willing to lend Albert today? (Round to nearest dollar.) A) $6,000 B) $7,035 C) $6,500 D) $7,150 Answer: A Explanation: 0 4 years ├────────────────────┤ PV =? i = 5.45% FV = $7,418.87 Loan repayment amount after 4 years = FV4 = $7,418.87 Return expected from loan = i = 5.45% Duration of loan = n = 4 years Amount to be loaned today = PV PV =

= $6,000

Financial calculator solution: FV = 7,418.87; N = 4; I/Y = 5.45; PMT = 0; CPT PV = $6,000 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

93) Joyce Thomas wants to buy a house in six years. She hopes to have $25,000 at that time. If the bank CD she wants to invest in will pay 7.5 percent annually, how much will she have to invest today? (Round to the nearest dollar.) A) $18,472 B) $13,987 C) $16,199 D) $23,256 Answer: C Explanation: 0 6 years ├───────────────────┤ PV =? i = 7.5% FV = $25,000 Amount needed for down payment after 6 years = FV6 = $25,000 Return expected from investment = i = 7.5% Duration of investment = n = 6 years Amount to be invested today = PV PV =

= $16,199

Financial calculator solution: FV = 25,000; N = 6; I/Y = 7.5; PMT = 0; CPT PV = $16,199.04 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

94) Robert Kelly wants to start a business in 10 years. He hopes to have $100,000 at that time to invest in the business. To reach his goal, he plans to invest a certain amount today in a bank CD that will pay him 9.50 percent annually. How much will he have to invest today to achieve his target? (Round to the nearest dollar.) A) $54,233 B) $63,837 C) $91,324 D) $40,351 Answer: D Explanation: 0 10 years ├────────────────────┤ PV =? i = 9.5% FV = $100,000 Value of investment after 10 years = FV10 = $100,000 Return expected from investment = i = 9.5% Duration of investment = n = 10 years Amount to be invested today = PV PV =

= $40,351.42

Financial calculator solution: FV = 100,000; N = 10; I/Y = 9.5; PMT = 0; CPT PV = $40,351.42 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

95) Leroy Diaz plans to invest some money today so that he will have $7,500 in three years. If the investment he is considering will pay 3.65 percent compounded daily, how much will he have to invest today? A) $5,276 B) $6,722 C) $6,897 D) $7,140 Answer: B Explanation: 0 3 years ├────────────────────┤ PV =? i = 3.65% FV = $7,500 Return expected from investment = i = 3.65% Duration of investment = n = 3 years Frequency of compounding = m = 365 Target investment proceeds in 3 years = FV3 = $7,500 Present value of amount = PV PV =

= $6,722.15 Financial calculator solution: FV = 7,500; N = 3x365; I/Y = 3.65/365; PMT = 0; CPT PV = $6,722.15 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

96) You need to have $15,000 in five years to pay off a home equity loan. You can invest in an account that pays 5.75 percent compounded quarterly. How much will you have to invest today to attain your target in five years? (Round to the nearest dollar.) A) $4,903 B) $11,275 C) $13,184 D) $12,250 Answer: B Explanation: 0 5 years ├────────────────────┤ PV =? i = 5.75% FV = $15,000 Return expected from investment = i = 5.75% Duration of investment = n = 5 years Frequency of compounding = m = 4 Target investment proceeds in 5 years = FV5 = $15,000 Present Value of amount = PV PV =

= $11,275.10 Financial calculator solution: FV = 15,000; N = 20; I/Y = 5.75/4; PMT = 0; CPT PV = $11,275.10 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

97) Tamera Watson is saving for her daughter's college education. She wants to have $50,000 available when her daughter graduates from high school in four years. If the investment she is considering will pay 8.25 percent compounded monthly, how much will she have to invest today to reach her target? (Round to the nearest dollar.) A) $35,987 B) $39,659 C) $41,275 D) $36,450 Answer: A Explanation: 0 4 years ├────────────────────┤ PV =? i = 8.25% FV = $50,000 Return expected from investment = i = 8.25% Duration of investment = n = 4 years Frequency of compounding = m = 12 Target investment proceeds in 4 years = FV4 = $50,000 Present value of amount = PV PV =

= $35,986.80 Financial calculator solution: FV = 50,000; N = 48; I/Y = 8.25/12; PMT = 0; CPT PV = $35,986.80 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

98) Michael Peterson needs $25,000 in six years to invest in a real estate venture. He can earn 6.35 percent annual interest with monthly compounding in a private investment. How much will he have to invest today to reach his goal? (Round to the nearest dollar.) A) $18,527 B) $23,015 C) $17,097 D) $19,648 Answer: C Explanation: 0 6 years ├────────────────────┤ PV =? i = 6.35% FV = $25,000 Return expected from investment = i = 6.35% Duration of investment = n = 6 years Frequency of compounding = m = 12 Target investment proceeds in 6 years = FV6 = $25,000 Present value of amount = PV PV = FVn/(1 + i/m)mn = $25,000/(1 + (0.005292/12))12 × 6 = $17,096.61 Financial calculator solution: FV = 25,000; N = 72; I/Y = 6.35/12; PMT = 0; CPT PV = $17,096.61 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

99) Celesta Frank wants to go on a cruise in three years. She could earn 8.2 percent compounded monthly in an account if she deposits the money today. She needs to have $10,000 in three years. How much will she have to deposit today? (Round to the nearest dollar.) A) $6,432 B) $7,826 C) $8,148 D) $7,763 Answer: B Explanation: 0 3 years ├────────────────────┤ PV =? i = 8.2% FV = $10,000 Return expected from investment = i = 8.2% Duration of investment = n = 3 years Frequency of compounding = m = 12 Target investment proceeds in 3 years = FV3 = $10,000 Present value of amount = PV PV =

= $7,825.77 Financial calculator solution: FV = 10,000; N = 36; I/Y = 8.2/12; PMT = 0; CPT PV = $7,825.77 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

100) Celesta Frank wants to go on a cruise in three years. She could earn 8 percent compounded daily in an account if she deposits the money today. She needs to have $10,000 in three years. How much will she have to deposit today? (Round to the nearest dollar.) A) $6,432 B) $7,826 C) $7,866 D) $7,763 Answer: C Explanation: Return expected from investment = i = 8%; 0.08/365 daily = 0.00021918 Duration of investment = n = 3 years; 3 × 365 = 1,095 Frequency of compounding = m = 365 Target investment proceeds in 3 years = FV = $10,000 Present value of amount = PV = 10,000/(1 + 0.00021919)1,095 = $7,866.49 Financial calculator solution: FV = 10,000; N = 1,095; I/Y = 8/365; PMT = 0; CPT PV = $7,866.49 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 101) The process of converting future cash flows into their present value is called: A) annualizing. B) discounting. C) compounding. D) capital budgeting. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

102) Which of the following equations is used to calculate the present value of a sum to be received in future? A) PV = FVn ÷ (1 + i)n B) PV = FVn × (1 + i)n C) PV = (1 + i)n + FVn D) PV = (1 + i)n ÷ FVn Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 103) Based on the rule of 72, the amount of time to double your money (TDM) approximately equals: A) 72/n. B) 72/i. C) 72/Initial investment. D) 72/Future value. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 104) Which of the following statements is true of the rule of 72? A) It can be used to determine the amount of time it takes to double an investment. B) It is fairly accurate for interest rates between 25 and 50 percent. C) It states that the time to double your money (TDM) approximately equals 72/i, where i represents the years it takes to double your investment. D) It can be used to estimate approximate compound interest earned for a period of 72 days. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

105) Your tuition for the coming year is due today. You borrow $8,000 from your uncle and agree to repay in the three years an amount of $9,250. What is the interest rate on this loan? Round to the nearest percent. A) 5% B) 6% C) 7% D) 8% Answer: A Explanation: 0 3 years ├────────────────────┤ PV = $8,000 FV = $9,250 Amount to be borrowed = PV = $8,000 Amount to be paid back after 3 years = FV3 = $9,250 Interest rate on investment = i =? Duration of investment = n = 3 years Present value of investment = PV PV = $8,000 = (1 + i)3 =

= 1.15625

(1 + i) = (1.15625)1/3 = 1.0496 i = 4.96% Financial calculator solution: PV = -$8,000; N = 3; FV = 9,250; PMT = 0; CPT I/Y = 4.958% Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

106) Anne Morgan wants to borrow $6,000 for a period of four years. She has two choices. Her bank will lend her the amount at 7.25 percent compounded annually. She can also borrow from her firm and will have to repay a total of $8,130.93 at the end of four years. Should Anne choose her bank or the firm, and what is the interest rate if she borrows from her firm? (Round to the nearest percent.) A) She should borrow from the bank as the bank is charging a higher interest of 9 percent. B) She should borrow from her firm as it is charging a lower interest of 7 percent. C) She should borrow from the bank as the firm is charging a higher interest of 8 percent. D) She should borrow from her firm as it is charging a lower interest of 6 percent. Answer: C Explanation: 0 4 years ├────────────────────┤ PV = $6,000 FV = $8,130.93 Amount to be borrowed = PV = $6,000 Amount to be paid back after 4 years = FV = $8,130.93 Interest rate on investment = i =? Duration of investment = n = 4 years Present value of investment = PV PV = $6,000 = (1 + i)4 =

= 1.355155

(1 + i) = (1.355155)1/4 = 1.07894 i = 7.89% Financial calculator solution: PV = -6,000; N = 4; PMT = 0; FV = 8,130.93; CPT I/Y = 7.894% Since borrowing from her firm results in a loan rate of 7.89 percent, she should take the bank loan at 7.25 percent. Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

107) Patrick Smith has $5,000 to invest in a small business venture. His partner has promised to pay him back $8,200 in five years. What is the return that this investment earns? A) 9.3% B) 8.7% C) 11.1% D) 10.4% Answer: D Explanation: 0 5 years ├────────────────────┤ PV = $5,000 FV = $8,200 Amount being invested = PV = $5,000 Amount to be paid back after 5 years = FV = $8,200 Interest rate on investment = i =? Duration of investment = n = 5 years Present value of investment = PV PV = $5,000 = (1 + i)5 =

= 1.6400

(1 + i) = (1.6400)1/5 = 1.103999 i = 10.4% Financial calculator solution: PV = -5,000; N = 5; PMT = 0; FV = 8,200; CPT I/Y = 10.40% Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

108) Suppose you just won the state lottery, and you have a choice between receiving $2,550,000 today or $250,000 a year for 20 years, with the first payment starting one year from today. What annual interest rate does the second choice provide? A) 7.12% B) 7.49% C) 7.87% D) 8.26% Answer: B Explanation: N = 20 PV = -$2,550,000 PMT = $250,000 FV = $0 Compute I/YR 7.49% Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 109) Assume that you own an investment that will pay you $15,000 per year for 12 years, with the first payment today. You need money today to start a new business, and your uncle offers to give you $120,000 for the investment. If you sell it, what rate of return would your uncle earn on the annuity? A) 7.12% B) 7.59% C) 7.99% D) 8.41% Answer: D Explanation: BEGIN Mode N 12 PV -$120,000 PMT $15,000 FV $0 Compute I/YR = 8.41% Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

110) Winston Baker will invest $25,000 in a spa that his sister is starting. He will triple his investment in six years. What is the rate of return that Winston is being promised? (Round to the nearest percent.) A) 18% B) 20% C) 12% D) 25% Answer: B Explanation: 0 6 years ├────────────────────┤ PV = $25,000 FV = $75,000 Amount being invested = PV = $25,000 Amount to be paid back after 6 years = FV = $75,000 Interest rate on investment = i =? Duration of investment = n = 6 years Present value of investment = PV PV = $25,000 = (1 + i)6 =

= 3.0000

(1 + i) = (3.0000)1/6 = 1.200937 i = 20% Financial calculator solution: PV = -25,000; N = 6; PMT = 0; FV = 75,000; CPT I/Y = 20.09% Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

111) Michael Harper has $3,000 to invest for three years. He wants to receive $5,000 at the end of the three years. What invest rate would his investment have to earn to achieve his goal? (Round to the nearest percent.) A) 19% B) 21% C) 13% D) 16% Answer: A Explanation: 0 3 years ├────────────────────┤ PV = $3,000 FV = $5,000 Amount being invested = PV = $3,000 Amount to be paid back after 3 years = FV = $5,000 Interest rate on investment = i =? Duration of investment = n = 3 years Present value of investment = PV PV = $3,000 = (1 + i)3 =

= 1.66667

(1 + i) = (3.0000)1/3 = 1.1856 i = 18.6% Financial calculator solution: PV = -3,000; N = 3; PMT = 0; FV = 5,000; CPT I/Y = 18.56% Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

112) Finor Traps manufactures an innovative mouse trap. Total sales for the current year is $325,000. The company expects its sales to increase to $500,000 in five years. What is the expected growth rate in sales for this firm? (Round to the nearest percent.) A) 9% B) 11% C) 6% D) 12% Answer: A Explanation: 0 5 years ├────────────────────┤ PV = $325,000 FV = $500,000 Current sales = PV = $325,000 Expected sales five years from now = $500,000 To calculate the expected sales growth rate, we set up the future value equation. FV5 = PV × (1 + g)5 $500,000 = $325,000(1 + g)5 (1 + g)5 =

= 1.538461538

g = (1.538461538)1/5 - 1 = 9.00% Financial calculator solution: PV = 325,000; N = 5; PMT = 0; FV = 500,000; CPT I/Y = 9.000% Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

113) Bovic Inc. is a growing company with sales of $1.25 million this year. The company expects to grow at an annual rate of 25 percent for the next three years, followed by 20 percent per year for the next two years. What will be Bovic's sales at the end of five years? (Round to the nearest dollar.) A) $2,160,000 B) $3,515,625 C) $1,875,000 D) $2,929,688 Answer: B Explanation: 0 5 years ├────────────────────┤ = 25% = 20% PV = $1.25 million

FV =?

Current sales = PV = $1,250,000 Expected sales five years from now = FV To calculate the expected sales, we set up the future value equation. FV5 = PV × (1 + g1)3(1 + g2)2 = ($1,250,000)(1.25)3(1.20)2 = $3,515,625 Financial calculator solution: PV = 1,250,000; N = 3; PMT = 0; I/Y = 25; CPT FV = $2,441,406.25 After 5 years: PV = -2,441,406.25; N = 2; PMT = 0; I/Y = 20; CPT FV = $3,515,625 Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

114) Manufic, a detergent manufacturer, has announced this year's net income as $832,500. It expects its net earnings to grow at a rate of 15 percent per year for the next two years, before dropping to 12 percent for each of the following two years. What is the firm's net income after four years? (Round to the nearest dollar.) A) $1,381,071 B) $1,266,128 C) $1,233,099 D) $1,072,260 Answer: A Explanation: 0 4 years ├────────────────────┤ = 15% = 12% PV = $832,500

FV =?

Current net income = PV = $832,500 Expected net income four years from now = FV To calculate the expected net earnings, we set up the future value equation. FV4 = PV × (1 +

)2(1 +

= ($832,500)(1.15)2(1.12)2 = $1,381,070.88 Financial calculator solution: PV = 832,500; I/Y = 15; N = 2; PMT = 0; CPT FV = 1,100,951.25 After 2 years: PV = -1,100,981.25; I/Y = 12; N = 2; PMT = 0; CPT FV = $1,381,070.88 Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

115) Your subscription to BusinessWeek is about to expire. You plan to subscribe to the magazine for the rest of your life. You can renew it by paying $50 annually, beginning immediately, or you can get a lifetime subscription for $500, also payable immediately. Assuming that you can earn 6.525 percent on your funds and that the annual renewal rate will remain constant, how many years must you live to make the lifetime subscription the better buy? A) 12 B) 15 C) 10 D) 18 Answer: B Explanation: BGN Mode I/Y = 6.525 PV = -500 PMT = 50 FV = 0 CPT N = 15 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

116) Genor Peterson Electrical Supplies has generated a net income of $161,424 this year. The firm expects to see an annual growth of 30 percent for the next five years, followed by a growth rate of 15 percent for each of the next three years. What will be the firm's expected net income in eight years? (Round to the nearest dollar.) A) $319,157 B) $241,329 C) $911,546 D) $689,259 Answer: C Explanation: 0 5 8 years ├────────────────┼────────────┤ = 30% = 15% PV = $161,424

FV =?

Current net income = PV = $161,424 Expected net income eight years from now = FV8 To calculate the expected net earnings, we set up the future value equation. FV8 = PV × (1 +

)5(1 +

= ($161,424)(1.30)5(1.15)3 = $911,545.58 Financial calculator solution: PV = 161,424; N = 5: I/Y = 30; PMT = 0; CPT FV = $599,356.0123 After 5 years: PV = 599,356.0123; I/Y = 15; N = 3; PMT = 0; CPT FV = $911,545.58 Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

117) Locil Agencies is a fast-growing advertising agency. Currently, its sales is at $700,000. The company expects its sales to grow at an annual rate of 35 percent in the next two years, followed by an annual rate of 25 percent in years 3 through 7. Finally, its growth rate would slow down to 10 percent in years 8-10. What will its sales be in year 10? (Round to the nearest dollar.) A) $1,698,023 B) $2,843,323 C) $3,893,280 D) $5,181,956 Answer: D Explanation: 0 5 10 years ├────────────────┼──────────────────┤ = 35% = 25% = 10% PV = $700,000

FV =?

Current sales = PV = $700,000 Expected sales 10 years from now = FV10 To calculate the expected sales, we set up the future value equation. FV10 = PV × (1 +

)2(1 +

)5(1 +

= ($700,000)(1.35)2(1.25)5(1.10)3 = $5,181,955.72 Financial calculator solution: PV = -700,000; I/Y = 35; N = 2; PMT = 0; CPT FV = 1,275,750 After 2 years: PV = -1,275,750; I/Y = 25; N = 5; PMT = 0; CPT FV = $3,893,280.029 After 7 years: PV = -3,893,280.029; I/Y = 10; N = 3; CPT FV = $5,181,955.72 Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

118) Your uncle is looking to double his investment of $10,000. He claims he can get earn 14 percent on his investment. How long will it take to double his investment? Use the Rule of 72 and round to the nearest year. A) 5 years B) 14 years C) 10 years D) 7 years Answer: A Explanation: Initial investment = $10,000 Rate of return on investment = i = 14% Time to double the investment = TDM = 72/i = 72 / 14 = 5.14 years Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 119) Animist Designers has generated sales of $625,000 for the current year. If it can increase its sales at a rate of 12 percent every year, how long will it take for its sales to triple? (Round to the nearest year.) A) 8 years B) 7 years C) 10 years D) 9 years Answer: C Explanation: By entering the following data into a financial calculator, the required number of years can be calculated as 9.69.

12 I

0 PMT

-$625,000 PV

$1,875,000 FV

Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

120) Transent Foods announced that its current sales is $1,233,450 this year. The company forecasts a growth rate of 16 percent for the foreseeable future. How long will it take the firm to produce earnings of $3 million? (Round to the nearest year.) A) 7 years B) 6 years C) 8 years D) 10 years Answer: B Explanation: By entering the following data into a financial calculator, the required number of years can be calculated as 5.99.

12 I

0 PMT

-$625,000 PV

$1,875,000 FV

Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 121) Nickole wants to invest in a bank CD that will pay her 7.8 percent annually. If she invests $11,500 today, when will she reach her goal of $15,000? (Round to the nearest year.) A) 5 years B) 7 years C) 2 years D) 4 years Answer: D Explanation: By entering the following data into a financial calculator, the required number of years can be calculated as 3.54.

7.8 i

0 PMT

-$11,500 PV

$15,000 FV

Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

122) Albend Holmes wants to deposit $4,500 in a bank account that pays 8.25 percent annually. How many years will it take for his investment to grow to $10,000? (Round to the nearest year.) A) 8 years B) 11 years C) 10 years D) 12 years Answer: C Explanation: By entering the following data into a financial calculator, the required number of years can be calculated as 10.07.

8.25 i

0 PMT

-$4,500 PV

$10,000 FV

Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

123) Amanda Sorenson is planning her retirement. She is presently investing in a 401(k) but needs an additional $500,000 to reach her retirement goal. As luck would have it, Amanda just won a brand new car that is worth $36,000 in a raffle. If Amanda were to sell the car and invest the $36,000 proceeds at a rate of 6.50 percent, compounded annually, how long will it be before Amanda has the additional funds she needs to reach her goal? (Round to the nearest 1/10 of a year.) A) 36.6 years B) 41.8 years C) 52.2 years D) 24.0 years Answer: B Explanation: Present Value = PV = -$36,000 Future Value = FV = $500,000 Interest rate = i = 6.50% Number of Periods = n = 41.8 years FVn = PV(1 + i)n =

= (1 + i)n

= (1.065)n = 13.88889 = (1.065)n nLN(1.065) = LN(13.88889) n=

= 41.78 years

Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

124) Omniva Inc. just generated earnings per share of $3.75 for the fiscal year ending September 30, 2014. The firm is expected to achieve earnings per share of $8.76 in 5-years. At what rate will Omniva Inc.'s earnings per share be growing over this 5-year period? (Round to the nearest 1/10 percent.) A) 15.7% B) 18.5% C) 21.3% D) 13.4% Answer: B Explanation: Present Value = PV = -$3.75 Period = n = 5 years Future Value = FV5 = $8.76 Interest rate = i = 18.49%

-1

= -1 = 1.184935 - 1 =.184935 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

125) You agree to deposit $500 at the beginning of each month into a bank account for the next 24 months. At the end of the 24th month, you will have $13,000 in your account. If the bank compounds interest monthly, what annual interest rate will you have earned? A) 7.62% B) 8.00% C) 8.40% D) 8.82% Answer: A Explanation: BEGIN Mode N 24 PV $0 PMT -$500 FV $13,000 I/MO 0.6347% I/YR 0.6347% × 12 = 7.62% Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 126) You just deposited $2,500 in a bank account that pays a 4.0 percent annual interest rate, compounded quarterly. If you also add $5,000 to the account one year (4 quarters) from now and $7,500 to the account two years (8 quarters) from now, how much will be in the account three years (12 quarters) from now? A) $15,234.08 B) $16,035.87 C) $16,837.67 D) $17,679.55 Answer: B Explanation: Interest rate 4.0% Periods/year 4 Years on Quarters Ending Quarterly rate 1.0% Deposit on Deposit Amount 1st deposit $2,500 3 12 $ 2,817.06 2nd deposit $5,000 2 8 $5,414.28 3rd deposit $7,500 1 4 $7,804.53 Total $16,035.87 Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

127) Explain the difference between simple interest and compound interest. Answer: Simple interest refers to the interest earned on the initial investment over the investment period. Compound interest includes not only simple interest but also interest earned on the reinvestment of previously earned interest. Thus, compound interest includes both the simple interest and the interest on interest. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 128) Explain how the future and the present value equations are related. Answer: To get the future value (FVn) of funds invested for n years, we multiply the original investment by (1+ i)n. To find the present value of a future payment (PV), we divide FVn by (1 + i)n. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 129) Suppose you win $10 million in a lottery. You have a choice of how you will receive your winnings. The first choice is to receive a certain lump sum today. The second choice is to receive a certain amount at the end of five years. How will you evaluate your choices to make your decision? Answer: In order to make the correct choice, one has to make the comparison on the same basis. That is, you calculate the future value of the lump sum invested today at your opportunity cost and compare it to the future value under your second choice. Or you discount the future value of the amount in your second choice to its present value and compare it to the lump sum in your first choice. Either of the two approaches would allow you to select the choice that provides you the highest amount. Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

130) Suppose that you just attended a lecture on Time Value of Money. On your way home, you stopped in to get a cup of coffee. One of your classmates, who missed the lecture, joined you for coffee and asked you to explain to her the key concepts of time value of money and how you could use it to solve some of practical financial problems. What would you tell her? Answer: Time value of money has to do with making decisions about investments; e.g., how much should one pay today for a share of common stock, for an apartment building, etc. This amount is known as the present value. The answer involves a number of important concepts: (1) The expected/required rate of return; this is known as rate. (2) The expected time that the investment will be held; this is known as number of periods. (3) The expected cash flow(s); this is known as future value, or if a series of future values it is known as payments. (4) The frequency at which the rate is compounded or discounted; i.e., annually, quarterly, monthly, etc. The way in which these types of problems can be solved is by usage of mathematical formulas, financial calculators, or spreadsheet models. Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 6 Discounted Cash Flows and Valuation 1) Calculating the present and future values of multiple cash flows is relevant only for individual investors. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 2) In calculating the present value or the future value of a cash flow stream one must either discount or compound the cash flows to the same point in time. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 3) Calculating the present or future values of multiple cash flows is relevant for businesses only. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 4) Each cash flow is discounted at the same rate when calculating the present values of multiple cash flows. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

5) The present value of multiple cash flows is greater than the sum of those cash flows assuming the discount rate is greater than zero. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 6) The future value of multiple cash flows is greater than the sum of those cash flows when the discount rate is zero. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 7) Jacob Oram pays the same insurance premium amount every month for a term life policy for a period of five years. The stream of cash flows is called a perpetuity. Answer: FALSE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 8) Allen Bell pays the same amount every month on a car loan for a period of three years. The stream of cash flows is called an annuity. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

9) The future value of the annuity due exceeds the future value of the ordinary annuity, but the present value of the annuity due will be lower than the present value of the ordinary annuity. Answer: FALSE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 10) The present value of a perpetuity exceeds the present value of a 100-year ordinary annuity as long as the discount rate is positive. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 11) In today's financial markets, the best example of a perpetuity is the common stock issued by firms. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 12) In today's financial markets, the best example of a perpetuity is the preferred stock issued by firms. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

13) Since the issuers of preferred stock promise to pay investors a fixed quarterly dividend, forever, this is an example of perpetuities in the financial markets. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 14) The present value of a perpetuity is the promised constant cash payment divided by the interest rate (i). Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 15) In an ordinary annuity, cash flows occur at the beginning of each period. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 16) In an annuity due, cash flows occur at the beginning of each period. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 17) The lease payments by a business for renting a warehouse are an example of an annuity due. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 4

18) The present value of an annuity due is less than the present value of an ordinary annuity. Answer: FALSE Diff: 1 Learning Objective: LO 2, 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 19) The present value of an annuity due is equal to the present value of an ordinary annuity. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 20) The future value of an annuity due is greater than the future value of an ordinary annuity. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 21) The future value of an annuity due is equal to the future value of an ordinary annuity. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 22) Cash flow streams that increase at a constant rate over time are called growing annuities or growing perpetuities. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

23) A fertilizer manufacturing company enters into a contract with a county parks and recreation department that calls for the company to sell 10 percent more of its best lawn feed every year for the next five years. If they also agree to maintain the unit price as constant over the contract period, this growth in revenue is an example of a growing perpetuity. Answer: FALSE Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 24) You have received news about an inheritance that will pay you $5,000 next year. Beginning next year, your inheritance will increase by 5 percent every year forever. This is a growing perpetuity. Answer: TRUE Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 25) Natalia Greenberg opened a pizza place last year. She expects to increase her revenues from last year by 7 percent every year for the next 10 years. This is an example of a growing annuity. Answer: TRUE Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 26) The annual percentage rate (APR) is the annualized interest rate using compound interest. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

27) Credit card issuers are required to disclose the Annual Percentage Rate (APR) on their monthly statements. If the APR is stated to be 23.50 percent, with interest compounded monthly, the Effective Annual Interest Rate (EAR) will be less than 23.50 percent. Answer: FALSE Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 28) The annual percentage rate (APR) is defined as the simple interest charged per period multiplied by the number of periods per year. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 29) The correct way to annualize an interest rate is to compute the effective annual interest rate. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 30) The correct way to annualize an interest rate is to compute the annual percentage rate (APR). Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

31) The effective annual interest rate (EAR) is defined as the annual growth rate that takes compounding into account. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 32) The effective annual interest rate (EAR) is the true cost of borrowing and lending. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 33) The quoted interest rate is by convention a simple annual percentage interest rate (APR). Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 34) The quoted interest rate is by definition a simple annual interest rate, such as the effective annual interest rate (EAR). Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

35) The Truth-in-Lending Act and the Truth-in-Savings Act require by law that the annual percentage rate (APR) be disclosed on all consumer loans and savings plans and that it be prominently displayed on advertising and contractual documents. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Legal/Regulatory Perspective 36) Only the annual percentage rate (APR) or some other quoted rate should be used as the discount rate for present or future value calculations. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 37) A car manufacturer enters into a contract for 25-years lease of warehouse rental that adjusts annually for the expected rate of inflation over the life of the contract. This is an example of growing perpetuity. Answer: FALSE Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 38) A growing annuity for an infinite number of periods is called a growing perpetuity. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

39) For computation of the present value of growing annuity with n periods, the cash flow for the current period is used and not the cash flow to be received in the next period. Answer: FALSE Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 40) Growing perpetuity is widely used in the valuation of common stock of firms that have a policy of paying dividends that grow at a constant rate every year. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 41) The present value of a growing perpetuity is computed as the cash flow occurring at the end of the first period divided by the difference between the interest or discount rate and the growth rate. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 42) A growing annuity is a series of cash flows that grow at a constant rate for a specified number of periods. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

43) Which of the following is used as the denominator when calculating the present value for a growing perpetuity that begins next period (PVP)? A) The difference between i (the discount or interest rate) and g (the constant growth rate of the cash flow) B) i (the discount or interest rate) C) g (the constant growth rate of the cash flow) D) The addition of i (the discount or interest rate) and g (the constant growth rate of the cash flow) Answer: A Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 44) The present value of a future cash flow is computed by multiplying the future cash flow value with the: A) discounting factor. B) compounding factor. C) interest rate. D) number of periods. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

45) Nick invested $2,000 in a bank savings account today and another $2000 a year from now. If the bank pays interest of 10 percent per year, how much money will Nick have at the end of two years? A) $4,210 B) $4,200 C) $4,000 D) $4,620 Answer: D Explanation: Future value of two cash flows = [PV × (1 + i)2]+ [PV × (1 + i)] = [$2,000 × (1 + 0.10)2] + [$2,000 × (1 + 0.10)] = [$2,000 × (1.10)2] + [$2,000 × (1.10)] = [$2,000 × 1.21]+ [$2,000 × 1.10] = $2,420 + $2,200 = $4,620 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 46) Which of the following is true of the discounting factor? A) The discounting factor is the reciprocal of compounding factor. B) The discounting factor is the sum of 1 and the rate of interest. C) The discounting factor is period n times the rate of interest. D) The discounting factor is computed by dividing period n by the sum of 1 and the rate of interest. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

47) William deposited $25,000 today that would earn an annual interest of 3 percent each year for a period of 2 years. The amount of $25,000 represents the: A) present value of an annuity. B) future value of an annuity. C) present value. D) future value. Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 48) In computing the present and future value of multiple cash flows: A) each cash flow is discounted or compounded at the same rate. B) each cash flow is discounted or compounded at a different rate. C) earlier cash flows are discounted at a higher rate. D) later cash flows are discounted at a higher rate. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 49) Anna will receive $15,000 from a bank deposit in 2 years which earned an annual interest rate of 3.5 percent. The amount of $15,000 represents the: A) present value of an annuity. B) future value of an annuity. C) present value. D) future value. Answer: D Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

50) The present value of multiple cash flows is: A) greater than the sum of the cash flows. B) equal to the sum of all the cash flows. C) less than the sum of the cash flows. D) higher or lower than the cash flows depending on the interest rate. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 51) Assuming a 10 percent positive rate, the future value of multiple cash flows is: A) greater than the sum of the cash flows. B) equal to the sum of all the cash flows. C) less than the sum of the cash flows. D) higher or lower than the cash flows depending on the interest rate. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 52) If your investment pays the same amount at the end of each year for a period of six years, the cash flow stream is called: A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) a growing perpetuity. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

53) If your investment pays the same amount at the beginning of each year for a period of 10 years, the cash flow stream is called: A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) a growing perpetuity. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 54) A preferred stock would be an example of: A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) a growing annuity. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 55) Cash flows associated with annuities are considered to be: A) an uneven cash flow stream. B) a constant cash flow stream. C) a mix of constant and uneven cash flow streams. D) a cash flow stream with decreasing trend. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

56) Which of the following statements is true of amortization? A) Amortization solely refers to the total value to be paid by the borrower at the end of maturity. B) The amortization schedule represents only the interest portion of the loan. C) The computation of loan amortization is wholly based on the computation of simple interest. D) The amortization schedule provides principal, interest, and unpaid principal balance for each period. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 57) Which of the following statements is true of amortization? A) With an amortized loan, a periodic payment of principal portion gradually decreases over a period. B) Amortization schedule represents only the interest portion of the loan. C) With an amortized loan, a larger proportion of each periodic payment goes toward interest in the early periods. D) The computation of loan amortization is wholly based on the computation of simple interest. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 58) Which of the following statements is true of an amortized loan? A) A larger proportion of each periodic payment goes toward interest in the early periods. B) A larger proportion of each periodic payment goes toward interest in the later periods. C) A smaller proportion of each periodic payment goes toward interest in the early periods. D) The interest portion of each periodic payment remains unchanged. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

59) The annuity transformation method is used to transform: A) a present value annuity to a future value annuity. B) a present value annuity to an annuity due. C) an ordinary annuity to an annuity due. D) a perpetuity to an annuity. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 60) A firm receives a cash flow from an investment that will increase by 10 percent annually for an infinite number of years. This cash flow stream is called: A) an annuity due. B) a growing perpetuity. C) an ordinary annuity. D) a growing annuity. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 61) Your investment in a small business venture will produce cash flows that increase by 15 percent every year for the next 25 years. This cash flow stream is called: A) an annuity due. B) a growing perpetuity. C) an ordinary annuity. D) a growing annuity. Answer: D Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

62) Which of the following statements is true about the effective annual rate (EAR)? A) The EAR is defined as the annual growth rates that do not take compounding into account. B) The EAR is the annualized interest rate using simple interest. It ignores the interest earned on interest associated with compounding periods of less than one year. C) The EAR is the simple interest charged per period multiplied by the number of periods per year. D) The EAR is the interest rate actually paid or earned after accounting for compounding over one year. Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 63) The true cost of borrowing is the: A) annual percentage rate. B) effective annual rate. C) quoted interest rate. D) periodic rate. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 64) The true cost of lending is the: A) annual percentage rate. B) effective annual rate. C) quoted interest rate. D) interest rate per period. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

65) Which of the following statements is true of annual percentage rate (APR)? A) The APR is similar to the quoted interest rate, which is a simple annual rate. B) The APR calculation adjusts for the effects of compounding and, hence, the time value of money. C) The APR is the true cost of borrowing and lending. D) The APR takes compounding effect into account. Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 66) Which of the following statements is true of annual percentage rate (APR)? A) The Truth-in-Savings Act was passed by Congress to ensure that the true cost of credit was disclosed to consumers. B) The Truth-in-Lending Act was passed to provide consumers an accurate estimate of the return they would earn on an investment. C) The Truth-in-Savings Act and Truth-in-Lending Act require by law that the APR be disclosed on all consumer loans and savings plans. D) The annual percentage rate (APR), and not the effective annual interest rate (EAR), represents the true economic interest rate. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 67) What is the appropriate interest rate to use when making future value or present value calculations? A) The effective annual interest rate (EAR) B) The annual percentage rate (APR) C) The quoted interest rate D) The simple interest Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

68) Krysel Inc. is expecting a new project to begin producing cash flows at the end of this year. They expect cash flows to be as follows: 1 $663,547

2 $698,214

3 $795,908

4 $798,326

5 $755,444

If they can reinvest these cash flows to earn an annual return of 9.2 percent, what is the future value of this cash flow stream at the end of five years? (Round to the nearest dollar.) A) $4,368,692 B) $4,429,046 C) $4,468,692 D) $4,529,046 Answer: B Explanation: 0 1 2 3 4 5 ├───────┼───────┼───────┼───────┼───────┤ $663,547 $698,214 $795,908 $798,326 $755,444 n=5

i = 9.20%

FV5 = $663,547(1.092)4 + $698,214(1.092)3 + $795,908(1.092)2 + $798,326(1.092)1 + $755,444 = $943,544.19 + $909,193.80 + $949,091.64 + $871,771.99 + $755,444.00 = $4,429,045.62 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

69) Phosfranc, Inc. is expecting the following cash flows starting at the end of the year– $133,245, $152,709, $161,554, and $200,760. If their opportunity cost of capital is 9.4 percent, what is the future value of these cash flows at the end of four years? (Round to the nearest dollar.) A) $734,731 B) $756,525 C) $734,231 D) $776,252 Answer: A Explanation: 0 1 2 3 4 ├────────┼────────┼────────┼────────┼ $133,245 $152,709 $161,554 $200,760 n=4

i = 9.40%

FV4 = $133,245(1.094)3 + $152,709(1.094)2 + $161,554(1.094)1 + $200,760 = $174,462.82 + $182,767.63 + $176,740.08 + $200,760.00 = $734,730.53 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

70) Robert White will receive cash flows of $4,450, $4,775, and $5,125 from his investment at the end of in the next three years. If he can earn 7 percent on the investment, what is the future value of his investment cash flows at the end of three years? (Round to the nearest dollar.) A) $15,329 B) $15,427 C) $16,427 D) $14,427 Answer: A Explanation: 0 1 2 3 ├────────┼────────┼────────┼ $4,450 $4,775 $5,125 n=4

i = 7.0%

FV3 = $4,450(1.07)2 + $4,775(1.07)1 + $5,125 = $5,094.81 + $5,109.25 + $5,125.00 = $15,329.06 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

71) Scottie Barnes has an investment that will pay him $6,400, $6,450, $7,225, and $7,500 over the next four years. If his opportunity cost is 10 percent, what is the future value of the cash flows he will receive after four years? (Round to the nearest dollar.) A) $27,150 B) $32,020 C) $30,455 D) $31,770 Answer: D Explanation: 0 1 2 3 4 ├────────┼────────┼────────┼────────┼ $6,400 $6,450 $7,225 $7,500 n = 4;

i = 10%

FV4 = $6,400(1.10)3 + $6,450(1.10)2 + $7,225(1.10)1 + $7,500 = $8,518.40 + $7,804.50 + $7,947.50 + $7,500 = $31,770.40 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 72) Global Shippers Inc. has forecasted earnings of $1,233,600, $1,345,900, and $1,455,650 for the next three years. What is the future value of these earnings in three years if the firm's opportunity cost is 13 percent? (Round to the nearest dollar.) A) $4,214,360 B) $4,551,701 C) $3,900,865 D) $4,362,428 Answer: B Explanation: 0 1 2 3 ├─────────┼────────┼─────────┼ 1,233,600 1,345,900 1,455,650 FV3 = $1,233,600(1.13)2 + 1,345,900(1.13)1 + $1,455,650 = 1,575,183.84 + $1,520,867.00 + $1,455,650.00 = $4,551,700.84 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 23

73) Damien McCoy has loaned money to his brother at an annual interest rate of 5.85 percent. He expects to receive $987, $1,012, $1,062, and $1,162 at the end of the next four years as complete repayment of the loan with interest. How much did he loan out to his brother? (Round to the nearest dollar.) A) $3,785 B) $3,757 C) $3,657 D) $3,685 Answer: C Explanation: 0 1 2 3 4 ├────────┼────────┼────────┼────────┼ $987 $1,012 $1,062 $1,162 n=4 =

i = 5.85% +

= $932.45 + $903.23 + $895.47 + $925.64 = $3,656.80 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

74) Newship Inc. has borrowed from its bank at an annual interest rate of 8 percent and will repay the loan with interest over the next five years. Its scheduled payments, starting at the end of the year are as follows: -$450,000, $560,000, $750,000, $875,000, and $1,000,000. What is the present value of these payments? (Round to the nearest dollar.) A) $2,735,200 B) $2,989,351 C) $2,431,224 D) $2,815,885 Answer: D Explanation: 0 1 2 3 4 5 ├──────┼──────┼──────┼──────┼──────┤ $450,000 $560,000 $750,000 $875,000 $1,000,000 n = 5; PV =

i = 8% +

= $416,666.67 + $480,109.74 + $595,374.18 + $643,151.12 + $680,583.20 = $2,815,884.91 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

75) David Stephens has made an investment that will pay him $11,455, $16,376, and $19,812 annually starting next year. His investment was to offer an annual return of 14 percent. What is the present value of these cash flows? (Round to the nearest dollar.) A) $37,712 B) $36,022 C) $41,675 D) $39,208 Answer: B Explanation: 0 1 2 3 ├────────┼────────┼────────┼ $11,455 $16,376 $19,812 n = 3; PV =

i = 14% +

= $10,048.25 + $12,600.80 + $13,372.54 = $36,021.58 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

76) Nutech Corp. is expecting the following annual cash flows–$79,000, $112,000, $164,000, $84,000, and $242,000–over the next five years. If the company's opportunity cost of capital is 15 percent, what is the present value of these cash flows? (Round to the nearest dollar.) A) $429,560 B) $485,097 C) $480,906 D) $477,235 Answer: A Explanation: 0 1 2 3 4 5 ├──────┼──────┼──────┼──────┼──────┤ $79,000 $112,000 $164,000 $84,000 $242,000 n = 5; PV =

i = 15% +

= $68,695.65 + $84,688.09 + $107,832.66 + $48,027.27 + $120,316.77 = $429,560.45 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

77) Helen Ashley is expecting annual cash flows of $50,000, $75,000, $125,000, and $250,000 from an inheritance over the next four years. If she can earn 11 percent on any investment that she makes, what is the present value of her inheritance? (Round to the nearest dollar.) A) $361,998 B) $414,454 C) $412,372 D) $434,599 Answer: A Explanation: 0 1 2 3 4 ├────────┼────────┼─────────┼────────┼ $50,000 $75,000 $125,000 $250,000 n = 4; PV =

i = 11% +

= $45,045.05 + $60,871.68 + $91,398.92 + $164,682.74 = $361,998.39 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

78) Ransport Company has made an investment in another company that will guarantee a cash flow of $37,250 each year for the next five years. If the company uses a discount rate of 15 percent on its investments, what is the present value of this investment? (Round to the nearest dollar.) A) $101,766 B) $124,868 C) $251,154 D) $186,250 Answer: B Explanation: 0 1 2 3 4 5 ├───────┼───────┼───────┼───────┼───────┤ $37,250 $37,250 $37,250 $37,250 $37,250 n = 5;

i = 15%

Annual payment = PMT = $37,250 No. of payments = n = 5 Required rate of return = 15% Present value of investment = PVA5

PVAn = PMT ×

= $37,250 ×

= $37,250 × 3.3522

= $124,867.78 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

79) Ryan Campbell has invested in a fund that will provide him an annual cash flow of $11,700 for the next 20 years. If his opportunity cost of capital is 8.5 percent, what is the present value of this cash flow stream? (Round to the nearest dollar.) A) $234,000 B) $132,455 C) $110,721 D) $167,884 Answer: C Explanation: 0 1 2 3 19 20 ├───────┼───────┼───────┼……………┼───────┤ $11,700 $11,700 $11,700 $11,700 $11,700 n = 20;

i = 8.5%

PVAn = PMT ×

= $11,700 ×

= $11,700 × 9.4633

= $110,721.04 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

80) Moore's Inc. will be making annual lease payments of $3,895.50 for a 10-year period, starting at the end of this year. If the firm uses a 9 percent discount rate, what is the present value of this annuity? (Round to the nearest dollar.) A) $23,250 B) $29,000 C) $25,000 D) $20,000 Answer: C Explanation: 0 1 2 3 9 10 ├───────┼───────┼───────┼……………┼───────┤ $3,895.50 $3,895.50 $3,895.50 $3,895.50 $3,895.50 n = 10;

i = 9%

PVAn = PMT ×

= $3,895.50 ×

= $3,895.50 × 6.4177

= $24,999.99 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

81) Graciela Treadwell won a lottery. She will have a choice of receiving $25,000 at the end of each year for the next 30 years, or a lump sum today. If she can earn an annual return of 10 percent on any investment she makes, what is the least she should be willing to accept today as a lump-sum payment? (Round to the nearest hundred dollars.) A) $750,000 B) $334,600 C) $212,400 D) $235,700 Answer: D Explanation: 0 1 2 3 29 30 ├───────┼───────┼───────┼……………┼───────┤ $25,000 $25,000 $25,000 $25,000 $25,000 n = 30;

i = 10%

PVAn = PMT ×

= $25,000 ×

= $25,000 × 9.4269

= $235,672.86 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

82) Insulor Inc. is expecting cash flows of $67,000 at the end of each year for the next five years. If the firm's discount rate is 17 percent, what is the present value of this annuity? (Round to the nearest dollar.) A) $214,356 B) $241,653 C) $278,900 D) $197,776 Answer: A Explanation: 0 1 2 3 4 5 ├──────┼───────┼───────┼───────┼───────┤ $67,000 $67,000 $67,000 $67,000 $67,000 n=5

i = 17%

PVAn = PMT ×

= $67,000 ×

= $67,000 × 3.1993

= $214,356.19 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

83) Lloyd Harris is planning to invest $3,500 every year for the next six years in an investment paying 13 percent annually. What will be the total amount he will have at the end of the six years? (Round to the nearest dollar.) A) $21,000 B) $29,129 C) $24,670 D) $26,124 Answer: B Explanation: 0 1 2 3 4 5 6 ├─────┼──────┼──────┼──────┼──────┼──────┤ $3,500 $3,500 $3,500 $3,500 $3,500 $3,500 n = 6;

i = 13%

FVAn = PMT ×

= $3,500 × = $3,500 × 8.3227 = $29,129.47 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

84) Shaun Barringer has started on his first job. He plans to start saving for retirement. He will invest $5,000 at the end of each year for the next 45 years in a fund that will earn an annual return of 10 percent. How much will Shaun have at the end of 45 years? (Round to the nearest dollar.) A) $2,667,904 B) $3,594,524 C) $1,745,600 D) $5,233,442 Answer: B Explanation: 0 1 2 3 44 45 ├───────┼───────┼───────┼……………┼───────┤ $5,000 $5,000 $5,000 $5,000 $5,000 n = 45;

i = 10%

FVAn = PMT ×

= $5,000 ×

= $5,000 × 718.9048

= $3,594,524.18 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

85) John Mason decided to save $2,250 at the end of each of the next three years to pay for a vacation. If he invests it at 8 percent annually, how much will he have at the end of three years? (Round to the nearest dollar.) A) $7,304 B) $7,403 C) $6,297 D) $7,010 Answer: A Explanation: 0 1 2 3 ├────────┼────────┼────────┼ $2,250 $2,250 $2,250 n=3

i = 8.0%

FVAn = PMT ×

= $2,250 × = $2,250 × 3.2464 = $7,304.40 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

86) Barbara Lakey is saving to buy a new car in four years. She will save $5,500 at the end of each of the next four years. If she invests her savings at 7.75 percent annually, how much will she have after four years? (Round to the nearest dollar.) A) $22,000 B) $23,345 C) $27,556 D) $24,692 Answer: D Explanation: 0 1 2 3 4 ├────────┼────────┼────────┼────────┼ $5,500 $5,500 $5,500 $5,500 FVAn = PMT ×

= $5,500 × = $5,500 × 4.4895 = $24,692.25 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

87) Rosalia White will invest $3,000 annually in an IRA for the next 30 years starting at the end of this year. The investment will earn 13 percent annually. How much will she have at the end of 30 years? (Round to the nearest dollar.) A) $879,598 B) $912,334 C) $748,212 D) $1,233,450 Answer: A Explanation: 0 1 2 3 29 30 ├───────┼───────┼───────┼.................... ┼───────┼ $3,000 $3,000 $3,000 $3,000 $3,000 n = 30

i = 13%

FVAn = PMT ×

= $3,000 ×

= $3,000 × 293.1992

= $879,597.65 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

88) Viviana Carroll needs to have $25,000 in five years. If she can earn 8 percent annually on any investment, what is the amount that she will have to invest every year at the end of each year for the next five years? (Round to the nearest dollar.) A) $5,000 B) $4,261 C) $4,640 D) $4,445 Answer: B Explanation: 0 1 2 3 4 5 ├───────┼───────┼───────┼───────┼───────┤ PMT PMT PMT PMT PMT n=5

i = 8%

FVA = $25,000

FVAn = PMT ×

= $25,000 × PMT =

= $4,261.41 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

89) Cassandra Dawson wants to save for a trip to Australia. She will need $12,000 at the end of four years. Starting today, she can invest a certain amount at the beginning of each of the next four years in a bank account that will pay her 6.8 percent annually. How much will she have to invest each year to reach her target? (Round to the nearest dollar.) A) $3,000 B) $2,980 C) $2,538 D) $2,711 Answer: C Explanation: 0 1 2 3 4 ├────────┼────────┼─────────┼────────┼ PMT PMT PMT PMT n=4

i = 6.8%

FVAn = PMT ×

FVA = $12,000 × (1 + i)

PMT =

= $2,538.16 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

90) Dawson Electricals has borrowed $27,850 from its bank at an annual rate of 8.5 percent. It plans to repay the loan in eight equal installments, beginning in a year. What is its annual loan payment? (Round to the nearest dollar.) A) $4,708 B) $5,134 C) $4,939 D) $4,748 Answer: C Explanation: 0 1 2 3 7 8 ├───────┼───────┼───────┼................... ┼───────┼ PMT PMT PMT PMT PMT PVAn = $27,850

n = 8;

i = 8.5%

Present value of annuity = PVA = $27,850 Return on investment = i = 8.5% Payment required to meet target = PMT Using the PVA equation:

PVAn = PMT ×

PMT =

= $4,938.66 Each payment made by Dawson Electricals will be $4,938.66, starting at the end of next year. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

91) Tim Dodson has borrowed $8,600 to pay for his new car. The annual interest rate on the loan is 9.4 percent, and the loan needs to be repaid in four annual payments. What will be his annual payment if he begins his payments now? (Round to the nearest dollar.) A) $2,229 B) $2,304 C) $2,850 D) $2,448 Answer: D Explanation: 0 1 2 3 4 ├────────┼────────┼─────────┼────────┼ PMT PMT PMT PMT PVAn = $8,600

n = 4;

i = 9.4%

Present value of annuity = PVA = $8,600 Return on investment = i = 9.4% Payment required to meet target = PMT Type of annuity = Annuity due Using the PVA equation:

PVAn = PMT ×

(1 + i)

PMT =

= = $2,447.80 Each payment made by Tim Dodson will be $2,447.80, starting today. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

92) James Perkins wants to have a million dollars at retirement, which is 15 years away. He already has $200,000 in an IRA earning 8 percent annually. How much does he need to save each year, beginning at the end of this year, to reach his target? Assume he could earn 8 percent annually on any investment he makes. (Round to the nearest dollar.) A) $13,464 B) $14,273 C) $10,900 D) $16,110 Answer: A Explanation: Retirement investment target in 15 years = $1,000,000 Amount invested in IRA account now = PV = $200,000 Return earned by investment = i = 8% Value of current investment in 15 years = FV15 FV15 = PV(1 + i)15 = $200,000 (1.08)15 = $634,433.82 Balance of money needed to reach his target of having million dollars = $1,000,000 - $634,433.82 = $365,566.18 = FVA Payment needed to reach target = PMT FVA = PMT × PMT =

= 13,463.64 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

93) Stuart Weddle's father is 55 years old and wants to set up a cash flow stream that would be forever. He would like to receive $15,000 every year, beginning at the end of this year. These payments would then continue to future generations indefinitely. If he could invest in account earning 9 percent annually, how much would he have to invest today to receive his perpetual cash flow? (Round to the nearest dollar.) A) $166,667 B) $200,000 C) $222,222 D) $135,200 Answer: A Explanation: Annual payment needed = PMT = $15,000 Investment rate of return = i = 9% Term of payment = Perpetuity Present value of investment needed = PV PV of Perpetuity = = = $166,666.67 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

94) A lottery winner was given a perpetual payment of $25,362 starting next year. She could invest the cash flows at 7.5 percent annually. What is the present value of this perpetuity? (Round to the nearest dollar.) A) $338,160 B) $390,215 C) $238,160 D) $201,356 Answer: A Explanation: Annual payment needed = PMT = $25,362 Investment rate of return = i = 7.5% Term of payment = Perpetuity Present value of investment needed = PV PV of Perpetuity = = = $338,160 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

95) Brandon Ramirez wants to set up an annual perpetual scholarship at his alma mater. He is willing to invest $320,000 in an account earning 11 percent annually. What will be the annual scholarship that can be given from this investment? (Round to the nearest dollar.) A) $50,000 B) $32,600 C) $35,200 D) $40,300 Answer: C Explanation: Annual payment needed = PMT Present value of investment = PVA = $320,000 Investment rate of return = i = 11% Term of payment = Perpetuity PV of Perpetuity = PMT = PV of Perpetuity × i = $320,000 × 0.11 = $35,200 Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

96) Sid Phillips has funded a retirement investment with $250,000 earning a return of 6.75 percent annually. What is the value of the annual payment that he can receive in perpetuity starting next year? (Round to the nearest dollar.) A) $12,150 B) $15,250 C) $16,875 D) $14,900 Answer: C Explanation: Annual payment needed = PMT Present value of investment = PVA = $250,000 Investment rate of return = i = 6.75% Term of payment = Perpetuity PV of Perpetuity = PMT = PV of Perpetuity × i = $250,000 × 0.0675 = $16,875 Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

97) Ralf Wilson wants to receive $25,000 annually in perpetuity and will invest his money in an investment that will earn a return of 14 percent annually. What is the value of the investment that he needs to make today to receive his perpetual cash flow stream starting next year? (Round to the nearest dollar.) A) $640,225 B) $252,325 C) $144,350 D) $178,571 Answer: D Explanation: Annual Payment needed = PMT = $25,000 Investment rate of return = i = 14% Term of payment = Perpetuity Present value of investment needed = PV PV of Perpetuity = = = $178,571.43 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

98) Starting today, you plan to make four annual contributions of $1,400 to save for a vacation. If you can invest it at 6 percent annually, how much will you have at the end of four years? (Round to the nearest dollar.) A) $6,124 B) $5,618 C) $4,019 D) $6,492 Answer: D Explanation: 0 1 2 3 4 ├───────┼────────┼────────┼────────┤ $1,400 $1,400 $1,400 $1,400 n = 4; i = 6% FVA = PMT ×

× (1 + i)

= $1,400 ×

× (1.06)

= $1,400 × 4.3746 × 1.06 = $6,491.93 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

99) Jeff Lovett has a five-year loan on which he will make annual payments of $2,235, beginning now. If the interest rate on the loan is 8.3 percent annually, what is the present value of this annuity? (Round to the nearest dollar.) A) $9,588 B) $8,854 C) $8,612 D) $9,122 Answer: A Explanation: 0 1 2 3 4 5 ├───────┼───────┼───────┼───────┼───────┤ $2,235 $2,235 $2,235 $2,235 $2,235 n = 5; i = 8.3% Annual payment = PMT = $2,235 No. of payments = n = 5 Required rate of return = 8.3% Present value of investment = PVA5

PVA = PMT ×

× (1 + i)

= $2,235 ×

× (1.083)

= $2,235 × 3.9613 × 1.083 = $9,588.44 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

100) Starting today, Ann Chang is making seven annual contributions of $2,500 into her savings account. If her investment can earn 12 percent annually, how much will she have at the end of seven years? (Round to the nearest dollar.) A) $25,223 B) $28,249 C) $31,127 D) $29,460 Answer: B Explanation: 0 1 2 3 6 7 ├───────┼───────┼───────┼…………┼───────┤ PMT PMT PMT PMT PMT n = 7;

i = 12%

Present value of annuity = PVA Return on investment = i = 12% Payment required to meet target = $2,500 Type of annuity = Annuity due FVA = PMT × = $2,500 ×

× (1 + i) × (1.12)

= $2,500 × 10.0890 × 1.12 = $28,249.23 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

101) Your inheritance will pay five annual payments of $100,000 starting today. You can invest it in a CD that will pay 7.75 percent annually. What is the present value of your inheritance? (Round to the nearest dollar.) A) $399,356 B) $401,916 C) $433,064 D) $467,812 Answer: C Explanation: 0 1 2 3 4 5 ├───────┼───────┼───────┼───────┼───────┤ $100,000 $100,000 $100,000 $100,000 $100,000 n = 5;

i = 7.75%

Annual payment = PMT = $100,000 No. of payments = n = 5 Required rate of return = 7.75% Present value of investment = PVA5

PVA = PMT ×

× (1 + i)

= $100,000 ×

× (1.0775)

= $100,000 × 4.0192 × 1.0775 = $433,064.19 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

102) Noel Klinger is planning to invest in an insurance company product. The product will pay $12,500 at the end of this year. Thereafter, the payments will grow annually at a 2.5 percent rate forever. Jack will be able to invest his cash flows at an annual rate of 5.5 percent. What is the present value of this investment cash flow stream? (Round to the nearest dollar.) A) $326,908 B) $312,766 C) $416,667 D) $446,667 Answer: C Explanation: Cash flow at t = 1 = CF1 = $12,500 Annual growth rate = g = 2.5% Discount rate = i = 5.5% Present value of growing perpetuity = PVP PVA∞ =

= $416,666.67 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 103) Bryant Investments is putting out a new product. The product will pay out $32,000 in the first year, and after that the payouts will grow by an annual rate of 2.75 percent forever. If you can invest the cash flows at 7.25 percent, how much will you be willing to pay for this perpetuity? (Round to the nearest dollar.) A) $721,111 B) $633,111 C) $531,111 D) $711,111 Answer: D Explanation: Cash flow at t = 1 = CF1 = $32,000 Annual growth rate = g = 2.75% Discount rate = i = 7.25% Present value of growing perpetuity = PVP PVA∞ =

= $711,111.11 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 53

104) Shelton Enterprises is expecting tremendous growth from its newest boutique store. Next year the store is expected to bring in net cash flows of $675,000. The company expects its cash flows to grow annually at a rate of 13 percent for the next 15 years. What is the present value of this growing annuity if the firm uses a discount rate of 18 percent on its investments? (Round to the nearest dollar.) A) $6,448,519 B) $6,750,000 C) $7,115,449 D) $5,478,320 Answer: A Explanation: Time of growth = n = 15 years Next year's expected net cash flow = CF1 = $675,000 Expected annual growth rate = g = 13% Firm's required rate of return = i = 18% Present value of growing annuity = PVAn PVAn =

= $13,500,000 × 0.477668109 = $6,448,519.47 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

105) Your 75-year-old grandmother expects to live for another 15 years. She currently has $1,000,000 of savings which is invested to earn a guaranteed annual 5 percent rate of return. If inflation averages 2 percent per year, how much can she withdraw (to the nearest dollar) at the beginning of each year and keep the withdrawals constant in real terms, i.e., growing at the same rate as inflation and thus enabling her to maintain a constant standard of living? A) $65,632 B) $72,925 C) $81,027 D) $89,130 Answer: C Explanation: Change PMT to BGN Mode N = 15 years PV = -1,000,000 FV = 0 CPT PMT = $81,027.42 $1,000,000 =

CF1 = $1,000,000 × (i - g) /

(1 + i) (1 + i)

CF1 = $1,000,000 × (0.05 - 0.02) ÷ {[1 - [(1 + 0.02) / (1 + 0.05)]15](1 + 0.05)} = $81,027.42 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

106) You are evaluating a growing perpetuity investment from a large financial services firm. The investment promises an initial payment of $20,000 at the end of this year and subsequent annual payments that will grow at a rate of 3.4 percent. If you use a 9 percent annual discount rate for investments like this, what is the present value of this growing perpetuity? A) $365,632 B) $372,925 C) $357,143 D) $378,130 Answer: C Explanation: Cash flow at t = 1 = CF1 = $20,000 Annual growth rate = g = 3.4% Discount rate = i = 9% Present value of growing perpetuity = PVA∞ PVA∞ =

= $357,142.86 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

107) Foodelicious Corp. is evaluating whether it should take over the lease of an ethnic restaurant in Manhattan. The current owner had originally signed a 25-year lease, of which 16 years still remain. The restaurant has been growing steadily at the rate of 7 percent for the last several years. Foodelicious Corp. expects the restaurant to continue to grow at the same rate for the remaining lease term. Last year, the restaurant brought in net cash flows of $310,000. If the firm evaluates similar investments using a 15 percent discount rate, what is the present value of this investment? (Round to the nearest dollar.) A) $2,966,350 B) $2,838,182 C) $3,109,460 D) $2,709,124 Answer: B Explanation: Time for lease to expire = n = 16 years Last year's net cash flow = CF0 = $310,000 Expected annual growth rate = g = 7% Firm's required rate of return = i = 15% Expected cash flow next year = CF1 = $310,000(1 + g) = $310,000(1.07) = $331,700 Present value of growing annuity = PVAn PVAn =

= $4,146,250 × 0.684518 = $2,838,181.52 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

108) Beautinator Cosmetics borrowed $152,300 from a bank for three years. If the quoted rate (APR) is 11.75 percent, compounded daily, what is the effective annual rate (EAR)? (Round to one decimal place.) A) 11.7% B) 14.3% C) 12.5% D) 11.6% Answer: C Explanation: Loan amount = PV = $152,300 Interest rate on loan = i = 11.75% Frequency of compounding = m = 365 Effective annual rate = EAR EAR =

-1=

-1

= 1.12455 - 1 = 12.46% Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

109) Surreal Corp. has borrowed to invest in a project. The loan calls for a payment of $17,500 every month for three years. The lender quoted Surreal an APR of 8.40 percent with monthly compounding. What is the effective annual rate (EAR) for this loan? (Round to two decimal places.) A) 8.40% B) 8.73% C) 8.95% D) 8.44% Answer: B Explanation: Loan amount = PV Interest rate on loan = i = 8.4% Frequency of compounding = m = 12 Effective annual rate = EAR EAR =

-1=

-1

= 1.0873 - 1 = 8.73% To discount present or future value of cash flows, the most appropriate rate is the EAR, that is, 8.73 percent. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 110) How is an annuity due different from the ordinary annuity? Answer: When constant cash flows are received or paid at the end of each period for a length of time, we have an ordinary annuity. If the same cash flows happen at the beginning of each period, we call it an annuity due. Cash flows received at the beginning of each period earn interest for an extra period compared to cash flows received at the end of each period for an investment of the same time frame. Thus, annuity dues have higher values than ordinary annuities. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

111) The annual percentage rate (APR) is not the appropriate rate to perform present or future value calculations. Explain this statement. Answer: The APR is the annualized interest rate using simple interest. In other words, the APR is the simple interest charged per period multiplied by the number of periods per year. However, the APR ignores the impact of compounding on cash flows. This makes it an inappropriate discount rate for doing present and future value calculations. An appropriate rate for such calculations is the effective annual rate (EAR). Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 112) What was the purpose behind the passage of the two consumer protection acts discussed in this chapter? Answer: In 1968, Congress passed the Truth-in-Lending Act to ensure that all borrowers receive meaningful information about the cost of credit so they can make intelligent economic decisions. The act applies to all lenders that extend credit to consumers, and it covers credit card loans, auto loans, home mortgage loans, home equity loans, home improvement loans, and some small business loans. Similar legislation, the so-called Truth-in-Savings Act, applies to consumer savings vehicles such as consumer certificates of deposits (CDs). These two pieces of legislation require by law that the APR be disclosed on all consumer loans and savings plans and that it be prominently displayed on advertising and contractual documents. Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Legal/Regulatory Perspective

113) What are the three types of interest rate quoted in the market place? Answer: The interest rates in the marketplace are quoted in three ways. 1. The quoted interest rate. This is an interest rate that has been annualized by multiplying the rate per period by the number of compounding periods. The annual percentage rate (APR) is an example. All consumer borrowing and lending rates are annualized in this manner. 2. The interest rate per period. The bank credit card rate of 1 percent per month is an example of this kind of rate. You can find the interest rate per period by dividing the quoted interest rate by the number of compounding periods. 3. The effective annual interest rate (EAR). This is the interest rate actually paid (or earned) after accounting for compounding. Sometimes it is difficult to distinguish a quoted rate from an EAR. Generally, however, an annualized consumer rate is an APR rather than an EAR. Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 7 Risk and Return 1) The rate of return that investors require for an investment depends on the risk associated with that investment. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 2) The capital appreciation component of a stock's return considers the change in price of a stock divided by the initial price of the stock. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 3) If the price of a security has increased since the original purchase of the asset, then the total return of the security (if no dividends were paid during the period) is equal to the capital appreciation component return. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 4) The income component of return for a common stock comes from the cash dividend a firm pays. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

5) If the capital appreciation return from owning a stock is positive, then the total return from owning the same stock can be negative. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 6) In order to keep the total return of a stock equal to 100 percent, the income component for that stock must be zero. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 7) Robert paid $100 for a stock one year ago. The total return on the stock was 10 percent. This means that the stock must be selling for $110 today. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 8) Whenever the outcome of an event has a number of different possibilities that have equal probability of occurrence, then the expected value of the outcome is equal to the simple average of the individual events. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

9) You have placed a wager such that you will either receive nothing if you lose the bet or you will receive $10 if you win the bet. If your expected cash receipt is $9, then there is a 100 percent probability that you will win the wager. Answer: FALSE Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 10) The smaller the range of expected future returns, the greater the risk of a given investment as measured by its mean. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 11) If the returns of two stocks are negatively correlated, then the associated covariance is also negative. Answer: TRUE Diff: 1 Learning Objective: LO 46 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation

12) The distributions of rates of return for Companies AA and BB are given below: State of the Economy Boom Normal Recession

Probability 0.2 0.6 0.2

Company AA 30% 10% -5%

Company BB -10% 5% 50%

We can conclude from the above information that any rational investor would be better off investing in only Company AA instead of investing only in Company BB. Answer: FALSE Explanation: The securities from both companies have the same expected return, but Company AA has a lower variance. Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 13) A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. Answer: FALSE Diff: 2 Learning Objective: LO 6 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 14) The expected return on the market portfolio is equal to the market risk premium. Answer: FALSE Diff: 1 Learning Objective: LO 8 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 15) The variance of a distribution can be negative. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 4

16) The standard deviation of a return distribution can be a negative value. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 17) The normal distribution is completely described by its mean and standard deviation where 50 percent of the distribution's probability is less than the mean and 50 percent of the distribution's probability is greater than the mean. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 18) The variance is denominated in squared units, whereas the standard deviation is denominated in the same units as the expected value. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 19) The best measure of assessing the risk of an investment is its expected return. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 20) Variance is equal to the square root of standard deviation. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 5

21) If you are calculating the variance and standard deviation of percentage returns on a stock, the variance will always be larger than the standard deviation assuming the standard deviation is less than one. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 22) The coefficient of variation is calculated by dividing the variance of the returns of an asset by the expected rate of return of that asset. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 23) The coefficient of variation is a good measure of the amount of risk that an asset will contribute to a diversified portfolio of assets. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 24) If you are building a diversified portfolio, then your goal is to select assets that have a correlation coefficient of zero in order to minimize the risk of your portfolio. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation

25) If the returns on two assets have a correlation coefficient of positive one, then there are benefits from diversification by combining these assets in a two-asset portfolio. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 26) Utilizing the fact that values of two or more assets do not always move in the same direction at the same time in forming a risk reduction portfolio is called diversification. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Measurement 27) If you are trying to determine whether to purchase Security A or Security B for your portfolio, then you can consider the coefficient of variation in order to understand the risk-return relationship of the individual securities. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement 28) The coefficient of variation is the same as the Sharpe Ratio. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

29) If two assets with correlation coefficients of less than one make up a portfolio, then the portfolio does not take advantage of any diversification benefits. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 30) If the covariance between the returns on two assets is equal to zero, then the correlation coefficient must also be zero. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 31) If the distribution of returns on an asset has a variance of zero, then covariance of returns between that asset and the returns on any other asset must equal zero. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 32) If you were to completely diversify your portfolio by purchasing a portion of every asset in the investment universe, then the expected return of your portfolio is equal to the risk-free rate. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 33) Complete diversification means that the portfolio is no longer subject to market risk. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 8

34) Based on the historical performance provided in the chapter, the beta of a small stock should be greater than the beta of a corporate bond. Answer: TRUE Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 35) The appropriate measure of risk for a diversified portfolio is beta. Answer: TRUE Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 36) The market risk-premium is equal to the expected return on the market less the risk-free rate. Answer: TRUE Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 37) If you know the risk-free rate, the market risk-premium, and the beta of a stock, then using the Capital Asset Pricing Model (CAPM) you will be able to calculate the expected rate of return for the stock. Answer: TRUE Diff: 2 Learning Objective: LO 8 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 38) According to the CAPM, the firm's market risk is expected to remain constant over time. Answer: FALSE Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 9

39) Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant. Answer: TRUE Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 40) Which of the following statements is correct? A) The greater the risk associated with an investment, the lower the return investors expect from it. B) When choosing between two investments that have the same level of risk, investors prefer the investment with the higher return. C) If two investments have the same expected return, investors prefer the riskiest alternative. D) When choosing between two investments that have the same level of risk, investors prefer the investment with the lower return. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 41) Gunther earned a 62.5 percent return on a stock that he purchased one year ago. The stock is now worth $12, and he received a dividend of $1 during the year. How much did Gunther originally pay for the stock? A) $7.00 B) $7.50 C) $8.00 D) $8.50 Answer: C Explanation: = 0.625

$X = $8

Original price of the stock = $8 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

42) Moshe purchased a stock for $30 last year. He found out today that he had a -100 percent return on his investment. Which of the following must be true? A) The stock is worth $30 today. B) The stock is worth $0 today. C) The stock paid no dividends during the year. D) The stock is worth $0 today and paid no dividends during the year. Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 43) Barbra purchased a piece of real estate last year for $85,000. The real estate is now worth $102,000. If Barbra needs to have a total return of 25 percent during the year, then what is the dollar amount of income that she needs to have to reach her objective? A) $3,750 B) $4,250 C) $4,750 D) $5,250 Answer: B Explanation: = 0.25

$X = $4,250

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation

44) Books Brothers stock was priced at $15 per share two years ago. The stock sold for $13 last year and now it sells for $18. What was the total return for owning Books Brothers stock during the most recent year? Assume that no dividends were paid. Round your answer to the nearest percent. A) 17% B) 20% C) 23% D) 38% Answer: D Explanation:

= 0.3846

Total rate of return = 38.46% OR 38% (rounded). Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 45) George Wilson purchased Bright Light Industries common stock for $47.50 on January 31, 2020. The firm paid dividends of $1.10 during the last 12 months. George sold the stock today (January 30, 2021) for $54.00. What is George's holding period return? A) 16.00% B) 14.00% C) 11.00% D) 19.00% Answer: A Explanation: R1 =

= 0.1600 = 16.00%

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

46) In a game of chance, the probability of winning a $50 prize is 40 percent, and the probability of winning a $100 prize is 60 percent. What is the expected value of the prize in the game? A) $50 B) $75 C) $80 D) $100 Answer: C Explanation: Expected value = $50 × (0.4) + $100 × (0.6) = $80 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 47) In a game of chance, the probability of winning $50 is 40 percent and the probability of having to pay $50 is 60 percent. What is the expected value of this game? A) -$10 B) $0 C) $10 D) $25 Answer: A Explanation: Expected value = $50 × (0.4) - $50 × (0.6) = -$10 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

48) Use the following table to calculate the expected return from the asset. Return 0.1 0.2 0.25

Probability 0.25 0.5 0.25

A) 15.00% B) 17.50% C) 18.75% D) 20.00% Answer: C Explanation: Expected return from an asset = (0.1) × (0.25) + (0.2) × (0.5) + (0.25) × (0.25) = 0.1875 = 18.75% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 49) Use the following table to calculate the expected return from the asset. Return 0.05 0.1 0.15 0.25

Probability 0.1 0.15 0.5 0.25

A) 12.50% B) 13.75% C) 15.75% D) 16.75% Answer: C Explanation: Expected return from an asset = (0.05) × (0.1) + (0.1) × (0.15) + (0.15) × (0.5) + (0.25) × (0.25) = 0.1575 = 15.75% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

50) The expected return for Stock Z is 30 percent. If we know the following information about Stock Z, then what return will it produce in the Lukewarm state of the world?

Poor Lukewarm Dynamite

Return 0.2 ? 0.4

Probability 0.25 0.5 0.25

A) 20% B) 30% C) 40% D) 50% Answer: B Explanation: Expected return from stock Z in Lukewarm state of the world = (0.2) × (0.25) + (X) × (0.5) + (0.4) × (0.25) = 0.3, X = 0.3 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 51) The expected return for Stock V is 24.5 percent. If we know the following information about Stock V, then what is the probability that the Dynamite state of the world will occur?

Poor Lukewarm Dynamite

Return 0.15 0.28 0.19

Probability 0.2 0.7 ?

A) 5% B) 10% C) 15% D) 20% Answer: B Explanation: Probability of the Dynamite state of the world occurring = 0.2 + 0.7 + X = 1.0⇒ X = 0.1 or 10% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

52) Ahmet purchased a stock for $45 one year ago. The stock is now worth $65. During the year, the stock paid a dividend of $2.50. What is Ahmet's total return? A) 5% B) 44% C) 35% D) 50% Answer: D Explanation:

= 0.5 = 50%

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 53) Julio purchased a stock one year ago for $27. The stock is now worth $32, and the total return to Julio for owning the stock was 37 percent. What is the dollar amount of dividends that he received from owning the stock during the year? Round your final answer to nearest whole dollar. A) $4 B) $5 C) $6 D) $7 Answer: B Explanation: = 0.37 $X = $5 Dividend paid = $5 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

54) Francis purchased a stock one year ago for $20, and it is now worth $24. The stock paid a dividend of $3 during the year. What was the stock's rate of return from capital appreciation during the year? A) 17% B) 20% C) 29% D) 35% Answer: B Explanation:

= 0.20

Capital appreciation percentage = 20% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 55) Gwen purchased a stock one year ago for $25, and it is now worth $31. The stock paid a dividend of $1.50 during the year. What was the stock's rate of return from dividend income during the year? A) 6% B) 15% C) 24% D) 26% Answer: A Explanation:

= 0.06

Stock's rate of return = 6% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

56) Genaro needs a return of 40 percent for his one-year investment in a property. He believes that he can sell the property at the end of the year for $150,000 and that the property will provide him with rental income of $25,000. What is the maximum amount that Genaro would be willing to pay for the property? A) $112,500 B) $125,000 C) $137,500 D) $150,000 Answer: B Explanation: = 0.4

$X = $125,000

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 57) Serox stock was selling for $20 two years ago. The stock sold for $25 one year ago, and it is currently selling for $28. Serox pays a $1.10 dividend per year. What was the rate of return for owning Serox in the most recent year? (Round to the nearest percent.) A) 12% B) 16% C) 32% D) 40% Answer: B Explanation:

= 0.164

Total rate of return = 16% (Rounded off) Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

58) Security Analysts that have evaluated Concordia Corporation, have determined that there is a 15 percent chance that the firm will generate earnings per share of $2.40; a 60 percent probability that the firm will generate earnings per share of $3.10; and a 25 percent probability that the firm will generate earnings per share of $3.80. What are the expected earnings per share for Concordia Corporation? (Round to the nearest $0.01.) A) $3.10 B) $3.17 C) $2.75 D) $2.91 Answer: B Explanation: Probability Projected Expected EPS EPS 15.00% $ 2.40 $ 0.36 60.00% 3.10 1.86 25.00% 3.80 0.95 100.00% $ 3.17 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 59) Niles is making an investment with an expected return of 12 percent and the standard deviation of the return is 4.5 percent. If Niles is investing $100,000, he can be 90% confident that he will have at least what dollar amount at the end of the year ? (Do not round intermediate computations.) A) $100,000.00 B) $104,597.50 C) $116,500.00 D) $119,402.50 Answer: B Explanation: {1 + [0.12 - 1.645 (0.045)]} × $100,000 = $104,597.50 Number of standard deviations from mean for 90 percent observations is 1.645 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

60) Given the historical information in the chapter, which of the following investment classes had the highest average return? A) Intermediate-term government bonds B) Long-term government bonds C) Large U.S. stocks D) Small U.S. stocks Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 61) Given the historical information in the chapter, which of the following investment classes had the highest variability in returns? A) Intermediate-term government bonds B) Long-term government bonds C) Large U.S. stocks D) Small U.S. stocks Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

62) The expected return for an asset is 18.75 percent. If the return distribution for the asset is described in the following table, what is the variance for the asset's returns? Round intermediate computations and final answer to six decimal places. Return 0.10 0.20 0.25

Probability 0.25 0.50 0.25

A) 0.002969 B) 0.000613 C) 0.015195 D) 0.054486 Answer: A Explanation: (0.25) × (0.1 - 0.1875)2 + (0.5) × (0.2 - 0.1875)2 + (0.25) × (0.25 - 0.1875)2 = 0.002969 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 63) The expected return for the asset shown in the following table is 18.75 percent. If the return distribution for the asset is described as below, what is the standard deviation for the asset's returns? Round intermediate computations and final answer to six decimal places. Return 0.10 0.20 0.25

Probability 0.25 0.50 0.25

A) 0.002969 B) 0.000613 C) 0.015195 D) 0.054486 Answer: D Explanation: Standard Deviation = {(0.25) × (0.10 - 0.1875)2 + (0.5) × (0.2 - 0.1875)2 + (0.25) × (0.25 - 0.1875)2 }1/2 = 0.054486 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

64) You have observed that the average size of a particular goldfish is 1.5 inches long. The standard deviation of the size of the goldfish is 0.25 inches. What is the size of a goldfish such that 95 percent of the goldfish are smaller from such size? Assume a normal distribution for the size of goldfish. Round your final answer to two decimal places. A) 1.01 inches B) 1.09 inches C) 1.91 inches D) 1.99 inches Answer: C Explanation: 1.5 + 1.645 × (0.25) = 1.91 inches Number of standard deviations from mean for 90 percent observations is 1.645. This means that only the upper tail of the distribution is greater. Both the upper and lower tails have 5 percent. Thus, 95 percent would be lower. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 65) You know that the average college student eats 0.75 pounds of food at lunch. If the standard deviation is 0.2 pounds of food, then what is the total amount of food that a cafeteria should have on hand to be 95 percent confident that it will not run out of food when feeding 50 college students? A) 17.90 pounds B) 21.05 pounds C) 53.95 pounds D) 57.10 pounds Answer: C Explanation: 50 students × {0.75 pounds per student + 1.645 × (0.2 pounds per student)} = 53.95 pounds of food required. Number of standard deviations from mean for 90 percent observations is 1.645. Both the upper and lower tails have 5 percent. Thus, 95 percent would be lower. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

66) If a random variable follows a normal distribution, what is the probability that the random variable is larger than 1.96 standard deviations from the mean? A) 1.25% B) 2.50% C) 3.75% D) 5.00% Answer: B Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 67) If a random variable follows a normal distribution, what is the probability that the random variable is larger than 1.96 standard deviations below the mean? A) 95.00% B) 96.25% C) 97.50% D) 98.75% Answer: C Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

68) Tommie has made an investment that will generate returns that are based on the state of the economy during the year. Use the following information to calculate the standard deviation of the return distribution for Tommie's investment. Do not round intermediate computations. Round your final answer to four decimal places. State Weak OK Great

Return 0.13 0.20 0.25

Probability 0.30 0.40 0.30

A) 0.0453 B) 0.0467 C) 0.0481 D) 0.0495 Answer: B Explanation: E(R) = (0.30 × 0.13) + (0.40 × 0.20) + (0.30 × 0.25) = 0.194 Var (R) = 0.30 × (0.13 - 0.194)2 + 0.4 × (0.20 - 0.194)2 + 0.30 × (0.25 - 0.194)2 = 0.002184 Std (R) = = 0.0467 (rounded) Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

69) Elrond has made an investment that will generate returns that are based on the state of the economy. Use the following information to calculate the variance of the return distribution for Elrond's investment. Do not round intermediate computations. Round your final answer to four decimal places. State Weak OK Great

Return 0.10 0.17 0.28

Probability 0.8 0.1 0.1

A) 0.0536 B) 0.0543 C) 0.0550 D) 0.0031 Answer: D Explanation: E(R) = (0.8 × 0.10) + (0.1 × 0.17) + (0.1 × 0.28) = 0.125 Var(R) = 0.8 × (0.10 - 0.125)2 + 0.1 × (0.17 - 0.125)2 + 0.1 × (0.28 - 0.125)2 = 0.0031 (rounded) Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 70) Stock A's returns have a standard deviation of 0.5, and stock B's returns have standard deviation of 0.6. The correlation coefficient between A and B equals 0.5. What is the variance of a portfolio composed of 70 percent Stock A and 30 percent Stock B? A) 0.1549 B) 0.2179 C) 0.4668 D) 0.5500 Answer: B Explanation: Var(port) = x12σ12 + x22σ22 + 2x1x2σ1σ2ρ12 = (0.7)2(0.5)2 + (0.3)2(0.6)2 + 2(0.7)(0.3)(0.5)(0.6)(0.5) = 0.1225 + 0.0324 + 0.063 = 0.2179 Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

71) Aquaman's stock returns have a standard deviation of 0.7, and Green Lantern's stock returns have standard deviation of 0.8. The correlation coefficient is 0.1. What is the standard deviation of a portfolio composed of 70 percent Aquaman and 30 percent Green Lantern? Round the answer to five decimal points. A) 0.32122 B) 0.54562 C) 0.56676 D) 0.75000 Answer: C Explanation: Var(port) = x12σ12 + x22σ22 + 2x1x2σ1σ2ρ12 = (0.7)2(0.7)2 + (0.3)2(0.8)2 + 2(0.7)(0.3)(0.7)(0.8)(0.1) = 0.32122 Std(port) = Sqrt(Var(port)) = Sqrt(0.32122) = 0.566763 Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

72) View Point Industries has forecasted a rate of return of: • 20.00 percent if the economy booms (25.00 percent probability) • 15.00 percent if the economy is in a growth phase (45.00 percent probability) • 2.50 percent if the economy is in decline (20.00 percent probability) • -15.00 percent if the economy is in a depression (10.00 percent probability). What is View Point's standard deviation of returns? Do not round intermediate computations. Round your final answer to two decimal points. A) 17.31% B) 9.25% C) 15.00% D) 10.46% Answer: D Explanation: Prob times State of the Rate of Expected Squared Squared Economy Return Probability Return Deviation Deviation Deviation Boom 20.0% Growth 15.0% Decline 2.5% Depression -15.0%

25% 45% 20% 10%

5.00% 6.75% 0.50% -1.50% 10.75%

0.0925 0.0425 -0.0825 -0.2575

0.0085 0.0021 0.0018 0.0008 0.0068 0.0014 0.0663 0.0066 Variance = 0.0109 Std Dev = 10.461%

Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 73) Braniff Ground Services stock has an expected return of 9 percent and a variance of 0.25 percent. What is the coefficient of variation for Braniff? Round your final answer to four decimal places. A) 0.0278 B) 0.5556 C) 1.8001 D) 36.0002 Answer: B Explanation: Coefficient of Variation =

Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

= 0.5556 (rounded)

74) Sayers purchased a stock with a coefficient of variation equal to 0.125. The expected return on the stock is 20 percent. What is the variance of the stock? A) 0.000625 B) 0.025000 C) 0.625000 D) 0.790500 Answer: A Explanation:

Coefficient of Variation =

= 0.125

σ2 = 0.000625

Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 75) You have invested 40 percent of your portfolio in an investment with an expected return of 12 percent and 60 percent of your portfolio in an investment with an expected return of 20 percent. What is the expected return of your portfolio? A) 15.2% B) 16.0% C) 16.8% D) 17.6% Answer: C Explanation: E® = 0.4 × 0.12 + 0.60 × 0.20 = 0.168 = 16.8% Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

76) You have invested 25 percent of your portfolio in Homer, Inc., 50 percent in Marge Co., and 25 percent in Bart Resources. What is the expected return of your portfolio if Homer, Marge, and Bart have expected returns of 2 percent, 18 percent, and 3 percent, respectively? A) 7.75% B) 10.25% C) 8.20% D) 9.20% Answer: B Explanation: ®(R) = (0.25 × 0.02) + (0.50× 0.18) + (0.25 × 0.03) = 0.1025 = 10.25% Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 77) You invested $3,000 in a portfolio with an expected return of 10 percent and $2,000 in a portfolio with an expected return of 16 percent. What is the expected return of the combined portfolio? A) 6.2% B) 12.4% C) 13.0% D) 13.6% Answer: B Explanation:

(0.1) +

(0.16) = 0.124

= 12.4% Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

78) Given the distributions of returns for the following two stocks, calculate the covariance of the returns for the two stocks. Assume the expected return is 10.8 percent for Stock 1 and 9.7 percent for Stock 2. Prob 0.4 0.5 0.1

Stock 1 0.09 0.11 0.17

Stock 2 0.11 0.08 0.13

A) 0.000094 B) 0.000516 C) 0.000321 D) 0.717507 Answer: A Explanation: Cov(R1,R2) = 0.4 × (0.09 - 0.108) × (0.11 - 0.097) + 0.5 × (0.11 - 0.108) × (0.08 - 0.097) + 0.1 × (0.17 - 0.108) × (0.13 - 0.097) = 0.000094 Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

79) Given the distributions of returns for the following two stocks, calculate the correlation coefficient of the returns for the two stocks. Assume the expected return for Stock 1 is 10.8 percent and 9.7 percent for Stock 2. Do not round intermediate computations. Prob 0.4 0.5 0.1

Stock 1 0.09 0.11 0.17

Stock 2 0.11 0.08 0.13

A) 0.230967 B) -0.00002548 C) 0.00032100 D) 0.17671455 Answer: A Explanation: First find the covariance between the return of the two stocks. Cov(R1,R2) = 0.4 × (0.09 - 0.108) × (0.11 - 0.097) + 0.5 × (0.11 - 0.108) × (0.08 - 0.097) + 0.1 × (0.17 - 0.108) × (0.13 - 0.097) = 0.000094 Then solve for the standard deviation of the returns of each individual stock. σ12 = 0.4 × (0.09 - 0.108)2 + 0.5 × (0.11 - 0.108)2 + 0.1 × (0.17 - 0.108)2 = 0.000516, σ1 = 0.02271563 σ22 = 0.4 × (0.11 - 0.097)2 + 0.3 × (0.08 - 0.097)2 + 0.2 × (0.13 - 0.097)2 = 0.000321 σ2 = 0.01791647 PR1,2 =

= 0.230967

Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

80) Given the distributions of returns for the following two stocks, calculate the covariance of the returns for the two stocks. Assume the expected return is 14.4 percent for Stock 1 and 15.9 percent for Stock 2. Round your final answer to five decimal places. Prob 0.5 0.3 0.2

Stock 1 0.11 0.17 0.19

Stock 2 0.18 0.15 0.12

A) 0.00120 B) 0.00054 C) -0.00079 D) -0.33720 Answer: C Explanation: Cov(R1,R2) = 0.5 × (0.11 - 0.144) × (0.18 - 0.159) + 0.3 × (0.17 - 0.144) × (0.15 0.159) + 0.2 × (0.19 - 0.144) × (0.12 - 0.159) = -0.00079 Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

81) Given the distributions of returns for the following two stocks, calculate the correlation coefficient of the returns for the two stocks. Assume the expected return is 14.4 percent for Stock 1 and 15.9 percent for Stock 2. Do not round intermediate computations. Prob 0.5 0.3 0.2

Stock 1 0.11 0.17 0.19

Stock 2 0.18 0.15 0.12

A) 0.00120 B) 0.00054 C) -0.00271 D) -0.97169 Answer: D Explanation: Cov(R1,R2) = 0.5 × (0.11 - 0.144) × (0.18 - 0.159) + 0.3 × (0.17 - 0.144) × (0.15 0.159) + 0.2 × (0.19 - 0.144) × (0.12 - 0.159) = -0.00079 σ12 = 0.5(0.11 - 0.144)2 + 0.3(0.17 - 0.144)2 + 0.2(0.10 - 0.144)2 = 0.001204 σ1 = 0.03469870 σ22 = 0.5(0.18 - 0.159)2 + 0.3(0.15 - 0.159)2 + 0.2(0.12 - 0.159)2 = 0.000549 σ2 = 0.02343075 PR1,2 =

= -0.9716899

Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 82) The covariance of the returns between Stock A and Stock B is 0.0087. The standard deviation of Stock A is 0.26, and the standard deviation of Stock B is 0.37. What is the correlation coefficient between the returns of the two stocks? A) 0.090437 B) 0.096200 C) 0.90437 D) 0.96200 Answer: A Explanation: ρ =

= 0.090437

Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 33

83) The covariance of the returns between Wildcat Stock and Sun Devil Stock is 0.09875. The variance of Wildcat is 0.2116, and the variance of Sun Devil is 0.1369. What is the correlation coefficient between the returns of these two stocks? A) 0.170200 B) 0.293347 C) 0.340823 D) 0.580199 Answer: D Explanation: ρ =

= 0.580199

Diff: 2 Learning Objective: LO 6 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 84) Horse Stock returns have a standard deviation of 0.57, whereas Mod T Stock returns have a standard deviation of 0.63. The correlation coefficient between the returns is 0.078042. What is the covariance of the returns? Round your answer to six decimal places. A) 0.028025 B) 0.217327 C) 0.359100 D) 0.993094 Answer: A Explanation: Cov(R1R2) = ρ12σ1σ2 = (0.078042) × (0.57) × (0.63) = 0.028025 Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement 85) Most of the risk-reduction benefits from diversification can be achieved when the correlation between two securities is: A) 0.0 B) -0.5 C) -1.0 D) 0.5 Answer: C Diff: 2 Learning Objective: LO 6 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 34

86) The covariance that provides the most risk reduction between two securities with standard deviations of 0.26 and 0.32 is: A) 0.0000 B) -0.0832 C) -0.0416 D) 0.0624 Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation 87) Which of the following is the best measure of the systematic risk in a portfolio? A) Variance B) Standard deviation C) Covariance D) Beta Answer: D Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation 88) A portfolio with a level of systematic risk that is the same as that of the market has a beta that is: A) equal to zero. B) equal to one. C) less than the beta of the risk-free asset. D) less than zero. Answer: B Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

89) The beta of Elsenore, Inc., stock is 1.6 and the risk-free rate of return is 8 percent. If the expected return on the market is 15 percent, then what should investors expect as a return on Elsenore? A) 11.20% B) 19.20% C) 24.00% D) 32.00% Answer: B Explanation: E(REls) = Rrf + βEls (E(RM) - Rrf) = 0.08 + 1.6(0.15 - 0.08) = 0.1920 = 19.20% Diff: 2 Learning Objective: LO 8 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 90) The beta of Ricci Co.'s stock is 3.2 and the risk-free rate of return is 9 percent. If the expected return on the market is 18 percent, then what should investors expect as a return on Ricci Co.? A) 28.80% B) 37.80% C) 48.60% D) 57.60% Answer: B Explanation: E(RRicci) = Rrf + βRicci(E(RM) - Rrf) = 0.09 + 3.2(0.18 - 0.09) = 0.378 = 37.8% Diff: 2 Learning Objective: LO 8 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 91) The risk-free rate of return is currently 3 percent and the market risk premium is 6 percent. If the beta of Lenz, Inc., stock is 1.8, then what is the expected return on Lenz? A) 8.40% B) 10.80% C) 13.80% D) 19.20% Answer: C Explanation: E(RLenz) = Rrf + βLenz (E(RM) - Rrf) = 0.03 + (1.8 × 0.06) = 0.138 = 13.8% Diff: 2 Learning Objective: LO 8 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 36

92) The expected return on Kiwi Computers stock is 16.6 percent. If the risk-free rate is 4 percent and the expected return on the market is 10 percent, then what is Kiwi's beta? A) 1.26 B) 2.10 C) 2.80 D) 3.15 Answer: B Explanation: E(RKiwi) = 0.166 = Rrf + βKiwi (E(RM) - Rrf) = 0.04 + βKiwi(0.10 - 0.04) ⇒ βKiwi = 2.1 Diff: 2 Learning Objective: LO 8 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 93) The expected return on Mike's Seafood stock is 17.9 percent. If the expected return on the market is 13 percent and the beta for Mike is 1.7, then what is the risk-free rate? A) 4.5% B) 5.0% C) 5.5% D) 6.0% Answer: D Explanation: E(RMike) = 0.179 = Rrf + βMike (E(RM) - Rrf) = Rrf + 1.7 (0.13 - Rrf) ⇒ Rrf = 0.06 = 6% Diff: 2 Learning Objective: LO 8 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

94) The expected return on Karol Co. stock is 16.5 percent. If the risk-free rate is 5 percent and the beta of Karol Co is 2.3, then what is the risk premium on the market portfolio? A) 2.5% B) 5.0% C) 7.5% D) 10.0% Answer: B Explanation: E(RKarol) = 0.165 = Rrf + βKarol (E(RM) - Rrf) = 0.05 + 2.3 (Risk Premium) ⇒ Risk Premium 0.05 + 2.3 (Risk premium) = 0.165. Therefore Risk premium = 0.05 = 5% Diff: 2 Learning Objective: LO 8 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 95) Which of the following represents a plot of the relation between expected return and systemic risk? A) The beta coefficient B) The covariance of returns line C) The security market line D) The variance Answer: C Diff: 1 Learning Objective: LO 8 Bloomcode: Comprehension AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

96) Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the market portfolio is 11.00 percent, and the risk-free rate is 4.25 percent. What is the difference between A's and B's required rates of return? A) 2.75% B) 2.89% C) 3.05% D) 3.38% Answer: D Explanation: Beta A= 0.70 Beta B = 1.20 Market return = 11.00% Risk-free rate = 4.25% Market risk premium = E(Rm - Rrf) = 6.75% Expected return A = Rrf + beta A(RPM) = 8.98% Expected return B = Rrf + beta B(RPM) = 12.35% Difference 3.38% Diff: 3 Learning Objective: LO 8 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

97) Data for Hugh's Corporation is provided below. Hugh's recently acquired some risky assets that caused its beta to increase by 30 percent. What is the stock's new expected rate of return according to the CAPM? Initial beta 1.00 Initial expected return (rs) 10.20% Market risk premium, E(Rm - Rrf ) 6.00% Percentage increase in beta 30.00% Increase in inflation premium 2.00% A) 12.00% B) 14.70% C) 15.44% D) 16.21% Answer: A Explanation: Old beta 1.00 Old E(R) = Rrf + b(RPM) = 10.20% RPM = (E(Rm) - Rrf ) = 6.00% Percentage increase in beta = 30.00% Find new beta after increase = 1.30 Find old Rrf : Old E(R) = Rrf + b(RPM): 10.2% = Rrf + 1.0(6.0%): Rrf = 4.20% Find new E(R) = new Rrf + new beta(RPM) = 4.2 + 1.3 ∗ 6 = 12% Diff: 3 Learning Objective: LO 8 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation

98) Suppose Stan holds a portfolio consisting of a $10,000 investment in each of eight different common stocks. The portfolio's beta is 1.25. Now suppose Stan decided to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be? A) 1.17 B) 1.23 C) 1.29 D) 1.36 Answer: C Explanation: Number of stocks = 8 Percent in each stock = 1/number of stocks = 12.500% Portfolio beta = 1.25 Beta that is sold = 1.00 Beta that is bought = 1.35 Change in portfolio's beta = 0.125 × (β2 - β1) = 0.125 × (1.35 - 1) = 0.0438 New portfolio beta = 1.25 + 0.0438 = 1.29 Diff: 3 Learning Objective: LO 8 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement Analysis and Interpretation 99) Explain the difference between systematic risk and unsystematic risk. Answer: Systematic risk is the risk that cannot be diversified away and describes the risk that is inherent in the general economic world of investing. Systematic risk cannot be eliminated through diversification. Unsystematic risk is risk that can be diversified away and describes a risk that is unique to a particular investment. Diff: 3 Learning Objective: LO 7 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Measurement Analysis and Interpretation

100) While performing the regression analysis of historical returns of a stock with a historical return of a general market index, you would plot the line of best fit through those data points. The slope of that line represents the beta of the stock in question. However, in most instances the data points do not lie exactly on that line. Explain the reason. Answer: The slope of the line of best fit describes the beta of the stock in question that is capturing the systematic risk inherent in investing in that stock. The vertical distance between each point and the line represents the unsystematic, or diversifiable risk in investing in the stock. Diff: 2 Learning Objective: LO 7 Bloomcode: Analysis AACSB: Analytic IMA: Quantitative Methods AICPA: Measurement Analysis and Interpretation

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 8 Bond Valuation and the Structure of Interest Rates 1) The largest investors in corporate bonds are state government agencies. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2) The largest investors in corporate bonds are big institutional investors such as life insurance companies and pension funds. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3) Most secondary market transactions for corporate bonds take place on the New York Stock Exchange. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4) Most secondary market transactions for corporate bonds take place through dealers in the over-the-counter (OTC) market. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

5) A thin market for a security implies a high frequency of trades for that type of security in the markets. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6) Corporate bonds have a thin market relative to market for corporate stocks. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7) Prices in the corporate bond market tend to be more volatile than securities sold in markets with greater trading volumes. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8) Vanilla bonds have coupon payments that are fixed for the life of the bond, with the principal being repaid at maturity. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

9) The face or par value for most corporate bonds is equal to $1,000 and is the principal amount owed to bondholders at maturity. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 10) Zero coupon bonds sell well above their par value because they offer no coupons. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 11) Convertible bonds can be converted into shares of common stock at some predetermined ratio at the discretion of the bondholder. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 12) The value, or price, of any asset is the present value of its future cash flows. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

13) A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are below 10 percent and at a discount if interest rates are greater than 10 percent. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 14) You can buy a $1,000 par value bond for $800. The coupon rate is 10 percent (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. The price of the bond suggests that the expected return on bonds with this risk is lower than 10 percent. Answer: FALSE Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 15) The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 16) Interest rate risk is the risk that bond prices will fluctuate as interest rates change. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Risk Analysis

17) As interest rates fall, the prices of bonds decline. Answer: FALSE Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 18) Higher coupon bonds have greater interest rate risk. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Risk Analysis 19) All other things being equal, a given change in the interest rates will have a greater impact on the price of a low-coupon bond than a higher-coupon bond with the same maturity. Answer: TRUE Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 20) Bonds with a call provision pay lower yields than comparable noncallable bonds. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 21) The risk that the lender may not receive payments as promised is called default risk. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

22) U.S. Treasury securities are the best proxy measure for the risk-free rate. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 23) Upward-sloping yield curves often occur before the beginning of recession. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 24) If investors believe inflation will be increasing in the future, the prevailing yield curve will be downward sloping. Answer: FALSE Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 25) The real rate of interest varies with the business cycle, with the highest rates seen at the end of a period of business expansion and the lowest at the bottom of a recession. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

26) Which of the following statements is true? A) The largest investors in corporate bonds are small individual investors. B) The market for corporate stocks is thin compared to the market for corporate bonds. C) Institutional investors such as life insurance companies tend to not invest in corporate bonds. D) Prices in the corporate bond market tend to be more volatile than prices of securities sold in markets with greater trading volume. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 27) Which one of the following statements is NOT true? A) Prices in the corporate bond market tend to be more volatile than the markets for stocks or money market securities. B) Corporate bonds are more marketable than the securities that have higher daily trading volumes. C) The market for corporate bonds is thin compared to the market for corporate stocks. D) The largest investors in corporate bonds are life insurance companies and pension funds. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 28) It is not easy for individuals to trade in the corporate bond market because: A) the corporate bond market is considered to be very transparent. B) corporate bonds are more marketable than the securities that have higher daily trading volumes. C) centralized reporting of deals between buyers and sellers take place. D) prices in the corporate bond market tend to be less stable. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

29) Which one of the following statements about vanilla bonds is NOT true? A) They have fixed coupon payments. B) The face value, or par value, for most corporate bonds is $1,000. C) Coupon payments are usually made quarterly. D) The bond's coupon rate is calculated as the annual coupon payment divided by the bond's face value. Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 30) Which of the following statements is true of zero coupon bonds? A) Zero coupon bonds have a yield to maturity of 0%. B) Zero coupon bonds tend to sell above their face value. C) The most frequent and regular issuer of zero coupon securities are non-governmental agencies. D) Zero coupon bonds have no coupon payments over its life and only offer a single payment at maturity. Answer: D Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 31) Which of the following statements is true? A) To secure the conversion option on a bond, bondholders would pay a reduced (i.e. discounted) bond price. B) Typically, the conversion ratio is set so that the firm's stock price must appreciate at least 40 percent before it is profitable to convert bonds into stock. C) A convertible bond is issued by government agencies rather than a firm with stock. D) Convertible bonds can be converted into shares of common stock at some predetermined ratio at the discretion of the bondholder. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

32) Which of the following statements is true of convertible bonds? A) The most significant disadvantage to a corporation of issuing convertible bonds is that they increase the cash that the firm must use to make interest payments. B) The typical conversion ratio is set so that the firm's stock price must appreciate 5 percent or less before it is profitable for the holder to convert the bond to stock. C) Firms that issue convertible bonds can do so at a lower interest rate. D) The typical issue of convertible bonds allows the holder of the bond to convert it to preferred stock. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 33) Which of the following statements is true about zero coupon bonds? A) They typically sell at a premium over par when they are first issued. B) They typically sell for a higher price than similar coupon bonds. C) They are always convertible to common stock. D) They typically sell at a deep discount below par when they are first issued. Answer: D Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 34) Which one of the following statements about bonds is NOT true? A) To compute a bond's price, one needs to calculate the present value of the bond's expected cash flows. B) The value, or price, of any asset is the future value of its cash flows. C) The required rate of return, or discount rate, for a bond is the market interest rate called the bond's yield to maturity. D) The expected future cash flows are estimated using the coupons that the bond will pay and the maturity value to be received. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

35) If a bond's coupon rate is equal to the market rate of interest, then the bond will sell: A) at a price equal to its face value. B) at a price greater than its face value. C) at a price less than its face value. D) There is no relation between the coupon rate and market rate of interest. Answer: A Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 36) Bonds sell at a discount when the market rate of interest is: A) less than the bond's coupon rate. B) greater than the bond's coupon rate. C) equal to the bond's coupon rate. D) There is no relation between the coupon rate and market rate of interest. Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 37) Bonds sell at a premium when the market rate of interest is: A) less than the bond's coupon rate. B) greater than the bond's coupon rate. C) equal to the bond's coupon rate. D) There is no relation between the coupon rate and market rate of interest. Answer: A Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

38) In calculating the current price of a bond paying semiannual coupons, one needs to: A) use the annual discount rate for discounting the par payment at maturity. B) use double the annual coupon value. C) use the semiannual rate only for discounting the annual coupons. D) use double the number of years for the number of payments made. Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 39) Which one of the following statements about zero coupon bonds is NOT true? A) Zero coupon bonds have no coupon payments but promise a single payment at maturity. B) Zero coupon bonds must sell for less than similar bonds that make periodic coupon payments. C) Zero coupon bonds make coupon payments but no principal payment at maturity. D) Zero coupon bonds differ from vanilla bonds in terms of face value. Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

40) Briar Corp is issuing a 10-year bond with a coupon rate of 7 percent. The interest rate for similar bonds is currently 9 percent. Assuming annual payments, what is the present value of the bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $872 B) $1,066 C) $990 D) $945 Answer: A Explanation: Years to maturity = n = 10 Coupon rate = C = 7% Annual coupon = $1,000 × 0.07 = $70 Current market rate = i = 9% Present value of bond = PB 0 1 2 3 4 5 6 10 ├────┼────┼────┼────┼────┼────┼─………────┤ $70 $70 $70 $70 $70 $70 $70 $1,000 n = 10; PB =

=C×

C = 7%; +

i = YTM = 9% +

+ ......

= $70 ×

= $449.24 + $422.41 = $871.65 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

41) Regatta, Inc., has six-year bonds outstanding that pay an 8.25 percent coupon rate. Investors buying the bond today can expect to earn a yield to maturity of 6.875 percent. How much will you be willing to pay for Regatta's bond today? Assume annual coupon payments. (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $972 B) $1,066 C) $1,014 D) $923 Answer: B Explanation: Years to maturity = n = 6 Coupon rate = C = 8.25% Annual coupon = $1,000 × 0.0825 = $82.50 Current market rate = i = 6.875% 0 1 2 3 4 6 ├─────┼──────┼──────┼──────┼─…………─────┤ $82.50 $82.50 $82.50 $82.50 $82.50 n = 6; PB =

C = 8.25%; +

=C×

i = YTM = 6.875%

+ ......

= $82.50 ×

= $394.76 + $671.03 = $1,065.79 PV of bond = $1,065.79 = $1,066 (rounded) Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

42) Triumph Corp. issued five-year bonds that pay a coupon of 6.375 percent annually. The current market rate for similar bonds is 8.5 percent. How much will you be willing to pay for Triumph's bond today? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,023 B) $1,137 C) $916 D) $897 Answer: C Explanation: Years to maturity = n = 5 Coupon rate = C = 6.375% Annual coupon = $1,000 × 0.06375 = $63.75 Current market rate = i = 8.5% PB =

=C×

= $63.75 ×

+ ......

= $251.22 + $665.05 = $916 (rounded) Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

43) Your friend recommends that you invest in a three-year bond issued by Trimer, Inc., that will pay annual coupons of 10 percent. Similar investments today will yield 6 percent. How much should you pay for the bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,024 B) $979 C) $886 D) $1,107 Answer: D Explanation: Years to maturity = n = 3 Coupon rate = C = 10% Annual coupon = $1,000 × 0.10 = $100 Current market rate = i = 6% PB =

PB = C ×

= $100 ×

+ ......

PB = $267.30 + $839.62 = $1,107 (rounded) Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

44) Kevin Rogers is interested in buying a five-year bond that pays a coupon of 10 percent on a semiannual basis. The current market rate for similar bonds is 8.8 percent. What should be the current price of this bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,048 B) $965 C) $1,099 D) $982 Answer: A Explanation: Years to maturity = n = 5 Coupon rate = C = 10% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.10/2) = $50.00 Current market rate = i = 8.8% Present value of bond = PB 0 1 2 3 4 5 6 10 ├────┼────┼────┼────┼────┼────┼─……────┤ $50 $50 $50 $50 $50 $50 $50 $1,000 n = 5;

PB =

m=2

C = 10%;

= $50 ×

i = YTM = 8.8%

= $397.59 + $650.12 = $1,047.71 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

45) Giant Electronics is issuing 20-year bonds that will pay coupons semiannually. The coupon rate on this bond is 7.8 percent. If the market rate for such bonds is 7 percent, what will the bonds sell for today? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,037 B) $1,085 C) $861 D) $923 Answer: B Explanation: Years to maturity = n = 20 Coupon rate = C = 7.8% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.078/2) = $39.00 Current market rate = i = 7% Present value of bond = PB 0 1 2 3 4 40 ├─────┼──────┼──────┼──────┼─…………─────┤ $39 $39 $39 $39 $39 $1,000 n = 20;

PB =

m=2

C = 7.8%;

i = YTM = 7%

= $39 ×

= $832.85 + 252.57 = $1,085.42 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

46) Jane Thorpe has been offered a seven-year bond issued by Barone, Inc., for a price of $943.22. The bond has a coupon rate of 9 percent and pays the coupon semiannually. Similar bonds in the market have a yield to maturity of 10 percent today. Should she buy the bonds at the offered price? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) Yes, the bond is worth more at $1,015. B) No, the bond is only worth $921. C) Yes, the bond is worth more at $951. D) No, the bond is only worth $912. Answer: C Explanation: Years to maturity = n = 7 Coupon rate = C = 9% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.09/2) = $45.00 Current market rate = i = 10% Present value of bond = PB 0 1 2 3 4 5 6 14 ├────┼────┼────┼────┼────┼────┼─………────┤ $45 $45 $45 $45 $45 $45 $45 $1,000 n = 7;

PB =

m=2

C = 9%;

= $45 ×

i = YTM = 10%

= $445.44 + $505.07 = $950.51 She should buy the bond at $943.22 since it is worth $950.51. Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 18

47) Kevin Oh is planning to sell a bond that he owns. This bond has four years to maturity and pays a coupon of 10 percent on a semiannual basis. Similar bonds in the current market have a yield to maturity of 12 percent. What will be the price that he will get for his bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,044 B) $938 C) $970 D) $1,102 Answer: B Explanation: Years to maturity = n = 4 Coupon rate = C = 10% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.10/2) = $50.00 Current market rate = i = 12% Present value of bond = PB 0 1 2 3 4 8 ├─────┼──────┼──────┼──────┼─…………─────┤ $50 $50 $50 $50 $50 $1,000 n = 4;

PB =

m=2

C = 10%;

i = YTM = 12%

= $50 ×

= $310.49 + 627.41 = $937.90 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

48) Jeremy Kohn is planning to invest in a 10-year bond that pays a 12 percent coupon. The current market rate for similar bonds is 9 percent. Assume semiannual coupon payments. What is the maximum price that should be paid for this bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $951 B) $882 C) $1,033 D) $1,195 Answer: D Explanation: Years to maturity = n = 10 Coupon rate = C = 12% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.12/2) = $60.00 Current market rate = i = 9% Present value of bond = PB 0 1 2 3 4 20 ├─────┼──────┼──────┼──────┼─…………─────┤ $60 $60 $60 $60 $60 $1,000 n = 10;

PB =

m=2

C = 12%;

= $60 ×

i = YTM = 9%

= $780.48 + 414.64 = $1,195.12 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

49) Highland Corp., a U.S. company, has a five-year bond whose yield to maturity is 6.5 percent. The bond has no coupon payments. What is the price of this zero coupon bond? (Assume semiannual compounding for these zero-coupon bonds.) A) $927.83 B) $726.27 C) $729.88 D) $1,113.23 Answer: B Explanation: You have the following information: YTM = 6.5% No coupon payments N = 5 × 2 = 10 I/2 = 0.065/2 = 0.0325. Using Equation 7.3, we obtain the following: (1,000/(1 + 0.0325)10 = 726.27 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

50) Shana Norris wants to buy five-year zero coupon bonds with a face value of $1,000. Her yield to maturity is 8.5 percent. Assuming annual compounding, what would be the current market price of these bonds? (Round your answer to the nearest dollar.) A) $1,023 B) $665 C) $890 D) $1,113 Answer: B Explanation: Years to maturity = n = 5 Coupon rate = C = 0% Current market rate = i = 8.5% 0 1 2 3 4 5 ├───────┼───────┼───────┼───────┼───────┤ $0 $0 $0 $0 $0 $1,000 PB =

= $665.05

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

51) The U.S. Treasury has issued 10-year zero coupon bonds with a face value of $1,000. Assume that the bond compounds interest semiannually. What will be the current market price of these bonds if the yield to maturity for similar investments in the market is 6.75 percent? (Round your answer to the nearest dollar.) A) $520 B) $860 C) $515 D) $604 Answer: C Explanation: Frequency of payment = m = 2 Years to maturity = n = 10 Coupon rate = C = 0% Current market rate = i = 6.75% 0 1 2 3 4 5 6 20 ├────┼────┼────┼────┼────┼────┼─………────┤ $0 $0 $0 $0 $0 $0 $0 $1,000 PB =

= $514.86

Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

52) Robertsons, Inc., is planning to expand its specialty stores into five other states and finance the expansion by issuing 15-year zero coupon bonds with a face value of $1,000. If your opportunity cost is 8 percent and similar bonds pay coupons semiannually, what will be the price at which you will be willing to purchase these bonds? (Round your answer to the nearest dollar.) A) $308 B) $315 C) $803 D) $866 Answer: A Explanation: Frequency of payment = m = 2 Years to maturity = n = 15 Current market rate = i = 8% 0 1 2 3 4 5 6 30 ├────┼────┼────┼────┼────┼────┼─………────┤ $0 $0 $0 $0 $0 $0 $0 $1,000 PB =

= $308.32

Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

53) Jarmine Corp., is planning to fund a project by issuing 10-year zero coupon bonds with a face value of $1,000. Assuming semiannual compounding of interest, what will be the price of these bonds if the appropriate discount rate is 14 percent? (Round your answer to the nearest dollar.) A) $852 B) $258 C) $270 D) $841 Answer: B Explanation: Frequency of payment = m = 2 Years to maturity = n = 10 Coupon rate = C = 0% Current market rate = i = 14% 0 1 2 3 4 5 6 20 ├────┼────┼────┼────┼────┼────┼─………────┤ $0 $0 $0 $0 $0 $0 $0 $1,000 PB =

= $258.42

Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 54) Which one of the following statements is true of a bond's yield to maturity? A) The yield to maturity of a bond is the same as the coupon rate assuming the bond price is below par value. B) If the yield to maturity is less than the coupon rate, the bond will sell above par value. C) A bond's yield to maturity is the same as the bond's realized yield if the bond is held to maturity. D) The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. Answer: D Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

55) The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments: A) exceed the price of the bond. B) equal to zero. C) equal to the price of the bond. D) less than the price of the bond. Answer: C Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 56) Which one of the following statements is NOT true of realized yield? A) The realized yield is the return earned on a bond given the cash flows actually received by the investor. B) The realized yield is equal to the yield to maturity even if the bond is sold prior to maturity. C) It is the interest rate at which the present value of the actual cash flows generated by the investment equals the bond's price at the time of sale of the bond. D) The realized yield allows investors to see the return they actually earned on their investment. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 57) Jenny LePlaz is looking to invest in a five-year bond that pays annual coupons of 6.25 percent and currently sells at $912.34. What is the current market yield on such bonds? (Round to the closest answer.) A) 9.5% B) 8.5% C) 6.5% D) 7.5%

Answer: B Explanation: Years to maturity = n = 5 Coupon rate = C = 6.25% Annual coupon = $1,000 × (0.0625) = $62.50 Yield to maturity = i Present value of bond = PB = $912.34 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 8%: PB = C(PVIFAi,n) + F(PVIFi,n)

$912.34 = $62.50 ×

= $249.54 + 680.58 ≠ $930.12 Try a higher rate, say YTM = 8.5%: PB = C(PVIFAi,n) + F(PVIFi,n)

$912.34 = $62.50 ×

≅ $246.29 + 665.05 ≅ $911.33 The YTM is approximately 8.5 percent. Using a financial calculator provided an exact YTM of 8.47 percent. N=5

PMT = $62.50

PV = -$912.34

FV = $1,000

CPT I/Y gives the interest rate as 8.47 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

58) Nathan Akpan is planning to invest in a seven-year bond that pays annual coupons at a rate of 7 percent. It is currently selling at $927.23. What is the current market yield on this bond? (Round to the closest answer.) A) 10.4% B) 9.5% C) 8.4% D) 7.5% Answer: C Explanation: Years to maturity = n = 7 Coupon rate = C = 7% Annual coupon = $1,000 × (0.07) = $70 Yield to maturity = i Present value of bond = PB = $927.23 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 8%: PB = C(PVIFAi,n) + F(PVIFi,n)

$927.23 = $70 ×

= $364.45 + 583.49 ≠ $947.94 Try a higher rate, say YTM = 8.5%: PB = C(PVIFAi,n) + F(PVIFi,n)

$927.23 = $70 ×

= $358.30 + 564.93 ≠ $923.22

Try a lower rate, say YTM = 8.4%: The YTM is approximately 8.4 percent. Using a financial calculator provided an exact YTM of 8.42 percent. N=7

PMT = $70

PV = -$927.23

FV = $1,000

CPT I/Y gives the interest rate as 8.42 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 59) Jane Almeda is interested in a 10-year bond issued by Roberts Corp. that pays a coupon of 10 percent annually. The current price of this bond is $1,174.45. What is the yield that Jane would earn by buying it at this price and holding it to maturity? (Round to the closest answer.) A) 7.1% B) 7.5% C) 8.9% D) 8.5% Answer: B Explanation: Years to maturity = n = 10 Coupon rate = C = 10% Annual coupon = $1,000 × (0.10) = $100 Yield to maturity = i Present value of bond = PB = $1,174.45 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a premium, we know that the yield to maturity is lower than the coupon rate. Try YTM = 8%: PB = C(PVIFAi,n) + F(PVIFi,n)

$1,174.45 = $100 ×

= $671.01 + 463.19 ≠ $1,134.20

Try a lower rate, say YTM = 7.5%: PB = C(PVIFAi,n) + F(PVIFi,n)

$1,174.45 = $100 ×

= $686.41 + 4853.19 ≅ $1,171.60 The YTM is approximately 7.5 percent. Using a financial calculator provided an exact YTM of 7.46 percent. N = 10

PMT = $100

PV = -$1,174.45

FV = $1,000

CPT I/Y gives the interest rate as 7.46 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

60) Shawna Carter wants to invest her recent bonus in a four-year bond that pays a coupon of 11 percent semiannually. The bonds are selling at $962.13 today. If she buys this bond and holds it to maturity, what would be her yield? (Round to the closest answer.) A) 11.5% B) 11.8% C) 12.5% D) 12.2% Answer: D Explanation: Years to maturity = n = 4 Coupon rate = C = 11% Semiannual coupon = $1,000 × (0.11/2) = $55 Yield to maturity = i Present value of bond = PB = $962.13 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 12%:

$962.13 =

= $55 ×

= $341.54 + $627.41 ≠ $968.95

Try a higher rate, say YTM = 12.2%:

$962.13 =

= $55 ×

= $4,340.19 + $622.70 ≅ $962.89 The YTM is approximately 12.2 percent. Using a financial calculator provided an exact YTM of 12.22 percent (2 × 6.11%). N=8

PMT = $55

PV = -$962.13

FV = $1,000

CPT I/Y gives the semiannual interest rate as 6.11 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

61) Alice Trang is planning to buy a six-year bond that pays a coupon of 10 percent semiannually. Given the current price of $878.21, what is the yield to maturity on these bonds? (Round to the closest answer.) A) 11% B) 12% C) 13% D) 14% Answer: C Explanation: Years to maturity = n = 6 Coupon rate = C = 10% Semiannual coupon = $1,000 × (0.10/2) = $50.00 Yield to maturity = i Present value of bond = PB = $878.21 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 12%:

$878.21 =

= $50 ×

= $419.19 + $496.97 ≠ $916.16

Try a higher rate, say YTM = 13%:

$878.21 =

= $50 ×

= $407.94 + $469.68 ≅ $877.62 The YTM is approximately 13 percent. Using a financial calculator provided an exact YTM of 12.98 percent (2 × 6.49%). N = 12

PMT = $50

PV = -$878.21

FV = $1,000

CPT I/Y gives the semiannual interest rate as 6.49 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

62) John Wong purchased a five-year bond today at $1,034.66. The bond pays 6.5 percent semiannually. What will be his yield to maturity? (Round to the closest answer.) A) 6.7% B) 6.2% C) 3.25% D) 5.7% Answer: D Explanation: Years to maturity = n = 5 Coupon rate = C = 6.5% Semiannual coupon = $1,000 × (0.065/2) = $32.50 Yield to maturity = i Present value of bond = PB = $1,034.66 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a premium, we know that the yield to maturity is lower than the coupon rate. Try YTM = 6%:

$1,034.66 =

= $32.50 ×

= $277.23 + $744.09 ≠ $1,021.33

Try a lower rate, say YTM = 5.7%:

$1,034.66 =

= $32.50 ×

= $279.37 + $755.02 ≅ $1,034.38 The YTM is approximately 5.7 percent. Using a financial calculator provided an exact YTM of 5.69 percent (2 × 2.847%). N = 10

PMT = 32.50

PV = -$1,034.66

FV = $1,000

CPT I/Y gives the semiannual interest rate as 2.847 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

63) Huan Zhang bought a 10-year bond that pays 8.25 percent semiannually for $911.10. What is the yield to maturity on this bond? (Round your percentage answer to two decimal places.) A) 7.6% B) 8.6% C) 9.6% D) 10.6% Answer: C Explanation: Years to maturity = n = 10 Coupon rate = C = 8.25% Semiannual coupon = $1,000 × (0.0825/2) = $41.25 Yield to maturity = i Present value of bond = PB = $911.10 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 9.4%:

$911.10 =

= $41.25 ×

= $527.40 + $399.09 ≠ $926.48

Try a higher rate, say YTM = 9.6%:

$911.10 =

= $41.25 ×

= $522.90 + $391.54 ≠ $914.43 The YTM is approximately 9.66 percent. Using a financial calculator provided an exact YTM of 9.656 percent (2 × 4.828%). N = 20

PMT = $41.25

PV = -$911.10

FV = $1,000

CPT I/Y gives the semiannual interest rate as 4.828 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

64) Five years ago, Shirley Harper bought a 10-year bond that pays 8 percent semiannually for $981.10. Today, she sold it for $1,067.22. What is the realized yield on her investment? (Round to the nearest percent.) A) 7% B) 8% C) 11% D) 10% Answer: D Explanation: Purchase price of bond = $981.10 Years investment held = n = 5 Coupon rate = C = 8% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.08/2) = $40 Realized Yield = i Selling price of bond = PB = $1,067.22 To compute the realized return, either the trial-and-error approach or the financial calculator can be used. Since the price has increased, market rates must have decreased. So, the realized return is going to be greater than the bond's coupon. Try rates higher than the coupon rate. Try i = 10%, or i/2 = 5%:

PB =

$981.10 = $40 ×

= $308.87 + $655.18 ≠ $964.05

Try a lower rate, i = 9.6% or i/2 = 4.8%:

PB =

$981.10 = $40 ×

= $311.89 + $667.79 ≅ $979.68

N = 10

PMT = $40.00

PV = -$981.10

FV = $1,067.22

CPT I/Y gives the semiannual interest rate as 4.78 percent. The realized rate of return is approximately 9.6 percent rounded to 10 percent. Using a financial calculator provided an exact yield of 9.56 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

65) Rachel McGovern bought a 10-year bond for $921.77 seven years ago. The bond pays a coupon of 15 percent semiannually. Today, the bond is priced at $961.22. If she sold the bond today, what would be her realized yield? (Round to the nearest percent.) A) 17% B) 18% C) 9% D) 10% Answer: A Explanation: Purchase price of bond = $921.77 Years investment held = n = 7 Coupon rate = C = 15% Frequency of payment = m = 2 Annual coupon = $1,000 × (0. 15/2) = $75.00 Realized Yield = i Selling price of bond = PB = $961.22 To compute the realized return, either the trial-and-error approach or the financial calculator can be used. Since the price has increased, market rates must have decreased. So, the realized return is going to be greater than the bond's coupon. Try rates higher than the coupon rate. Try i = 17%, or i/2 = 8.5%:

PB =

$921.10 = $75 ×

= $600.76 + $306.77 ≠ $907.52

Try a lower rate, i = 16.6% or i/2 = 8.3%:

PB =

$921.10 = $75 ×

= $607.69 + $314.79 ≅ $922.50 The realized rate of return is approximately 16.6 percent. Using a financial calculator provided an exact yield of 16.625 percent. N = 14

PMT = $75.00

PV = -$921.77

FV = $961.22

CPT I/Y gives the semiannual interest rate as 8.31 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

66) Jorge Cabrera paid $980 for a 15-year bond 10 years ago. The bond pays a coupon of 10 percent semiannually. Today, the bond is priced at $1,054.36. If he sells the bond today, what will be his realized yield? (Round to the nearest percent.) A) 12% B) 8% C) 11% D) 9% Answer: C Explanation: Purchase price of bond = $980 Years investment held = n = 10 Coupon rate = C = 10% Frequency of payment = m = 2 Annual coupon = $1,000 × (0. 10/2) = $50.00 Realized Yield = i Selling price of bond = PB = $1,054.36 To compute the realized return, either the trial-and-error approach or the financial calculator can be used. Since the price has increased, market rates must have decreased. So, the realized return is going to be greater than the bond's coupon. Try rates higher than the coupon rate. Try i = 10.5%, or i/2 = 5.25%:

PB =

$980 = $50 ×

= $610.11 + $378.92 ≠ $989.03

Try a higher rate, i = 10.7% or i/2 = 5.35%:

PB =

$980 = $50 ×

= $605.03 + $371.70 ≠ $976.82 The realized rate of return is approximately 10.7 percent. Using a financial calculator provided an exact yield of 10.648 percent. N = 20

PMT = $50.00

PV = -$980.00

FV = $1,054.36

CPT I/Y gives the semiannual interest rate as 5.32 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

67) Suppose an investor earned a semiannual yield of 6.4 percent on a bond paying coupons twice a year. What is the effective annual yield (EAY) on this investment? (Round to two decimal places.) A) 12.80% B) 6.40% C) 6.50% D) 13.21% Answer: D Explanation: Semiannual yield = 6.4% The effective annual yield can be computed as: EAY =

EAY =

-1

= 13.21% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 68) Which of the following statements is true? A) Long-term bonds have lower price volatility than short-term bonds of similar risk. B) As interest rates decline, the prices of bonds rise and as interest rates rise, the prices of bonds decline. C) All other things being equal, short-term bonds are riskier than long-term bonds. D) Interest rate risk decreases as maturity increases. Answer: B Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

69) Which one of the following statements is NOT true? A) Interest rate risk is the risk that bond prices will change as interest rates change. B) Interest rate changes and bond prices are inversely related. C) As interest rates increase, bond prices increase. D) Long-term bonds have more price volatility than short-term bonds of similar risk. Answer: C Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 70) Which of the following statements is true? A) The longer the maturity of a security, the greater its interest rate risk. B) If investors believe inflation will be subsiding in the future, the prevailing yield curve will have a positive slope. C) The real rate of interest varies with the business cycle, with the lowest rates at the end of a period of business expansion and the highest at the bottom of a recession. D) The interest rate risk premium always adds a downward bias to the slope of the yield curve. Answer: A Diff: 2 Learning Objective: LO 4, 6 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 71) Which of the following statements is true? A) For a given change in market interest rates, the prices of higher-coupon bonds change more than the prices of lower-coupon bonds. B) If market interest rates rise, a 1-year bond will fall in value more than a 10-year bond. C) If market interest rates rise, bond prices will rise. D) If market interest rates rise, a 10-year bond will fall in value more than a 1-year bond. Answer: D Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

72) Stanley Hart invested in a municipal bond that promised an annual yield of 6.7 percent. The bond pays coupons twice a year. What is the effective annual yield (EAY) on this investment? (Round percentage to two decimal places.) A) 13.4% B) 6.81% C) 6.70% D) 4.89% Answer: B Explanation: Annual yield = 6.7% The effective annual yield can be computed as: EAY =

EAY =

-1

EAY = 0.06812 or 6.81% Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 73) Marketability is the ability of an investor: A) to sell a security quickly, at a low transaction cost, and at a price close to its fair market value. B) to sell at a profit under all circumstances. C) to sell the security above its par value. D) to sell a security with the highest profit. Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

74) Which of the following statements is true? A) The lower the transaction costs are, the less marketable a security becomes. B) The interest rate, or yield, on a security does not affect its marketability. C) U.S. Treasury bonds are considered to be the most marketable of all debt securities. D) U.S. Treasury bills have the largest and most active secondary market and are considered to be the most marketable of all debt securities. Answer: D Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 75) Which of the following statements is NOT true? A) The risk that the lender may not receive payments as promised is called default risk. B) Investors must pay a premium to purchase a security that exposes them to default risk. C) U.S. Treasury securities are the best proxy measure for the risk-free rate. D) A bond's yield to maturity is inversely related to its price. Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 76) Downward-sloping yield curves usually occur: A) when the economy is growing. B) when the economy is stagnant. C) before the beginning of a recession. D) after the beginning of a recession. Answer: C Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

77) Which one of the following statements is NOT true? A) The relationship between yield to maturity and marketability is known as the term structure of interest rates. B) The shape of the yield curve is not constant over time. C) As the general level of interest rises and falls over time, the yield curve shifts up and down and has different slopes. D) Yield curves show graphically how market yields vary as term to maturity changes. Answer: A Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 78) The three economic factors that affect the shape of the yield curve are: A) the real rate of interest, the expected rate of inflation, and marketability. B) the real rate of interest, the expected rate of inflation, and interest rate risk. C) the nominal rate of interest, the expected rate of inflation, and default risk. D) the real rate of interest, the nominal rate of interest, and currency risk. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 79) Which of the following statements is true? A) Investment grade bonds are those rated single B and higher. B) Federal laws typically allow insurance companies and pension funds to purchase noninvestment grade bonds. C) Because investors are risk averse, they require a premium to purchase a security that exposes them to default risk. D) All else equal, the higher a bond's rating, the higher the coupon rate. Answer: C Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

80) Which of the following statements is true? A) Downward-sloping yield curves typically appear in the early to mid-period of a business expansion. B) The interest rate risk premium always adds an upward bias to the slope of the yield curve. C) If investors believe that inflation will be increasing in the near future, the yield curve will be downward sloping. D) The yield curve most commonly observed is downward-sloping. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 81) What is the marketability risk premium? Why should an issuing firm consider paying this premium? Answer: Marketability is the ability of an investor to sell a security quickly at a low transaction cost and at its fair market value. The difference in interest rates or yields between the most marketable security and a less marketable security is known as the marketability risk premium. Investors would prefer more marketable securities. Investors prefer securities that can be easily converted to cash without a loss in value. The lower the marketability of a particular bond, the higher the compensation that would be demanded by investors. In order for investors to buy securities that are less marketable, issuing companies have to pay a marketability risk premium (MRP). Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 82) Why does the default risk premium vary over the business cycle? Answer: Default risk premiums vary over the business cycle. Larger premiums are required during recessionary times, while economic expansions reduce such premiums. During periods of economic expansion, investors are willing to hold bonds with low credit ratings in their portfolios because there is little chance of default and these bonds normally have higher yields. During such times, investors tend to seek out the highest-yielding investments. On the other hand, during a recession, the prime concern of investors becomes safety. We call this the flight to quality. Since firms have a higher probability of failing during an economic downturn, investors are more concerned about default risk and will demand a higher default risk premium. Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 50

83) What economic factors affect the level and the shape of the yield curve? Explain. Answer: Three economic factors affect the shape of the yield curve: (1) the real rate of interest; (2) the expected rate of inflation; and (3) the interest rate risk. As an economy grows, the real rate of interest will increase, causing the yield curve to have an upward slope. Similarly, if investors think that inflation will increase in the future, they will require a higher inflation premium, again forcing an upward tilt to the yield curve. Since the observed or nominal interest rate is a combination of these two factors, the slope of the yield curve will shift upward. The opposite will happen during an economic downturn. The third factor, the interest rate risk, will cause longer term securities to have a higher yield than shorter term securities, again giving the yield curve an upward bias. Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 9 Stock Valuation 1) Equity securities are certificates of ownership of a corporation. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2) Brokers are exposed to inventory risk since they facilitate transactions on behalf of their clients while dealers are subject to capital risk because they must finance their inventories of securities. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3) Dealers are subject to capital risk, because they hold inventories of securities and must finance those inventories. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4) More than half of U.S. households have some investment in the stock market. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

5) A large number of investors in equities actually own securities through pension or retirement funds. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 6) Companies raise capital in secondary markets by issuing new securities. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 7) The existence of active secondary market for debt or equity securities makes raising new capital less expensive for firms. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 8) The function of secondary markets is to provide investors with marketability for the securities they own at a fair price. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 9) Secondary market transactions in the United States mostly take place over the counter and not in exchanges. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2

10) In terms of the total stock value of the firms listed, the NYSE is the largest stock exchange in the world and NASDAQ is the second largest. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11) Direct search markets provide the best price information because buyers and sellers seek each other out directly. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12) Direct search is the least efficient type of secondary market because securities are not bought and sold frequent enough to warrant profit for brokers. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13) For a commission fee that is less than the cost of direct search, brokers give investors an incentive to make use of the information by hiring them. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

14) A broker market eliminates the need for time-consuming searching for a fair deal by buying and selling immediately from its inventory of securities. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15) NASDAQ is the best-known example of a direct market. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16) In an auction market, buyers and sellers confront each other directly and bargain over price. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17) The New York Stock Exchange is the best-known example of an auction market in the United States. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18) The common shareholders of a company have unlimited liability. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

19) Preferred shareholders are not guaranteed any dividend payments and have the lowestpriority claim on the firm's assets in the event of bankruptcy. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 20) Preferred dividend payments are contractual obligations of the firm to pay dividends to preferred shareholders, similar to the interest payments paid to bondholders. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 21) The market considers preferred stock to be a debt security because the dividend payment is a fixed contractual obligation and has credit ratings like bonds. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 22) Common and preferred stock are valued using a different formula than that used for bonds. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 23) Based on the general dividend valuation model, the price of a share of stock is the present value of all expected future dividends. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 5

24) For a company that has no growth, dividends stay constant over time. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 25) A fast-growing company will pay constant dividends over time. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 26) The constant-growth stock has dividends growing at a constant rate over time. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 27) The constant-growth dividend model tells us that the current price of a share of stock is the next period dividend divided by the difference between the discount rate and the dividend growth rate. Answer: TRUE Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 28) Whenever the constant-growth rate for dividends exceeds the required rate of return on the common stock, the constant-growth model provides invalid solutions. Answer: TRUE Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 6

29) The value of a supernormal growth stock is the present value of the mixed growth dividend payments and the present value of the constant-growth dividend payments. Answer: TRUE Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 30) Failure to pay a preferred dividend signals to the market that the firm is in serious financial trouble. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 31) Preferred stock with no fixed maturity can be valued as a perpetuity. Answer: TRUE Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 32) The bond valuation model can be used to value preferred stocks with no fixed maturity. Answer: FALSE Diff: 1 Learning Objective: LO 7 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 33) A preferred stock with a definite maturity date is similar to a bond with a fixed maturity date. Thus, a preferred stock can be valued in a similar fashion to a bond. Answer: TRUE Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 7

34) ________ of U.S. households have an investment in the stock market. A) 30% B) 40% C) 50% D) More than 50% Answer: D Diff: 2 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 35) Which of the following statement(s) is (are) true about secondary markets? A) In secondary markets, outstanding shares of stock are bought and sold among investors. B) Most secondary market transactions directly affect the capital of the firm that issues the securities. C) An active secondary market causes firms to sell their debt or equity issues at a higher transaction cost of funds. D) In secondary markets, firms sell new shares of stock to investors to raise money. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36) Which of the following statements is true about secondary markets in the United States? A) In terms of total stock value of the firms listed, the NASDAQ is the largest stock exchange in the world and the NYSE is the second largest. B) NASDAQ is an OTC (over the counter) market. C) Firms listed on the NASDAQ tend to be, on average, larger in size, and their shares trade more frequently than those traded on NYSE. D) In the United States, most secondary market transactions are done over the counter. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

37) Which of the following statements is NOT true about secondary markets? A) In terms of total stock value of the firms listed, the NASDAQ is the largest stock exchange in the world and the NYSE is the second largest. B) The role of NYSE, NASDAQ, and other stock exchange is to bring together buyers and sellers. C) Firms listed on the NYSE tend to be larger in size and their shares trade more frequently than those traded on NASDAQ. D) In the United States, most secondary market transactions are done on one of the many stock exchanges. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38) In comparison to the NYSE: A) NASDAQ has fewer companies listed. B) total share volume is lower on the NASDAQ. C) firms listed on the NASDAQ tend to be smaller. D) NASDAQ firms exceed NYSE listed firms in total market capitalization. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39) Direct search markets are characterized by: A) complete price information. B) extensive broker and dealer participation. C) private placement transactions and sale of common stock of small private companies. D) a high level of efficiency. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

40) The least efficient of all the different types of secondary markets is the: A) auction market. B) direct search market. C) dealer market. D) broker market. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41) Which of the following statements is NOT true about broker markets? A) Brokers charge commission fees for their services of bringing together buyers and sellers. B) Brokers' extensive contacts provide them with a pool of price information that individual investors could not economically duplicate themselves. C) Investors have an incentive to hire a broker because what they charge as a commission is less than the cost of direct search. D) Brokers can guarantee an order because they have an inventory of securities. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42) In a broker market: A) the commission charged by brokers is a higher cost to buyers and sellers than the cost of direct search. B) buyers and sellers are brought together generally without payment of a commission. C) brokers provide the greatest benefit when direct search costs are low. D) brokers build a pool of price information through their extensive contacts. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

43) Which of the following statements is true about dealer markets? A) NYSE is the best-known example of a dealer market. B) A dealer market involves time-consuming search for a fair deal. C) The advantage of a dealer over a brokered market is that brokers cannot guarantee that an order will be executed promptly, while dealers can promise execution due to their holding of inventory of securities. D) Buying and selling in dealer markets take quite some time to execute. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44) Which of the following is (are) the characterization of dealer market? A) It is time-consuming to search for a fair deal. B) The dealer does not hold an inventory of securities. C) The presence of a dealer market does not affect market efficiency because search costs are still high. D) It improved market efficiency because dealers provide continuous bid and ask prices for securities. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45) Which of the following statements is NOT true about auction markets? A) In an auction market, buyers and sellers confront each other directly and bargain over price. B) The participants can only communicate orally in auction markets. C) The New York Stock Exchange is the best-known example of an auction market. D) The auctioneer in an auction market is the specialist, who is designated by the exchange to represent orders placed by public customers. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

46) Which of the following statements is NOT true about common stock? A) Common stockholders have the right to vote on the election of the board of directors of their company. B) Common stock is considered to have no fixed maturity. C) Owners of common stock are guaranteed dividend payments by the firm. D) Common stockholders have limited liability toward the obligations of the corporation. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 47) Which of the following statements is true about common stock? A) Common stock is considered to have a fixed maturity. B) Owners of common stock are guaranteed dividend payment by the firm. C) Owners of common stock have the last claim on the firm's assets in the event of bankruptcy. D) Common stockholders have unlimited liability toward the obligations of the corporation. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 48) Which of the following is NOT a widely-known stock market index? A) The Dow Jones Industrial Average B) The OTQ Composite Index C) The New York Stock Exchange Index D) The Standard and Poor's 500 Index Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

49) Which of the following statements is NOT true about preferred stock? A) Preferred stock represents ownership in the firm. B) Preferred stockholders are not guaranteed dividend payments by the firm. C) Preferred stock dividends are paid by the issuer with after-tax dollars. D) Preferred stockholders have no voting privileges relative to common stock owners. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 50) Which of the following statements is NOT true about preferred stock? A) Preferred dividend payments are paid by the issuer with after-tax dollars. B) Preferred dividends are tax deductible just like the interest payments on bonds. C) Preferred stock holders have no voting privileges relative to common stock owners. D) Preferred stocks are generally viewed as perpetuities because they have no fixed maturity. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 51) Owners of preferred stock: A) have the same voting rights as common shareholders. B) usually receive variable dividend payments. C) are given priority treatment over creditors' claims against the firm's assets in the event of bankruptcy or liquidation. D) have no voting rights. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

52) Preferred stock is sometimes treated like a debt security because: A) legally preferred stock is a debt security. B) preferred dividend payments are similar to bond interest payments and are fixed in nature regardless of the firm's earnings. C) preferred dividends are deductible from corporate taxable income just like interest payments on bonds. D) preferred stockholders receive a residual value and not a stated value. Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 53) Which of the following statements is true? A) Preferred stockholders are considered to be the true owners of public corporations. B) Dividends paid to preferred stockholders are not fixed. C) Preferred stockholders usually do not have voting rights. D) Preferred stock can never be converted to common stock. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 54) Applying the valuation procedure to common stocks is more difficult than applying it to bonds because: A) the size and timing of the dividend cash flows are more certain than the coupon payments for bonds. B) common stocks have a final maturity date. C) the rate of return on common stock is directly observable. D) common stocks make perpetual dividend payments. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

55) Assume that you are considering the purchase of a stock which will pay dividends of $4.50 during the next year. Further assume that you will be able to sell the stock for $85.00 one year from today and that your required rate of return is 15 percent. How much would you be willing to pay for the stock today? (Round to the nearest $0.01.) A) $89.50 B) $65.37 C) $94.10 D) $77.83 Answer: D Explanation: P0 =

= $77.82

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 56) Which of the following statements is NOT true about the general dividend valuation model? A) The model does not assume any specific pattern for future dividends, such as a constant growth rate. B) It makes a specific assumption about when the share of stock is going to be sold in the future. C) The model calls for forecasting an infinite number of dividends for a stock. D) The price of a share of stock is the present value of all expected future dividends. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

57) Which of the following statements is true about the general dividend valuation model? A) It implies that the underlying value of a share of stock is determined by the market's expectations of the future dividends that the firm will generate. B) It implies that the value of a firm's common stock can be determined only if the expected future dividends are infinite. C) It implies that the value of a growth stock can be determined by forecasting the future price of the stock. D) The model cannot be used to calculate the value of a common stock unless the dividends exceed the firm's expected growth rate. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 58) Which of the following statements is true about growth stocks? A) These are stocks of firms that grow their sales at below-average rates and are expected to do so for a length of time. B) These are stocks of firms that grow their earnings at above-average rates and are expected to do so for a length of time. C) They generally pay dividends during their fast growth phase. D) These are stocks of firms that grow their earnings at average rates and are expected to do so for a length of time. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

59) Which of the following are the three simplifying assumptions that cover most stock growth patterns? A) Dividends remain constant over time, dividends grow at a constant rate, and dividends are not growing. B) Dividends have a zero-growth rate, dividends grow at a varying rate, and dividends are not growing. C) Dividends remain constant over time, dividends grow at a constant rate, and dividends have a mixed growth pattern. D) Dividends have a zero-growth rate, dividends grow at a varying rate, and dividends are growing. Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 60) Which of the following statements is NOT true about zero-growth stocks? A) The dividend payment pattern remains constant over time. B) The cash flow pattern resembles a perpetuity with a constant cash flow. C) The dividend pattern grows over time. D) There is no growth in dividends over time. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 61) Which of the following statements is NOT true about constant-growth stocks? A) The cash dividend remains constant over time. B) Mature companies with a history of stable growth show this pattern. C) The dividends grow at a constant rate from one period to the next forever. D) Far distant-dividends have a very small present value and add little to the stock's price. Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

62) The constant-growth dividend model will provide invalid solutions when: A) the growth rate of the stock exceeds the required rate of return for the stock. B) the growth rate of the stock is less than the required rate of return for the stock. C) the growth rate of the stock is equal to the risk-free rate. D) the growth rate of the stock is less than the risk-free rate. Answer: A Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 63) Cortez, Inc., is expecting to pay out a dividend of $2.50 next year. After that it expects its dividend to grow at 7 percent for the next four years. What is the present value of dividends over the next five-year period if the required rate of return is 10 percent? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $10.76 B) $11.88 C) $11.50 D) $9.80 Answer: A Explanation: Expected dividends for Cortez, Inc., and their present value: D2 = D1(1 + g) = $2.50(1 + 0.07) = $2.675 D3 = D2(1 + g) = $2.675(1.07) = $2.862 D4 = D3(1 + g) = $2.862(1.07) = $3.063 D5 = D4(1 + g) = $3.063(1.07) = $3.277 Present value of the dividends = PV(D1) + PV(D2) + PV(D3) + PV(D4) + PV(D5) =

= $2.2727 + $2.2107 +$2.1502 + $2.0921 + $2.0347 = $10.76 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

64) Next year, Jenkins Traders will pay a dividend of $3.00. It expects to increase its dividend by $0.25 in each of the following three years. If their required rate of return is 14 percent, what is the present value of their dividends over the next four years? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $13.50 B) $9.72 C) $12.50 D) $11.63 Answer: B Explanation: Expected dividends for Jenkins Traders and their present value: D1 = $3.00; D2 = $3.25; D3 = $3.50; D4 = $3.75 Present value of the dividends = PV(D1) + PV(D2) + PV(D3) + PV(D4) PV of Dividends = $3.00/1.14 + $3.25/(1.14)2 +$3.50/(1.14)3 + $3.75/(1.14)4 = $2.6316 + $2.5008 + $2.3624 + $2.2203 = $9.72 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

65) Kleine Toymakers is introducing a new line of robotic toys, which it expects to grow their earnings at a much faster rate than normal over the next three years. After paying a dividend of $2.00 last year, it does not expect to pay a dividend for the next three years. After that Kleine plans to pay a dividend of $4.00 in year 4 and then increase the dividend at a rate of 10 percent in years 5 and 6. What is the present value of the dividends to be paid out over the next six years if the required rate of return is 15 percent? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $13.24 B) $12.00 C) $6.57 D) $10.24 Answer: C Explanation: Expected dividends for Kleine Toymakers and their present value: D0 = $2.00; D1 = D2 = D3 = $0 D4 = $4.00 D5 = D4(1 + g) = $4.00(1.10) = $4.40 D6 = D5(1 + g) = $4.40(1.10) = $4.84 Present value of the dividends = PV(D1) + PV(D2) +………+ PV(D6) = $0 + $0 + $0 +

= $0 + $0 + $0 + $2.2870 + $2.1875 + $2.0925 = $6.57 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

66) Givens, Inc., is a fast-growing technology company that paid a $1.25 dividend last week. The company's expected dividend growth rates over the next four years are as follows: 25 percent, 30 percent 35 percent, and 30 percent. The company then expects to settle down to a constantgrowth rate of 8 percent annually. If the required rate of return is 12 percent, what is the present value of the dividends over the fast growth phase? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $1.25 B) $6.46 C) $8.37 D) $7.23 Answer: D Explanation: Expected dividends for Givens, Inc., and their present value: D0 = $1.25 D1 = D0(1 + g) = $1.25(1.25) = $1.563 D2 = D1(1 + g) = $1.563(1.30) = $2.031 D3 = D2(1 + g) = $2.031(1.35) = $2.742 D4 = D3(1 + g) = $2.742(1.30) = $3.565 Present value of the dividends = PV(D1) + PV(D2) + PV(D3) + PV(D4) =

= $1.3955 + $1.6191 + $1.9517 + $2.2656 = $7.23 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

67) Jacob Suppliers has not paid out any dividend in the last three years. It does not expect to pay dividends in the next two years either as it recovers from an economic slowdown. Three years from now it expects to pay a dividend of $2.50 and then $3.00 in the following two years. What is the present value of the dividends to be received over the next five years if the discount rate is 15 percent? ( Do not round intermediate calculations. Round final answer to two decimal places.) A) $4.85 B) $5.37 C) $5.50 D) $6.14 Answer: A Explanation: Expected dividends for Jacobs Suppliers and their present value: D0 = D1 = D2 = $0; D3 = $2.50; D4 = $3.00; D5 = $3.00 Present value of the dividends = PV(D1) + PV(D2) + ………… + PV(D5) = $0 + $0 +

= $0 + $0 + $1.6438 + $1.7152 + $1.4915 = $4.85 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 68) Xinhua Manufacturing Company has been generating stable revenues that are not expected to grow at least for the next 12 months. The company's last dividend was $3.25, and it is unlikely to change the amount paid out. If the required rate of return is 12 percent, what is the stock worth today? (Round the final answer to two decimal places.) A) $39.00 B) $3.69 C) $27.08 D) $21.23 Answer: C Explanation: D0 = $3.25; g = 0; R = 12% P0 =

= $27.08

Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

69) Zephyr Electricals is a company with no growth potential. Its last dividend payment was $4.50, and it expects no change in future dividends. What is the current price of the company's stock given a discount rate of 9 percent? A) $40.50 B) $50.00 C) $45.00 D) $500.00 Answer: B Explanation: D0 = $4.50; g = 0; R = 9% P0 =

= $50.00

Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 70) Metasteel Limited Co. has a stable track record with sales that are not expected to grow in the future . Its last annual dividend was $5.75. If the required rate of return on similar investments is 18 percent, what is the current stock price? (Round the answer to two decimal places.) A) $103.50 B) $13.50 C) $39.30 D) $31.94 Answer: D Explanation: D0 = $5.75; g = 0; R = 18% P0 =

= $31.94

Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

71) Ambassador Corp. sells household cleaners producing a revenue stream that has remained unchanged in the last few years. The firm does not expect any future change in its earnings or dividends.. The stock is currently selling at $46.88. If the required rate of return is 16 percent, what is the dividend paid by this company? (Round the answer to two decimal places.) A) $2.93 B) $4.65 C) $6.89 D) $7.50 Answer: D Explanation: P0 = $46.88; g = 0; R = 16% P0 =

= $46.88

D0 = $46.88 × 0.16 = $7.50 Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 72) A communications company pays annual dividends of $8.50 with no possibility of it changing in the future. If the firm's stock is currently selling at $60.71, what is the required rate of return? (Round to nearest whole number.) A) 14% B) 16% C) 13% D) 15% Answer: A Explanation: P0 = $60.71; g = 0; D0 = $8.50 P0 = $60.71 = R=

= 14%

Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

73) You are interested in investing in a company that expects to have the same growth rate of 6 percent forever. The firm paid a dividend of $2.30 last year. If your required rate of return is 10 percent, what is the most you would be willing to pay for this stock? (Round to the nearest dollar.) A) $58 B) $61 C) $23 D) $24 Answer: B Explanation: D0 = $2.30; g = 6%; R = 10% P0 =

= $60.95

= $61.00 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 74) Johnson Corporation has just paid a dividend of $4.45. The company has forecasted a constant dividend growth rate of 8 percent forever. If the appropriate discount rate is 14 percent, what is the current price of this stock? (Round to the nearest dollar.) A) $74 B) $32 C) $80 D) $60 Answer: C Explanation: D0 = $4.45; g = 8%; R = 14% P0 = =

= =

= $80.10

= $80.00 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

75) Ryder Supplies has its stock currently selling at $63.25. The company is expected to grow at a constant rate of 7 percent. If the appropriate discount rate is 17 percent, what is the expected dividend, a year from now? (Round the answer to two decimal places.) A) $4.43 B) $3.25 C) $10.75 D) $6.33 Answer: D Explanation: P0 = $63.25; g = 7%; R = 17% P0 = D1 = P0(R - g) = $63.25(0.17 - 0.07) = $6.325 Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 76) Prior, Inc., is expected to grow at a constant rate of 9 percent. If the company's next dividend is $2.75 and its current price is $37.35, what is the required rate of return on this stock? (Do not round intermediate calculations. Round final answer to the nearest percent.) A) 13% B) 16% C) 20% D) 21% Answer: B Explanation: D1 = $2.75; P0 = $37.35; g = 9% P0 = $37.35 = $37.35(R - 0.09) = $2.75 -3.36155 - 2.75 = -37.35R R=

= 16.4%

Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

77) A company's earnings and dividends are growing at a constant rate of 8 percent. Last week it paid a dividend of $3.00. If the required rate of return is 15 percent, what is the price of the stock three years from now? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $58.31 B) $46.29 C) $51.02 D) $42.83 Answer: A Explanation: R = 15%; D0 = $3.00; g = 8% P3 = =

= = $58.31

Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 78) Which of the following is the most typical example of a zero-growth dividend stock? A) The common stock of a firm in the biotechnology industry. B) The preferred stock of a utility company. C) The common stock of a firm in the health care industry. D) The common stock of a firm in the information technology industry. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

79) The constant growth dividend model would be useful to determine the value of all but which of the following firms? A) A firm whose earnings and dividends are declining at a fairly steady rate B) A firm whose sales, profits, and dividends are growing at an annual average compound rate of 5 percent C) A firm whose earnings and dividends are growing at a fairly steady rate D) A firm whose expected sales, profits, and dividends are fluctuating Answer: D Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 80) Starskeep, Inc., is a fast-growing technology company. The firm projects a rapid growth of 40 percent for the next two years and then a growth rate of 20 percent for the following two years. After that, the firm expects a constant growth rate of 8 percent. The firm expects to pay its first dividend of $1.25 a year from now. If your required rate of return for such stocks is 20 percent, what is the current price of the stock? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $15.63 B) $4.70 C) $30.30 D) $22.68 Answer: A Explanation: g1 = g2 = 40%, g3 = g4 = 20%, g = 8%, D1 = $1.25, R = 20% D1 = $1.25, D2 = $1.25(1.40) = $1.75, D3 = $1.75(1.20) = $2.10 D4 = $2.10(1.20) = $2.52, D5 = $2.52(1.08) = $2.722 P4 =

P0 = P0 =

= $22.68 +

+ +

P0 = $1.0417 + $1.2153 + $1.2153 + $12.1528 P0 = $15.63 Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 28

81) BioSci, Inc., a biotech firm, has forecast the following growth rates for the next three years: 30 percent, 25 percent, and 20 percent. The company then expects to grow at a constant rate of 7 percent forever. The company paid a dividend of $2.00 last week. If the required rate of return is 16 percent, what is the market value of this stock? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $51.03 B) $36.86 C) $56.12 D) $46.37 Answer: B Explanation: g1 = 30%; g2 = 25%, g4 = 20%, g = 7%, D0 = $2.00, R = 16% D1 = $2.00(1.30) = $2.60, D2 = $2.60(1.25) = $3.25, D3 = $3.25(1.20) = $3.90 D4 = $3.90(1.07) = $4.173; P3 =

P0 = P0 =

= $46.37 +

P0 = $2.2414 + $2.4152 + $32.2059 P0 = $36.86 Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

82) Grant, Inc., is a high growth stock and expects to grow at a rate of 25 percent for the next four years. It will then settle to a constant growth rate of 10 percent. The first dividend will be paid out in year 3 and will be equal to $5.00. If the required rate of return is 18 percent, what is the current price of the stock? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $85.94 B) $97.19 C) $50.59 D) $65.68 Answer: C Explanation: g1 - 4 = 25%; g = 10%; D3 = $5.00; R = 18% D4 = D3 (1.25) = $5.00(1.25) = $6.25; D5 = $6.25(1.10) = $6.875 P4 =

P0 = P0 = 0 + 0 +

= $85.94 +

P0 = $3.0432 + $47.5506 = $50.59 Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

83) Stag Corp. will pay dividends of $4.75, $5.25, $5.75, and $7 for the next four years. Thereafter, the company expects 7 percent growth in dividends. If the required rate of return is 15 percent, what is the current market price of the stock? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $69.41 B) $93.63 C) $57.54 D) $80.29 Answer: A Explanation: D1 = $4.75; D2 = $5.25; D3 = $5.75; D4 = $7; g = 7%; R = 15% P4 =

P0 = P0 =

= $93.63 +

+ +

P0 = $4.1304 + $3.9697 + $3.7807 + $57.5355 = $69.42 Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

84) Lincoln, Inc. expects to pay no dividends for the next four years. It has projected a growth rate of 35 percent for the next four years. After four years, the firm will grow at a constant rate of 6 percent. Its first dividend to be paid in year 5 will be worth $4.25. If your required rate of return is 20 percent, what is the stock worth today? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $14.64 B) $32.18 C) $36.43 D) $21.82 Answer: A Explanation: gconstant = 6%; R = 20%; D5 = $4.25; D1 - D4 = 0 PV(D1) + PV(D2) + PV(D3) + PV(D4) = 0 P4 =

P0 = PV of dividends +

= $30.36 =0+

Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

= $14.64

85) Suppose a firm's expected dividends for the next three years are as follows: D1 = $1.10, D2 = $1.20, and D3 = $1.30. After three years, the firm's dividends are expected to grow at 5 percent per year. What should the current price of the firm's stock (P0) be today if investors require a rate of return of 12 percent on the stock? (Do not round intermediate calculations. Round final answer to the nearest $0.01.) A) $61.30 B) $10.10 C) $16.74 D) $24.12 Answer: C Explanation: P0 = =

+ +

P4 = $1.30(1.05)/(0.12-0.05) = $19.50 P0 = $0.9821 + $0.9566 + $0.9253 + $13.8797= $16.74 Diff: 2 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 86) Which of the following statements is true? A) In order for the constant growth dividend model to properly value a firm's common stock, R must be greater than g. B) From a practical perspective, the growth rate in the constant growth dividend model must be greater than the sum of the long-term rate of inflation and the long-term real growth rate of the economy. C) In order for the constant growth dividend model to properly value a firm's common stock, g must be greater than R. D) The constant growth dividend model can be used effectively to value the common shares of a mixed growth stock. Answer: A Diff: 1 Learning Objective: LO 5, 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

87) Ajax Company has issued perpetual preferred stock with a par of $100 and a dividend of 5.5 percent. If the required rate of return is 7.75 percent, what is the preferred stock's current market price? (Round to two decimal places.) A) $12.90 B) $70.97 C) $53.27 D) $62.14 Answer: B Explanation: D = 5.5% ($100) = $5.50; R = 7.75% P0 =

= $70.97

Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 88) The National Bank of Columbia has issued perpetual preferred stock with a $100 par value. The bank pays a quarterly dividend of $1.40 on this stock. What is the current price of this preferred stock given a required rate of return of 8.5 percent? (Round to two decimal places.) A) $23.06 B) $65.88 C) $37.57 D) $43.25 Answer: B Explanation: Quarterly dividend = $1.40 Required rate of return = R = 8.5% P0 =

= $65.88

Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

89) The preferred stock of Acme International is selling currently at $110.35. What is the dividend paid by this stock if your required rate of return is 9.75 percent? (Round to two decimal places.) A) $9.75 B) $11.32 C) $10.76 D) $8.53 Answer: C Explanation: P0 = $110.35; R = 9.75% P0 = $110.35 =

D = $110.35 × 0.0975 = $10.76 Diff: 2 Learning Objective: LO 7 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 90) Each quarter, Transam, Inc., pays a dividend on its perpetual preferred stock. Today, the stock is selling at $83.45. If the required rate of return for such stocks is 10.5 percent, what is the quarterly dividend paid by the firm? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $8.76 B) $10.50 C) $2.19 D) $2.63 Answer: C Explanation: P0 = $83.45; R = 10.5% P0 = $83.45 =

D = $83.45 × 0.105 = $8.76 Annual dividend = $8.76, Quarterly dividend = $8.76/4 = $2.19 Diff: 2 Learning Objective: LO 7 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

91) The Columbia Consumer Products Co. has issued perpetual preferred stock with a $100 par value. The firm pays a quarterly dividend of $2.60 on this stock. What is the current price of this preferred stock given a required rate of return of 12.5 percent? A) $47.25 B) $80.00 C) $20.80 D) $83.20 Answer: D Explanation: Quarterly dividend = $2.60 Required rate of return = R = 12.5% P0 =

= $83.20

Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 92) Which of the following statements about preferred stock is FALSE? A) Preferred stock has a higher-priority claim on the firm's assets than the common stock. B) Failure to pay dividends on preferred stocks will result in a default. C) Preferred stock has a lower-priority claim on the firm's assets than the firm's creditors in the event of default. D) Preferred stock typically pays a fixed dividend. Answer: B Diff: 2 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

93) Durango Water Works has an outstanding issue of preferred stock that has a par (maturity value) of $75.00. The stock, which pays a quarterly dividend of $1.10, will be retired by the firm in 20 years. If the preferred stock is currently selling for $68.00, what is the preferred stock's yield-to-maturity? (Round to the nearest 0.01%.) A) 6.72% B) 5.64% C) 4.28% D) 7.73% Answer: A Explanation: N = 20 × 4 = 80 PV = -$68.00 PMT = $1.10 FV = $75.00 Solve for i = 1.68% × 4 = 6.72% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Measurement 94) Discuss the significance of an active secondary market to both issuers of securities and to investors. Answer: Most secondary market transactions do not directly affect the firm which issues the securities. The presence of a secondary market does, however, affect the issuers indirectly. Simply put, investors will pay a premium price for primary securities that have an active secondary market because most investors do not hold securities forever. With the secondary market, investors will face lower transaction costs and receive a fair price when they sell the securities. Thus, the marketability provided by secondary markets is an important service to the issuers. Financial managers are well aware of the importance of secondary markets for the sale of their firm's primary securities, and as a result, they encourage investment banking firms to establish secondary markets for their securities. The presence of an active secondary market allows firms to sell their new debt or equity issues at a lower funding cost than firms selling similar securities that have no secondary market. From an investor's perspective, the function of secondary markets is to provide marketability for the shares of securities they own at a fair price. Diff: 3 Learning Objective: LO 1 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

95) How do the secondary markets for securities differ across the four types of markets? Answer: The direct search markets are the farthest from our ideal of complete price information and are those markets in which buyers and sellers must seek each other out directly. Securities are bought and sold so infrequently that no third party, such as a broker or dealer, has an incentive to serve the market. The sale of common stock of small private companies and private placement transactions are good examples of direct search markets. This is the least efficient type of secondary market. In broker markets, brokers bring buyers and sellers together to earn a fee, called a commission. Brokers have extensive contacts, who provide them with a pool of price information that individual investors could not economically duplicate themselves. Investors have an incentive to make use of the information by hiring brokers because what brokers charge them as a commission is less than the cost of direct search. In dealer markets, market efficiency is improved by dealers providing continuous bidding (selling or buying) for the security with the help of an inventory of securities that they hold and use to make a profit. The advantage of a dealer over a brokered market is that brokers cannot guarantee that an order will be executed promptly, while dealers can because they have an inventory of securities. NASDAQ is the best-known example of a dealer market in the United States. In an auction market, buyers and sellers confront each other directly and bargain over price. The New York Stock Exchange is the best-known example of an auction market and is also the most efficient equity market in the United States. In the NYSE, the auction for a security takes place at a specific location on the floor of the exchange, called a post. The auctioneer in this case is the specialist, who is designated by the exchange to represent orders placed by public customers. Diff: 3 Learning Objective: LO 1 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

96) Differentiate the characteristics of common and preferred stocks. Answer: Characteristics Common Stock Preferred Stock Ownership of Represents basic ownership claim Represents ownership interest in firm in a corporation the corporation Common stockholders can vote on all important matters that affect the day-to-day operation of the company, such as the election The preferred stockholders have of the board of directors, the no voting privileges in those capital budget decision, or merger matters affecting day-to-day Voting rights or acquisition decisions running the firm Liability of owners Limited liability Limited liability Preferred stockholders are given priority treatment over common stockholders with respect to dividends payments and the Lowest-priority claim on the claims against the firm's assets firm's assets in the event of in the event of bankruptcy or Claim on assets bankruptcy liquidation Owners of common stock are not Preferred dividend payments guaranteed any dividend take precedence over common Dividends payments dividends and are guaranteed Preferred stocks are legally classified as perpetuities Common stocks are perpetuities because they have no maturity, in the sense that they have no although some type of preferred Maturity maturity stock might have a maturity date Diff: 3 Learning Objective: LO 1 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Measurement

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 10 The Fundamentals of Capital Budgeting 1) The goal of the capital budgeting decision is to select capital projects that will decrease the value of the firm. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 2) Capital budgeting decisions, once made, are not easy to reverse because of the huge investments involved. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 3) Capital budgeting plans are made according to the firm's three- to five-year strategic plan. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 4) Most of the information required to make capital budgeting decisions are internally generated, beginning with the sales force. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

5) All capital budgeting projects are independent projects. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 6) When two projects have cash flows that are tied to each other, the projects may be classified as independent. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 7) Projects are classified as independent when their cash flows are unrelated. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 8) When two projects are independent, accepting one project implicitly eliminates the other. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 9) When two projects are mutually exclusive, accepting one project implicitly eliminates the other. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

10) Projects that are classified as contingent could be mandatory or optional projects. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 11) All contingent projects are mandatory projects. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 12) The cost of capital is the maximum return a project can earn. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 13) Capital rationing refers to the limiting of capital resources to underperforming divisions. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 14) The net present value technique is an approach that is inconsistent with the goal of shareholder wealth maximization. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

15) The NPV method determines how much the present value of cash inflows exceeds the present value of costs. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 16) Accepting a positive-NPV project decreases shareholder wealth. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 17) Accepting a positive-NPV project increases shareholder wealth. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 18) Accepting a negative-NPV project increases shareholder wealth. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 19) The discount rate used to determine the present value of future cash flows is the cost of capital. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

20) The payback method is a discounted cash flow technique. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 21) If the payback period for a project exceeds the firm's threshold period, then the project is accepted. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 22) The payback method is consistent with the goal of shareholder wealth maximization. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 23) The discounted payback period calculation calls for the future cash flows to be discounted by a firm's cost of capital. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 24) Unlike the regular payback method, the discounted payback method does not ignore cash flows beyond a firm's threshold period. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 5

25) The accounting rate of return is not a true return because it simply averages numbers from a firm's balance sheet and income statement. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 26) The decision criterion for the accounting rate of return is consistent with the goal of shareholder wealth maximization. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 27) The IRR and NPV decisions are consistent with each other when a project's cash flows follow a conventional pattern. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 28) Unconventional cash flow patterns could lead to conflicting NPV and IRR decisions. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 29) When mutually exclusive projects are considered, both NPV and IRR will always produce the same acceptance decision. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 6

30) When evaluating two projects that require different investments, the IRR does not recognize the difference in the size of the investments. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 31) Which of the following is NOT true about capital budgeting? A) It involves identifying projects that will add to a firm's value. B) It involves investing large amounts of capital. C) It allows a firm to reverse the decision of large capital investments at any time. D) It allows a firm's management to analyze potential business opportunities and decide on which ones to undertake. Answer: C Diff: 3 Learning Objective: LO 1 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 32) Which of the following is a characteristic of independent projects? A) The cash flows are related. B) The cash flows are unrelated. C) Selecting one would automatically eliminate accepting the other. D) Acceptance of one project is contingent on the acceptance of another. Answer: B Diff: 1 Learning Objective: LO 17 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

33) Two projects are considered to be independent if: A) selecting one does not affect whether the other is accepted or not. B) their cash flows are unrelated. C) selecting one does not affect whether the other is accepted or not, and their cash flows are unrelated. D) acceptance of one project is contingent on the acceptance of the other. Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 34) Two projects are considered to be mutually exclusive if: A) the projects perform the same function. B) selecting one would automatically eliminate accepting the other. C) the projects perform the same function, and selecting one would automatically eliminate accepting the other. D) the acceptance of one project is contingent on the acceptance of the other. Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 35) Two projects are considered to be contingent projects if: A) selecting one would automatically eliminate accepting the other. B) the acceptance of one project is dependent on the acceptance of the other. C) rejection of one project does not eliminate the selection of the other. D) their cash flows are unrelated. Answer: B Diff: 1 Learning Objective: LO 17 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

36) Contingent projects would imply that: A) the acceptance of one project is dependent on the acceptance of the other. B) the projects can be either mandatory or optional. C) the acceptance of one project is dependent on the acceptance of the other, and the projects can be either mandatory or optional. D) their cash flow are unrelated. Answer: C Diff: 2 Learning Objective: LO 1, 7 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective Reference 10-1 Use the following to answer the questions below: A construction firm is evaluating two value-adding projects. The first project deals with building access roads to a new terminal at the local airport. The second project is to build a parking garage on a piece of land that the hiring firm owns adjacent to the airport. 37) Refer to Reference 10-1. The firm's decision will be to: A) accept both projects because they are independent projects. B) accept both projects because they are contingent projects. C) pick the one that adds the most value because they are mutually exclusive projects. D) pick neither project. Answer: A Diff: 3 Learning Objective: LO 18 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 38) Refer to Reference 10-1. If both projects are positive-NPV projects, then the firm should: A) accept both projects because they are independent projects. B) select the higher NPV project because they are mutually exclusive. C) accept both projects because they are contingent projects. D) Not enough information is given to make a decision. Answer: A Diff: 3 Learning Objective: LO 1 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

39) The cost of capital is: A) the minimum return that a capital project must earn to be accepted. B) the maximum return a project can earn. C) the return the firm had earned on a previous project. D) not viewed as an opportunity cost. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 40) Capital rationing implies that: A) a firm has constraints to funding all of the available projects. B) funding needs are equal to funding resources. C) the available capital will be allocated equally to all available projects. D) the firm has more resources that it needs. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 41) Capital rationing implies that: A) funding resources exceed funding needs. B) funding needs exceed funding resources. C) funding needs equal funding resources. D) funding resources are not needed. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

42) Which one of the following statements is NOT true? A) Accepting a positive-NPV project increases shareholder wealth. B) Accepting a negative-NPV project has no impact on shareholder wealth. C) Accepting a negative-NPV project decreases shareholder wealth. D) Managers are indifferent about accepting or rejecting a zero NPV project. Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 43) Which one of the following statements is NOT true? A) Accepting a positive-NPV project increases shareholder wealth. B) Accepting a negative-NPV project decreases shareholder wealth. C) Accepting a zero NPV project has a negative impact on shareholder wealth. D) Managers are indifferent about accepting or rejecting a zero NPV project. Answer: C Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 44) When computing the NPV of a capital budgeting project, one should NOT: A) estimate the cost of the project. B) discount the future cash flows over the project's expected life. C) ignore the salvage value. D) make a decision based on the project's NPV. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

45) The net present value: A) uses undiscounted cash flows. B) has a preference for negative values for project acceptance. C) is inconsistent with the shareholder wealth maximization goal. D) will provide a direct measure of how much a firm's value will change because of the capital project. Answer: D Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 46) To accept a capital project when using NPV: A) the project NPV should be less than zero. B) the project NPV should be greater than zero. C) the project NPV should be greater than and less than zero. D) the project NPV should be equal to zero. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 47) Choose the answer below that does NOT describe the circumstances where IRR conflicts with NPV in the decision to accept a project. A) If the sign of the project's cash flows changes more than once during the life of a project. B) When two or more projects are mutually exclusive. C) When two or more projects are independent. D) IRR assumes that all cash flows received during the life of a project are reinvested at the IRR while the NPV method assumes that they are reinvested at the cost of capital rate. Answer: C Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

48) The Cyclone Golf Resorts is redoing its golf course at a cost of $2,744,320. It expects to generate cash flows of $1,223,445, $2,007,812, and $3,147,890 over the next three years. If the appropriate discount rate for the firm is 13 percent, what is the NPV of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $7,581,072 B) $2,092,432 C) $4,836,752 D) $3,112,459 Answer: B Explanation: Initial investment = $2,744,320 Length of project = n = 3 years Required rate of return = k = 13% Net present value = NPV NPV =

= -$2,744,320 +

= -$2,744,320 + $1,082,694.69 + $1,572,411.31 + $2,181,645.68 = $2,092,432 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

49) Cortez Art Gallery is adding to its existing buildings at a cost of $2 million. The gallery expects to bring in additional cash flows of $520,000, $700,000, and $1,000,000 over the next three years. Given a required rate of return of 10 percent, what is the NPV of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $1,802,554 B) $197,446 C) -$1,802,554 D) -$197,446 Answer: D Explanation: Initial investment = $2,000,000 Length of project = n = 3 years Required rate of return = k = 10% Net present value = NPV NPV =

= -$2,000,000 +

= -$2,000,000 + $472,727.27 + $578,512.40 + $751,314.80 = -$197,446 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

50) Johnson Entertainment Systems is setting up to manufacture a new line of video game consoles. The cost of the manufacturing equipment is $1,750,000. Expected cash flows over the next four years are $725,000, $850,000, $1,200,000, and $1,500,000. Given the company's required rate of return of 15 percent, what is the NPV of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $1,169,806 B) $2,919,806 C) $4,669,806 D) $3,122,607 Answer: A Explanation: Initial investment = 1,750,000 Length of project = n = 4 years Required rate of return = k = 15% Net present value = NPV NPV =

= -$1,750,000 +

= $1,750,000 + $630,434.78 + $642,722.12 + $789,019.48 + $857,629.870 = $1,169,806 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

51) Jackson Inc. is considering two mutually exclusive, equally risky projects S and L. Their cash flows are shown below. What is the crossover rate? WACC: 7.50% Year 0 CFS -$1,100 CFL -$2,700

2 $600 $725

3 $100 $800

4 $100 $1,400

$550

$600

$100

Compounded CFs: 683.26 9.5469% CFL -$2,700 $650

693.38 107.50

100

$725

$800

$1,400

Compounded CFs: 807.49 9.6663% Difference -$1,600 $100

837.83 860.00

1,400

$125

$1,300

A) 7.50% B) 9.67% C) 10.16% D) 10.38% Answer: C Explanation: WACC: Year CFS

1 $550 $650

7.5000% 0 MIRR -$1,100

$700

Crossover rate = 10.16%, IRR of the difference in compounded CFs Calculator Solution CF0 = -1,600; CF1 = 100; F1 = 1; CF2 = 125; F2 = 1; CF3 = 700; F3 = 1; Cf4 = 1,300; F4 = 1; CPT IRR = 0.1016 Diff: 3 Learning Objective: LO 2, 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

52) Jackson Inc. is considering two mutually exclusive, equally risky projects S and L. Their cash flows are shown below. The CEO believes the IRR is the best selection criterion, while the CFO advocates for the NPV method. What is the modified IRR (MIRR) for project S? WACC: 7.50% Year 0 1 CFS -$1,100 $550 CFL -$2,700 $650 A) 9.55% B) 9.67% C) 10.05% D) 10.29% Answer: A Explanation: WACC: 7.5000% Year CFS

0 MIRR -$1,100

2 $600 $725

3 $100 $800

4 $100 $1,400

$550

$600

$100

Find the FV using the WACC interest rate for CFs 1-4. Compounded CFs: 683.26 9.5469%

693.38

107.50

100

Calculator Solution: PV = -1,100; PMT = 0; FV = 683.26 + 693.38 + 107.50 + 100 = 1,584.14; N=4; CPT I/Y = 0.095469 Diff: 2 Learning Objective: LO 2, 5 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

53) Gao Enterprises plans to build a new plant at a cost of $3,250,000. The plant is expected to generate annual cash flows of $1,225,000 for the next five years. If the firm's required rate of return is 18 percent, what is the NPV of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $2,875,000 B) $3,830,785 C) $580,785 D) $2,225,875 Answer: C Explanation: Initial investment = $3,250,000 Annual cash flows = $1,225,000 Length of project = n = 5 years Required rate of return = k = 18% Net present value = NPV

NPV =

= -$3,250,000 + $1,225,000 ×

= -$3,250,000 + $3,830,784.50 = $580,785 Financial Calculator Solution to find PV of future cash flows: PMT = 1,225,000; N = 5; I/Y = 18; FV = 0; CPT PV = 3,830,785 Subtract cost of project from the present value of future cash flows. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

54) Jenkins Corporation is investing in a new piece of equipment at a cost of $6 million. The project is expected to generate annual cash flows of $1,850,000 over the next six years. The firm's cost of capital is 20 percent. What is the project's NPV? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $722,604 B) $351,097 C) $152,194 D) $261,008 Answer: C Explanation: Initial investment = $6,000,000 Annual cash flows = $1,850,000 Length of project = n = 6 years Required rate of return = k = 20% Net present value = NPV

NPV =

= -$6,000,000 + $1,850,000 ×

= -$6,000,000 + $6,152,193.72 = $152,194 Financial Calculator Solution to find PV of future cash flows: PMT = 1,850,000; N = 6; I/Y = 20; FV = 0; CPT PV = 6,152,194 Subtract cost of project from present value of future cash flows. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

55) Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the net present value of this project? (Do not round intermediate computations. Round final answer to nearest million dollars.) A) $10 million B) $12 million C) $14 million D) $16 million Answer: C Explanation: Initial investment = $30,000,000 Length of investment = n = 3 years Required rate of return = k = 20% Net present value = NPV NPV =

= -$30,000,000 +

= -$30,000,000 + $10,833,333 + $15,972,222 + $16,782,407 = $13,587,963 = 14 million (rounded) Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

56) Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the net present value of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $645,366 B) $1,213,909 C) $905,888 D) $777,713 Answer: D Explanation: Initial investment = $8,500,000 Length of investment = n = 4 years Required rate of return = k = 16% Net present value = -$8,500,000 + [$2,000,000/1.16] + [3,000,000/(1.16)2] + [$4,000,000/(1.16)3] + [$5,000,000/(1.16)4] = $777,713 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

57) Strange Manufacturing Company is purchasing a production facility at a cost of $21 million. The firm expects the project to generate annual cash flows of $7 million over the next five years. Its cost of capital is 18 percent. What is the net present value of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $890,197 B) $1,213,909 C) $905,888 D) $777,713 Answer: A Explanation: Initial investment = $21,000,000 Length of investment = n = 5 years Annual cash flows = $7,000,000 Required rate of return = k = 18% Net present value = NPV

NPV =

= -$21,000,000 + $7,000,000 ×

= -$21,000,000 + $21,890,197 = $890,197 Financial Calculator Solution to find PV of future cash flows: PMT = 7,000,000; N = 5; I/Y = 18; FV = 0; CPT PV = 21,890,197 Subtract cost of project from present value of future cash flows. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 58) Which of the following is true about the net present value method? A) The NPV does not utilize time value of money concepts. B) The NPV assumes that all cash flows are reinvested at the firm's discount rate. C) The NPV allows projects to be ranked by rate of return. D) The NPV is a rate of return that is acceptable to the firm. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

59) Which of the following statements about the payback method is true? A) The payback method is consistent with the goal of shareholder wealth maximization. B) The payback method represents the number of years it takes a project to recover its initial investment plus a required rate of return. C) There is no economic rational that links the payback method to shareholder wealth maximization. D) The payback method considers the time value of money. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 60) Which one of the following statements about the discounted payback method is FALSE? A) The discounted payback method represents the number of years it takes a project to recover its initial investment accounting for the time value of money. B) The discounted payback method calls for a project to be accepted if the payback period is greater than a target period. C) The discount payback method is a liquidity risk indicator. D) The expected cash flows from a project are discounted at the cost of capital. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 61) Which of the following is an advantage of the payback method? A) The technique is simple for managers to compute and interpret. B) It is a good measure of liquidity risk. C) The technique is simple for managers to compute and interpret, and it is a good measure of liquidity risk. D) The payback method incorporates the time value of money in the calculation. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

62) Which of the following about the payback method is true? A) It considers the time value of money. B) It is consistent with the goal of maximizing shareholder wealth. C) It does not consider the cost of a project. D) It ignores cash flows beyond the payback period. Answer: D Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 63) Binder Corp. has invested in new machinery at a cost of $1,450,000. This investment is expected to produce cash flows of $640,000, $715,250, $823,330, and $907,125 over the next four years. What is the payback period for this project? (Round your answer to two decimal places.) A) 2.12 years B) 1.88 years C) 4.00 years D) 3.00 years Answer: A Explanation: Binder Corp. Year CF Cumulative CF 0 $(1,450,000) $(1,450,000) 1 640,000 (810,000) 2 715,250 (94,750) 3 823,330 728,580 4 907,125 1,635,705 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year) = 2 + ($94,750/$823,330) = 2.12 years Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

64) Elmer Sporting Goods is getting ready to produce a new line of golf clubs by investing $1.85 million. The investment will result in additional cash flows of $525,000, $812,500, and 1,200,000 over the next three years. What is the payback period for this project? (Round your answer to two decimal places.) A) 3.55 years B) 2.43 years C) 1.57 years D) More than 3 years Answer: B Explanation: Elmer Sporting Goods Year CF Cumulative CF 0 $(1,850,000) $(1,850,000) 1 525,000 (1,325,000) 2 812,500 (512,500) 3 1,200,000 687,500 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year) = 2 + ($512,500/$1,200,000) = 2.43 years Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

65) Creighton, Inc. has invested $2,165,800 on equipment. The firm uses payback period criteria of not accepting any project that takes more than four years to recover costs. The company anticipates cash flows of $424,386, $512,178, $561,755, $764,997, $816,500, and $825,375 over the next six years. What is the payback period, and does this investment meet the firm's payback criteria? (Round your answer to two decimal places.) A) 4.13 years; no B) 4.13 years; yes C) 3.87 years; yes D) 3.87 years; no Answer: C Explanation: Creighton Inc. Year CF Cumulative CF 0 $(2,165,800) $(2,165,800) 1 424,386 (1,741,414) 2 512,178 (1,229,236) 3 561,755 (667,481) 4 764,997 97,516 5 816,500 914,016 6 825,375 1,739,391 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year) = 3 + ($667,481/$764,997) = 3.87 years Since the payback period of 3.87 years is less than the decision criteria of 4 years, this project should be accepted. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

66) Kathleen Dancewear Co. has bought some new machinery at a cost of $1,250,000. The impact of the new machinery will be felt in the additional annual cash flows of $375,000 over the next five years. What is the payback period for this project? If its acceptance period is three years, will this project be accepted? (Round your answer to two decimal places.) A) 2.67 years; yes B) 2.67 years; no C) 3.33 years; yes D) 3.33 years; no Answer: D Explanation: Kathleen Dancewear Inc. Year CF Cumulative CF 0 $(1,250,000) $(1,250,000) 1 375,000 (875,000) 2 375,000 (500,000) 3 375,000 (125,000) 4 375,000 250,000 5 375,000 625,000 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year) = 3 + ($125,000/$375,000) = 3.33 years Since the payback period of 3.33 years exceeds the decision criteria of 3 years, this project should be rejected. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

67) Carmen Electronics bought new machinery for $5 million. This is expected to result in additional cash flows of $1.2 million over the next seven years. What is the payback period for this project? If its acceptance period is five years, will this project be accepted? (Round your answer to two decimal places.) A) 4.17 years; yes B) 4.17 years; no C) 3.83 years; yes D) 3.83 years; no Answer: A Explanation: Carmen Electronics Year CF Cumulative CF 0 $(5,000,000) $(5,000,000) 1 1,200,000 (3,800,000) 2 1,200,000 (2,600,000) 3 1,200,000 (1,400,000) 4 1,200,000 (200,000) 5 1,200,000 1,000,000 6 1,200,000 2,200,000 7 1,200,000 3,400,000 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year) = 4 + ($200,000/$1,200,000) = 4.17 years Since the payback period of 4.17 years is less than the decision criteria of 5 years, this project should be accepted. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

68) Roswell Energy Company is installing new equipment at a cost of $10 million. Expected cash flows from this project over the next five years will be $1,045,000, $2,550,000, $4,125,000, $6,326,750, and $7,000,000. The company's discount rate for such projects is 14 percent. What is the project's discounted payback period? (Do not round intermediate computations. Round your answer to one decimal place.) A) 4.2 years B) 4.4 years C) 4.8 years D) 5.0 years Answer: A Explanation: Roswell Energy i = 14% Year CF 0 $(10,000,000) 1 1,045,000 2 2,550,000 3 4,125,000 4 6,326,750 5 7,000,000

PVCF $(10,000,000) 916,667 1,962,142 2,784,258 3,745,944 3,635,581

Cumulative PVCF $(10,000,000) (9,083,333) (7,121,191) (4,336,934) (590,990) 3,044,591

Discounted PB = Years before cost recovery + (Remaining cost to recover/Present value of Cash flow during the year) = 4 + ($590,990/$3,635,581) = 4.16 years or 4.2 years Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

69) Carmen Electronics bought new machinery for $5 million. This is expected to result in additional cash flows of $1.2 million over the next seven years. The firm's cost of capital is 12 percent. What is the discounted payback period for this project? If the firm's acceptance period is five years, will this project be accepted? (Do not round intermediate computations. Round your answer to one decimal place.) A) 5.4 years; no B) 6.1 years; no C) 6.1 years; yes D) 4.2 years; yes Answer: B Explanation: Carmen Electronics i = 12% Year CF PVCF 0 $(5,000,000) $(5,000,000) 1 1,200,000 1,071,429 2 1,200,000 956,633 3 1,200,000 854,136 4 1,200,000 762,622 5 1,200,000 680,912 6 1,200,000 607,957 7 1,200,000 542,819

Cumulative PVCF $(5,000,000) (3,928,571) (2,971,939) (2,117,802) (1,355,181) (674,269) (66,311) 476,508

Discounted PB = Years before cost recovery + (Remaining cost to recover/Present value of Cash flow during the year) = 6 + ($66,311/$542,819) = 6.12 years Since the payback period of 6.12 years exceeds the decision criteria of 5 years, this project should be rejected. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

70) Kathleen Dancewear Co. has bought some new machinery at a cost of $1,250,000. The machinery will result in additional annual cash flows of $375,000 over the next five years. The firm's cost of capital is 10 percent. What is the discounted payback period for this project? If its acceptance period is three years, will this project be accepted? (Do not round intermediate computations. Round your answer to one decimal place.) A) 2.7 years; yes B) 4.7 years; no C) 2.3 years; yes D) 4.3 years; no Answer: D Explanation: Kathleen Dancewear Inc. i = 10% Year 0 1 2 3 4 5

CF $(1,250,000) 375,000 375,000 375,000 375,000 375,000

PVCF $(1,250,000) 340,909 309,917 281,743 256,130 232,845

Cumulative PVCF $(1,250,000) (909,091) (599,174) (317,431) (61,300) 171,545

Discounted PB = Years before cost recovery + (Remaining cost to recover/Present value of Cash flow during the year) = 4 + ($61,300/$232,845) = 4.26 years Since the payback period of 4.3 years exceeds the decision criteria of 3 years, this project should be rejected. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

71) Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the payback period for this project? (Round your answer to one decimal place.) A) 1.7 years B) 2.2 years C) 1.2 years D) 2.7 years Answer: A Explanation: Initial investment = $30,000,000 Length of investment = n = 3 years Turnbull Corp. i = 20.00% Year CF Cumulative CF 0 $(30,000,000) $(30,000,000) 1 13,000,000 (17,000,000) 2 23,000,000 6,000,000 3 29,000,000 35,000,000 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year) = 1 + ($17,000,000/$23,000,000) = 1.74 years or 1.7 years Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

72) Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the payback period for this project? (Round your answer to one decimal place.) A) 2.7 years B) 2.9 years C) 3.1 years D) 3.4 years Answer: B Explanation: Initial investment = $8,500,000 Length of investment = n = 4 years Jamaica Inc. i = 16.00% Year CF Cumulative CF 0 $(8,500,000) $(8,500,000) 1 2,000,000 (6,500,000) 2 3,000,000 (3,500,000) 3 4,000,000 500,000 4 5,000,000 5,500,000 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year) = 2 + ($3,500,000/$4,000,000) = 2.88 years or 2.9 years Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

73) Strange Manufacturing Company is purchasing a production facility at a cost of $21 million. The firm expects the project to generate annual cash flows of $7 million over the next five years. Its cost of capital is 18 percent. What is the payback period for this project? A) 2.8 years B) 3.0 years C) 3.2 years D) 3.4 years Answer: B Explanation: Initial investment = $21,000,000 Length of investment = n = 5 years Annual cash flows = $7,000,000 Strange Manufacturing i = 18.00% Year CF Cumulative CF 0 $(21,000,000) $(21,000,000) 1 7,000,000 (14,000,000) 2 7,000,000 (7,000,000) 3 7,000,000 – 4 7,000,000 7,000,000 5 7,000,000 14,000,000 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year) = 3 + ($0/$7,000,000) = 3.0 years Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

74) You have been asked to analyze a potential project. The project's cost is $180,000. Cash inflows are projected to be: year 1 = $55,000, year 2 = $65,000; year 3 = $75,000; year 4 = $85,500; year 5 = $95,000. What is the investment project's payback? (Round to the nearest 0.1 years.) A) 4.1 years B) 1.6 years C) 3.5 years D) 2.8 years Answer: D Explanation: Payback Method Estimated Cumulative Year Cash Flows Cash Flows 0 ($180,000) (180,000) 1 55,000 (125,000) 2 65,000 (60,000) 3 75,000 15,000 4 85,500 100, 500 5 95,000 195, 500 PB = Years before cost recovery + (Remaining cost to recover/Cash flow during the year = 2 + 60000/75000 = 2.80 Years Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

75) LaGrange Corp. has forecasted that over the next four years the average annual after-tax income will be $45,731. The average book value of the manufacturing equipment that is used is $167,095. What is the accounting rate of return? (Round your answer to one decimal place.) A) 33.3% B) 27.4% C) 29.8% D) 22.3% Answer: B Explanation: Annual after-tax income = $45,731 Average book value of equipment = $167,095 Accounting rate of return = =

= 27.4%

Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 76) Stump Storage Co. is expecting to generate after-tax income of $155,708, $159,312, and $161,112 for each of the next three years. The equipment used will have an average book value of $251,575 over that period. What is the ARR? (Do not round intermediate computations. Round final answer to one decimal place.) A) 65.7% B) 69.4% C) 63.1% D) 66.8% Answer: C Explanation: Average after-tax income = ($155,708 + $159,312 + $161,112)/3 = $158,711 Average book value of equipment = $251,575 Accounting rate of return = =

= 63.1%

Diff: 2 Learning Objective: LO 46 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

77) Which of the following statements about IRR is FALSE? A) The IRR is the discount rate that makes the NPV greater than zero. B) The IRR is a discounted cash flow method. C) The IRR is an expected rate of return. D) The IRR considers the time value of money. Answer: A Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 78) The internal rate of return is: A) the discount rate that makes the NPV greater than zero. B) the discount rate that makes the NPV equal to zero. C) the discount rate that makes the NPV less than zero. D) Both A and C are correct. Answer: B Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 79) When evaluating capital projects, the decisions using the NPV method and the IRR method will agree if: A) the projects are independent. B) the cash flow pattern is conventional. C) the projects are mutually exclusive. D) the projects are independent and the cash flow pattern is conventional. Answer: D Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

80) In evaluating capital projects, the decisions using the NPV method and the IRR method may disagree if: A) the projects are independent. B) the cash flows pattern is conventional. C) the projects are mutually exclusive. D) the cash flows pattern is unconventional. Answer: D Diff: 3 Learning Objective: LO 6 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 81) Which of the following cash flow patterns is NOT an unconventional cash flow pattern? A) A positive initial cash flow is followed by negative future cash flows. B) A cash flow pattern in which there are alternate inflows and outflows. C) A negative initial cash flow is followed by positive future cash flows. D) A cash flow stream looks similar to a conventional cash flow stream except for a final negative cash flow. Answer: C Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

82) Quick Sale Real Estate Company is planning to invest in a new development. The cost of the project will be $23 million and is expected to generate cash flows of $14,000,000, $11,750,000, and $6,350,000 over the next three years. The company's cost of capital is 20 percent. What is the internal rate of return on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 22% B) 20% C) 24% D) 28% Answer: A Explanation: Initial investment = $23,000,000 Length of project = n = 3 years Required rate of return = k = 20% To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR = 21.6%. NPV = 0 =

0 = -$23,000,000 +

= -$23,000,000 + $11,513,158 + $7,946,405 + $3,531,612 = -$8,825 ≅ 0 The IRR of the project is 21.6 percent. Using a financial calculator, we find that the IRR is 21.572 percent. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

83) Modern Federal Bank is setting up a brand-new branch. The cost of the project will be $1.2 million. The branch will create additional cash flows of $235,000, $412,300, $665,000 and $875,000 over the next four years. The firm's cost of capital is 12 percent. What is the internal rate of return on this branch expansion? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 20% B) 23% C) 25% D) 27% Answer: B Explanation: Initial investment = $1,200,000 Length of project = n = 4 years To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR =23.1%. NPV = 0 =

0 = -$1,200,000 +

= -$1.200,000 + $190,902 + $272,080 + $356,490 + $381,045 = $517 ≅ 0 The IRR of the project is 23.1 percent. Using a financial calculator, we find that the IRR is 23.119 percent. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

84) Signet Pipeline Co. is looking to install new equipment that will cost $2,750,000. The cash flows expected from the project are $612,335, $891,005, $1,132,000, and $1,412,500 for the next four years. What is Signet's internal rate of return? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 11% B) 13% C) 15% D) 17% Answer: C Explanation: Initial investment = $2,750,000 Length of project = n = 4 years To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR =15.1%. NPV = 0 =

0 = -$2,750,000 +

= -$2,750,000 + $532,003 + $672,558 + $742,370 + $804,799 = $1,729 ≅ 0 The IRR of the project is 15.1 percent. Using a financial calculator, we find that the IRR is 15.127 percent. Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

85) Casa Del Sol Property Development Company is refurbishing a 200-unit condominium complex at a cost of $1,875,000. It expects that this will lead to expected annual cash flows of $415,350 for the next seven years. What internal rate of return can the firm earn from this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 10% B) 12% C) 14% D) 16% Answer: B Explanation: Initial investment = $1,875,000 Annual cash flows = $415,350 Length of investment = n = 7 years To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR =12.3%.

NPV = 0 =

= -$1,875,000 + $415,350 ×

0 = -$1,875,000 + $1,877,660 = $2,660 ≅ 0 The IRR of the project is 12.3 percent. Using a financial calculator, we find that the IRR is 12.345 percent. Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

86) Lowell Communications, Inc., has been installing a fiber-optic network at a cost of $18 million. The firm expects annual cash flows of $3.7 million over the next 10 years. What is this project's internal rate of return? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 10% B) 12% C) 14% D) 16% Answer: D Explanation: Initial investment = $18,000,000 Annual cash flows = $3,700,000 Length of investment = n = 10 years To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR =15.8%.

NPV = 0 =

= -$18,000,000 + $3,700,000 ×

0 = -$18,000,000 + $18,016,910 = $16,910 ≅ 0 The IRR of the project is 15.8 percent. Using a financial calculator, we find that the IRR is 15.825 percent. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

87) Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the internal rate of return that Turnbull can earn on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 41% B) 42% C) 43% D) 44% Answer: D Explanation: Initial investment = $30,000,000 Length of investment = n = 3 years Since NPV > 0, try IRR > 20%. Try IRR = 43.6%. NPV = 0 =

= -30,000,000 +

= -30,000,000 + $9,052,925+ 11,153,700 + $9,793,427 = $51 ≅ 0 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

88) Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the MIRR on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 36% B) 37% C) 38% D) 39% Answer: A Explanation: PV of costs = $30,000,000 Length of project = n = 3 years Cost of capital = k = 20% TV = CF1(1 + k)n - 1 + CF2(1 + k)n - 2 + ∙∙∙∙∙∙∙∙∙ + CFn(1 + k)n - n = $13,000,000(1.20)2 + $23,000,000(1.20)1 + $29,000,000(1.20)0 = $18,720,000 + $27,600,000 + $29,000,000 = $75,320,000 PVCosts = $30,000,000 = (1 + MIRR)3 =

= 2.5107

(1 + MIRR) = (2.5107)1/3 = 1.3591 MIRR = 0.3591 = 35.9% Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

89) Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the internal rate of return that Jamaica can earn on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 18% B) 19% C) 20% D) 21% Answer: C Explanation: Initial investment = $8,500,000 Length of investment = n = 4 years Since NPV > 0, try IRR > 16%. Try IRR = 19.9%. Net present value = -$8,500,000 + [$2,000,000 / 1.199] + [3,000,000 / (1.199)2] + [$4,000,000 / (1.199)3] + [$5,000,000 / (1.199)4] = -5,202 The IRR of the project is 19.9 percent. Using a financial calculator, we find that the IRR is 19.872 percent. Diff: 2 Learning Objective: LO 58 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

90) Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the MIRR on this project? (Round to the nearest percent.) A) 18% B) 19% C) 20% D) 21% Answer: B Explanation: Initial investment = $8,500,000 Length of investment = n = 4 years Cost of capital = k = 16% TV = CF1(1 + k)n -1 + CF2(1 + k)n -2 + ∙∙∙∙∙∙∙∙∙ + CFn(1 + k)n - n = $2,000,000(1.16)3 + $3,000,000(1.16)2 + $4,000,000(1.16)1 + $5,000,000(1.16)0 = $3,121,792 + 4,036,800 + $4,640,000 + $5,000,000 = $16,798,592 PVCosts = $8,500,000 = (1 + MIRR)4 =

= 1.9763

(1 + MIRR) = (1.9763)1/4 = 1.1857 MIRR = 0.1857 = 18.6% Diff: 2 Learning Objective: LO 58 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

91) Strange Manufacturing Company is purchasing a production facility at a cost of $21 million. The firm expects the project to generate annual cash flows of $7 million over the next five years. Its cost of capital is 18 percent. What is the internal rate of return on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 17% B) 18% C) 19% D) 20% Answer: D Explanation: Initial investment = $8,500,000 Length of investment = n = 4 years Since NPV > 0, try IRR > 18%. Try IRR = 19.9%.

NPV =

= -$21,000,000 + $7,000,000 ×

= -$21,000,000 + $20,980,433 = -$19,567 ≅ 0 The IRR of the project is 19.9 percent. Using a financial calculator, we find that the IRR is 19.858 percent. Diff: 2 Learning Objective: LO 58 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

92) Crossover Point/Rate: Packard Electronics Corp. is evaluating the two mutually exclusive projects shown below. Boundless Corp. Period 0 1 2 3 4 5

Project A Cash Flows $ (100,000) 50,000 40,000 30,000 20,000 10,000

Project B Cash Flows $ (150,000) 15,000 30,000 50,000 70,000 80,000

What is the "crossover rate" of the two projects? (Round to the nearest (0.01%.) A) 10.82% B) 8.24% C) 13.76% D) 16.38% Answer: A Explanation:

Diff: 3 Learning Objective: LO 58 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

93) What difficulties are associated with valuing real assets compared to financial assets? Answer: The valuation of real assets is less straightforward than the valuation of financial assets for several reasons: • First, in many cases, cash flows for financial assets are well documented in a legal contract. If they are not, we are at least able to make some reasonable assumptions about what they are. For real assets, no such information exists. Specialists within the firm, usually from the finance, marketing, and production groups, prepare estimates of future cash flows for the capital project. • Second, many financial securities are traded in public markets, and these markets are reasonably efficient. Thus, market data on rates of return are accessible. For real assets, no such markets exist. As a result, we must look at investors' opportunity cost, the rate of return they give up when they invest in real assets rather than financial assets. We must estimate required rates of return on real assets from market data on financial assets, which can be difficult to do. Diff: 3 Learning Objective: LO 28 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 94) What are the advantages of the net present value technique? Answer: 1. Uses the discounted cash flow valuation technique to adjust for the time value of money. 2. Provides a direct measure of how much a capital project will increase the value of the firm. 3. Consistent with the goal of maximizing stockholder value. Diff: 2 Learning Objective: LO 27 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

95) Explain under what circumstances the NPV and IRR could provide different decisions. Answer: The IRR and NPV methods can produce different accept/reject decisions: • If a project either has unconventional cash flows or the projects are mutually exclusive. Unconventional cash flows could follow several different patterns. It could be a positive initial cash flow followed by negative future cash flows, or both positive and negative cash flows, or a cash flow stream that looks similar to a conventional cash flow stream except for a final negative cash flow. • When you are comparing two mutually exclusive projects, the NPVs of the two projects will equal each other at a certain discount rate. This point at which the NPVs intersect is called the crossover point. Depending on whether the required rate of return is above or below this crossover point, the ranking of the projects will be different. While it is easy to identify the superior project based on the NPV, one cannot do so based on the IRR. Thus, ranking conflicts can arise. • Another situation involves comparing projects with different costs. While IRR gives you a return based on the dollars invested, it does not recognize the difference in the size of the investments. NPV does! Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 11 Cash Flows and Capital Budgeting 1) The term incremental in the context of incremental after-tax free cash flows refers to the fact that the firm's total after-tax free cash flows will change if the new project is not adopted. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 2) Conceptually, free cash flows are what is left over for distribution to creditors and stockholders after the firm has made the necessary investments in working capital and long-term assets. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 3) Incremental cash flow from operations is the cash flow from a project that is expected to be generated after all operating expenses have been paid. Answer: FALSE Diff: 2 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 4) The purchase of a factory building is an example of an incremental addition to working capital. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

5) If a firm expects to increase its investment in inventory due to a prospective project, then this is an example of an incremental capital expenditure. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 6) The stand-alone principle says that we can treat a project as if it were a stand-alone firm that has its own revenue, expenses, and investment requirements. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 7) If you add depreciation and amortization to incremental net operating profits after tax (NOPAT), then you will obtain incremental cash flow from operations. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 8) Free cash flow equals cash flow from operations minus required investments. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 9) Increases in working capital are considered cash flows associated with short term investments. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 2

10) Accounting earnings are a reliable measure of the costs and benefits of a project. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 11) If taken without accompanying changes in cash flow, changes in a company's accounting earnings do not affect the overall value of the firm. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 12) Allocated costs such as corporate overhead should be included in free cash flow calculations. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 13) The impact of a project on another project's free cash flows should be ignored. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 14) Opportunity costs should always be included in a project's projected free cash flow. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

15) The research and development costs to date of a project should be considered when analyzing the cash flows of a prospective project. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 16) Since our perspective when evaluating a project is that of all of the investors in the firm, creditors as well as stockholders, then we should use the pretax cash flows produced by the project. Answer: FALSE Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 17) Since our perspective when evaluating a project is that of the shareholders only, then we should use the after-tax cash flows produced by a project. Answer: FALSE Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 18) BioGeological Pharmaceuticals invested $100 million on a heart drug that does not prevent heart disease. BioGeological has since found that the drug does prevent diabetes. When considering whether to market the drug as a diabetic panacea, the firm should include the $100 million spent while investigating the heart-related effects. Answer: FALSE Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

19) When analyzing a project, if the expected future cash flows are denominated in nominal dollars, then the discount rate should represent a nominal rate as well. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 20) Nominal interest rates do not incorporate the expected rate of inflation. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 21) If the current market price of corn is $100 per bushel and the nominal rate of interest is 10 percent, then the nominal price of corn next period should also be $100. Answer: FALSE Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 22) A progressive tax system means that a taxpayer will pay a higher tax rate for a given dollar of earnings for every successive year. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 23) It is possible for a firm to have one depreciation schedule for tax purposes and another for financial reporting purposes. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 5

24) The MACRS depreciation tax schedule for three-year equipment provides a depreciation rate for a total of three years. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 25) Terminal-year free cash flows may differ from the cash flows provided in the typical year of a project for reasons such as the return/repayment of increases/reductions in additional working capital in the prior years. Answer: TRUE Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 26) If the salvage value is less than the book value of the asset at the time of an asset disposition, then the firm will effectively receive a positive cash flow from taxes on the sale. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 27) The expected cash flows for a project are fixed amounts that have zero variability in the projected values. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

28) The unadjusted NPVs of two projects with different useful lives can be compared to determine which project is the better of the two. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 29) When forecasting operating expenses, analysts distinguish between fixed costs which vary with sales and variable costs which do not. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 30) You own a uranium mine and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your firm is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately if the current NPV of the project is positive. Answer: TRUE Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 31) You own a uranium mine, and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your firm is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately under all circumstances. Answer: FALSE Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

32) The cash flows used in capital budgeting calculations are based on: A) historical estimates. B) forecasts of future cash revenues, expenses, and investment outlays. C) forecasts of net income. D) forecasts of retained earnings available for financing projects. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 33) The NPV of a project includes discounting: A) the expected cash flows of a project in the future. B) only the certain cash flows of a project in the future. C) the variance of the expected cash flows of a project in the future. D) the initial cash outflow. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 34) The ________ is intended to reconcile changes in the balance sheet cash accounts. A) capital budgeting cash flow calculation B) accounting statement of cash flows C) accounting statement of income D) accounting statement of changes in equity Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

35) The term ________ refers to the fact that these cash flows reflect the amount by which the firm's total after-tax free cash flows will change if the project is adopted. A) periodic B) ending cash flows C) incremental D) discounted Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 36) ________ refers to the cash flow that a project is expected to generate after all operating expenses and taxes have been paid. A) Incremental cash flow from operations B) Operating income C) EBITDA D) Net income Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 37) In order to calculate free cash flow by starting with incremental cash flow from operations, we should: A) subtract the incremental capital expenditures and add the incremental additions to working capital. B) add the incremental capital expenditures and the incremental additions to working capital. C) subtract the incremental capital expenditures and the incremental additions to working capital. D) add the incremental capital expenditures and subtract the incremental additions to working capital. Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

38) The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as the: A) stand-alone principle. B) dependent principle. C) independent principle. D) cash flow principle. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 39) The firm's ________ is used to calculate NOPAT because the profits from a project are assumed to be incremental to the firm. A) average tax rate B) marginal tax rate C) lowest marginal tax rate D) highest marginal tax rate Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 40) Additions to tangible assets, intangible assets, and current assets can be described as: A) cash flows associated with investments. B) operating cash flows. C) free cash flows. D) cash flows associated with financing. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

41) The impact of a project on a firm's overall value depends on a: A) firm's accounting earnings. B) firm's cash flows. C) project's cash flows. D) project's duration. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 42) Which of the following should NOT be included in a project's cash flows calculations? A) Cash expenses B) Cash revenues C) Allocated expenses D) Changes in working capital Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 43) In project analysis, corporate overhead allocations should only be taken into account if the: A) firm is currently covering all of its overhead allocations. B) firm is currently unable to cover all of its overhead allocations. C) overhead allocations involve cash expenditures. D) overhead allocations do not involve cash expenditures. Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

44) Brown Mack, Inc., currently has two large manufacturing divisions that share a single plant. Brown Mack owns the plant but has calculated that $6 million of overhead expenses should be allocated to the two equal-sized divisions. If Brown Mack starts a third manufacturing division, of equal size to the other two divisions, what overhead cost should the new division take into account on its capital budgeting cash flow analysis? A) $0 B) $2 million C) $3 million D) $6 million Answer: A Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 45) A firm is considering taking a project that will produce $12 million of revenue per year. Cash expenses will be $5 million, and depreciation expenses will be $1 million per year. The project would also reduce the cash revenues of an existing project by $2 million. What is the free cash flow on the project, per year, if the firm is in the 40 percent marginal tax rate? A) $2.4 million B) $3.4 million C) $4.6 million D) $5.0 million Answer: B Explanation: Revenue $12,000,000 Cash exp (5,000,000) Depreciation exp (1,000,000) Lost revenue (2,000,000) Pretax income $ 4,000,000 Less taxes 1,600,000 Net income $ 2,400,000 Add Depreciation 1,000,000 Free Cash Flow $ 3,400,000 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

46) Whenever a project has a negative impact on an existing project's cash flows, then that effect should: A) be ignored. B) be ignored if the project is evaluated using the correct cost of capital. C) be included as a negative revenue amount on the new project's cash flow analysis. D) be included if the impact is limited to noncash expenditures. Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 47) If Company X has the option of leasing some factory space to Company Y or utilizing it for another product line, how should Company X handle the lost lease payments on the factory space if it chooses the product line? A) Ignore it. B) Include it as an opportunity cost. C) Include half of it as additional revenue for the project. D) Include all of it as additional revenue for the project. Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 48) Which of the following is the best example of a sunk cost? A) Future payments on a leased building B) Future research and development costs C) Historical research and development costs D) Historical noncash expenses Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

49) ________ represent dollars stated in terms of constant purchasing power. A) Nominal dollars B) Real dollars C) Inflated dollars D) Constant dollars Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 50) If inflation is anticipated to be 10 percent during the next year while a nominal rate of 20 percent will be earned on U.S. Treasury bills, what is the accurate real rate of return on these securities? (Round final percentage answer to decimal places.) A) 20.05% B) 10.01% C) 9.09% D) 20.0% Answer: C Explanation: 1 + k = (1 + △ Pe) × (1 + r) 1 + 0.2 = (1 + 0.1) × (1 + r) 1.0909 = 1 + r 0.0909 = r Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

51) If the real return on U.S. Treasury bills is 14 percent while the rate of expected inflation is 8 percent, then what should nominal rate of return be? (Round final percentage answer to decimal places.) A) 14.05% B) 33.05% C) 23.12% D) 5.55% Answer: C Explanation: 1 + k = (1 + △ Pe) × (1 + r) 1 + k = (1 + 0.08) × (1 + 0.14) 1 + k = 1.2312 k = 0.2312 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 52) If you are discounting a project's cash flows using the nominal cost of capital, then that means that you have taken the ________ into account. A) real rate of return B) expected rate of inflation C) real rate of return and the expected rate of inflation D) real rate of return or the expected rate of inflation Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 53) A tax system in which taxpayers pay a progressively larger share of their income in taxes as their income rises is called: A) a flat tax system. B) a progressive tax system. C) a digressive tax system. D) a political tax system. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

54) For a U.S. C-corporation with a flat federal tax, the average federal tax rate is: A) less than the marginal tax rate. B) equal to the marginal tax rate. C) greater than the marginal tax rate. D) either less than or greater than the marginal tax rate. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 55) When compared to the straight-line depreciation method, MACRS has: A) a greater proportion of its depreciation early in the life of the asset. B) a lesser proportion of its depreciation early in the life of the asset. C) an equal proportion of its depreciation early in the life of the asset. D) either a greater or lesser proportion of its depreciation early in the life of the asset. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 56) In order for a project to generate a positive net working capital cash flow at the end of its useful life, the project: A) must have generated a cumulative negative cash flow during the life of the project. B) must have generated a cumulative positive cash flow during the life of the project. C) must have generated a cumulative negative cash flow at the conclusion of the project. D) could not have generated a positive cash flow at the opening of the project. Answer: A Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

57) When deciding to select one project or another where the projects have different useful lives, you could utilize: A) a repeated investment analysis to decide which project is better for the firm. B) a net present value analysis to compare each project without adjusting for the different useful lives of the projects because it is not applicable. C) payback period calculations to make a decision. D) an internal rate of return analysis which is preferred over an equivalent annual annuity analysis. Answer: A Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 58) Windy Burgers is trying to determine when to harvest a herd of cows that it currently owns. If it harvests the herd in year 1, the NPV of the project would increase over an immediate harvest by 25 percent. A year 2 harvest would create an NPV increase of 15 percent over that of year 1 and year 3 would create an NPV increase of 7 percent over that of year 2. If the cost of capital is 12 percent for Windy, then which harvest year would maximize the NPV for the firm? Assume that all NPVs are calculated from the perspective of today. A) Harvest immediately. B) Harvest in year 1. C) Harvest in year 2. D) Harvest in year 3. Answer: C Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

59) Stillwater Drinks is trying to determine when to harvest the water from the fountain of youth that it currently owns. If it harvests the water in year 1, the NPV of the project would increase over an immediate harvest by 18 percent. A year 2 harvest would create an NPV increase of 12 percent over that of year 1 and year 3 would create an NPV increase of 8 percent over that of year 2. If the cost of capital is 17 percent for Stillwater, then which harvest year would maximize the NPV for the firm? Assume that all NPVs are calculated from the perspective of today. A) Harvest immediately. B) Harvest in year 1. C) Harvest in year 2. D) Harvest in year 3. Answer: B Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 60) The proper time to harvest an asset is when the percentage NPV increase of harvesting a project at a future point in time is at the last date where the increase is: A) greater than the cost of capital. B) less than the cost of capital. C) 10 percent greater than the cost of capital. D) equal to the cost of capital. Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 61) Norman, Inc., is considering two mutually exclusive projects. Project A is a six-year project with a NPV of $3,000 and Project B is a four-year project with an NPV of $2,278. Project A has an equivalent annual cash flow of $730 and Project B has an equivalent annual cash flow of $750. Which project should the firm select? A) Choose Project A because it has the higher NPV. B) Choose Project B because it has the lower NPV. C) Choose Project B because it has the higher equivalent annual cash flow. D) Choose Project A because it has the lower equivalent annual cash flow. Answer: C Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 18

Reference 11-1 Use the following to answer the questions below: Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2020. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent. 62) Refer to Reference 11-1. Free cash flow: What is Provo's cash flow from operations for 2020? A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Answer: C Explanation: Provo, Inc. Revenue $10,000,000 - Operating Ex 5,000,000 EBITDA $ 5,000,000 - D&A 1,000,000 EBIT $ 4,000,000 - Taxes 1,600.000 NOPAT $ 2,400,000 + D&A 1,000,000 CF Opns $ 3,400,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

63) Refer to Reference 11-1. Free cash flow: What is Provo's free cash flow for 2020? A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Answer: B Explanation: Provo, Inc. Revenue $10,000,000 - Operating Ex 5,000,000 EBITDA $ 5,000,000 - D&A 1,000,000 EBIT $ 4,000,000 - Taxes $1,600,000 NOPAT $ 2,400,000 + D&A 1,000,000 CF from Operations $ 3,400,000 - Capital Expenditures $500,000 + Add WC 300,000 ________ FCF $ 2,600,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 64) Refer to Reference 11-1. Free cash flow: What is Provo's NOPAT for 2020? A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Answer: A Explanation: Provo, Inc. Revenue $10,000,000 - Operating Ex 5,000,000 EBITDA $ 5,000,000 - D&A 1,000,000 EBIT $ 4,000,000 - Taxes $1,600,000 NOPAT $ 2,400,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

65) Refer to Reference 11-1. Free cash flow: What is Provo's cash flows associated with investments for 2020? A) $300,000 B) $500,000 C) $800,000 D) $1,000,000 Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective Reference 11-2 Use the following to answer the questions below: Champagne, Inc., had revenues of $12 million, cash operating expenses of $8 million, and depreciation and amortization of $1.5 million during 2020. The firm purchased $700,000 of equipment during the year while increasing its inventory by $500,000 (with no corresponding increase in current liabilities). The marginal tax rate for Champagne is 30 percent. 66) Refer to Reference 11-2. Free cash flow: What is Champagne's cash flow from operations for 2020? A) $2,050,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Answer: C Explanation: Champagne, Inc. Revenue $12,000,000 - Operating Ex 8,000,000 EBITDA $ 4,000,000 - D&A 1,500,000 EBIT $ 2,500,000 - Taxes 750,000 NOPAT $ 1,750,000 + D&A 1,500,000 CF from Operations $ 3,250,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

67) Refer to Reference 11-2. Free cash flow: What is Champagne's free cash flow for 2020? A) $2,050,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Answer: A Explanation: Champagne, Inc. Revenue $12,000,000 - Operating Ex 8,000,000 EBITDA $ 4,000,000 - D&A 1,500,000 EBIT $ 2,500,000 - Taxes 750,000 NOPAT $ 1,750,000 + D&A 1,500,000 CF from Operations $ 3,250,000 - Capital Expenditures $700,000 - Add WC 500,000 FCF $ 2,050,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 68) Refer to Reference 11-2. Free cash flow: What is Champagne's NOPAT for 2020? A) $1,750,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Answer: A Explanation: Champagne, Inc. Revenue $12,000,000 - Operating Ex 8,000,000 EBITDA $ 4,000,000 - D&A 1,500,000 EBIT $ 2,500,000 - Taxes 750,000 NOPAT $ 1,750,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

69) Refer to Reference 11-2. Free cash flow: What are Champagne's cash flows associated with investments for 2020? A) $500,000 B) $700,000 C) $1,200,000 D) $1,700,000 Answer: C Explanation: Cash flows associated with investments equal the purchase of tangible and intangible assets as well as increases in working capital. Therefore, the cash flows associated with investments equal $700,000 + $500,000 = $1,200,000. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 70) Marginal and average tax rates: Use the tax rate taken from the table below to calculate the total taxes paid for Lansing, Inc., this year. Lansing's pretax income was $275,000. U.S. Corporate Tax Rate Schedule in 2019 Taxable Income More But Not Than More Than Tax Owed $0 $50,000 15% of amount beyond $0 $50,000 $75,000 $7,500 + 25% of amount beyond $50,000 $75,000 $100,000 $13,750 + 34% of amount beyond $75,000 $100,000 $335,000 $22,250 + 39% of amount beyond $100,000 $335,000 $10,000,000 $113,900 + 34% of amount beyond $335,000 $10,000,000 $15,000,000 $3,400,000 + 35% of amount beyond $10,000,000 $15,000,000 $18,333,333 $5,150,000 + 38% of amount beyond $15,000,000 $18,333,333 ------35% on all income A) $22,500 B) $68,250 C) $90,500 D) $107,250 Answer: C Explanation: From the instruction in the table, we can see that the tax bill should be equal to $22,250 + 0.39 × ($275,000 - $100,000) = $22,250 + $68,250 = $90,500 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

71) Marginal and average tax rates: Use the tax rate taken from below to calculate the average tax rate for Lansing, Inc., this year. Lansing's pretax income was $275,000. (Round final answer to nearest whole percent.)

More Than $0 $50,000 $75,000 $100,000 $335,000 $10,000,000 $15,000,000 $18,333,333

U.S. Corporate Tax Rate Schedule in 2019 Taxable Income But Not More Than Tax Owed $50,000 15% of amount beyond $0 $75,000 $7,500 + 25% of amount beyond $50,000 $100,000 $13,750 + 34% of amount beyond $75,000 $335,000 $22,250 + 39% of amount beyond $100,000 $10,000,000 $113,900 + 34% of amount beyond $335,000 $15,000,000 $3,400,000 + 35% of amount beyond $10,000,000 $18,333,333 $5,150,000 + 38% of amount beyond $15,000,000 ------35% on all income

A) 8.0% B) 25.0% C) 32.9% D) 39.0% Answer: C Explanation: From the instruction in the table, we can see that the tax bill should be equal to $22,250 + 0.39 × ($275,000 - $100,000) = $22,250 + $68,250 = $90,500. We see that the taxes due are $90,500 and with pretax income of $275,000, we then have an average tax rate of $90,500/$275,000 = 32.90%. Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

72) Computing the terminal-year FCF: Miles Cyprus Corp. purchased a truck that currently has a book value of $1,000. If the firm sells the truck for $5,000 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 30 percent marginal tax rate? A) $1,200 B) $3,800 C) $4,000 D) $5,000 Answer: B Explanation: The gain on the sale was $5,000 - $1,000 = $4,000 Taxes on the gain are: $4,000 × 0.3 = $1,200 Net cash flow from the sale is $5,000 - $1,200 = $3,800 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 73) Computing the terminal-year FCF: Babaloo Nightclubs purchased a disco mirror that currently has a book value of $10,000. If Babaloo sells the disco mirror for $500 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 39 percent marginal tax rate? A) $500 B) $3,705 C) $4,205 D) $9,500 Answer: C Explanation: The loss on the sale was $10,000 - $500 = $9,500 The tax refund on the loss is: $9,500 × 0.39 = $3,705 Net cash flow from the sale is $500 + $3,705 = $4,205 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

74) Expected cash flows: Fire Rock Wheel Corp is evaluating a project in which there is a 40 percent probability of revenues totaling $3 million and a 60 percent probability of revenues totaling $1 million per year. Its cash expenses will be $1.0 million while depreciation expense will be $200,000; then what is the expected free cash flow from taking the project if the marginal tax rate for the firm is 30 percent? A) $200,000 B) $420,000 C) $600,000 D) $620,000 Answer: D Explanation: Expected revenue = 0.4(3,000,000) + 0.6(1,000,000) = $1,800,000 Expected revenue $1,800,000 - Cash Expenses 1,000,000 - Depreciation Expense 200,000 EBIT $ 600,000 - Tax 180,000 NI $ 420,000 + Depreciation Expense 200,000 FCF $ 620,000 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

75) Projects with different lives: Your firm is deciding whether to purchase a durable delivery vehicle or a short-term vehicle. The durable vehicle costs $25,000 and should last five years. The short-term vehicle costs $10,000 and should last two years. If the cost of capital for the firm is 15 percent, then what is the equivalent annual cost for the best choice for the firm? (Round final answer to nearest whole dollar.) A) $5,000, either vehicle B) $5,000, short-term vehicle C) $6,151, short-term vehicle D) $7,458, long-term vehicle Answer: C Explanation: EAC = kNPV

EACdurable = 0.15 ($25,000)

, therefore the

= $7,457.89

EACshort-term = 0.15 ($10,000)

= $6,151.16, since we are analyzing costs, we

should choose the lowest cost per year, which is the short-term vehicle. Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

76) Projects with different lives: Your firm is deciding whether to purchase a high-quality printer for your office or one of lesser quality. The high-quality printer costs $40,000 and should last four years. The lesser quality printer costs $30,000 and should last three years. If the cost of capital for the firm is 13 percent, then what is the equivalent annual cost for the best choice for the firm? Round to the nearest dollar. A) $10,000, either printer B) $10,000, lesser quality printer C) $12,706, lesser quality printer D) $13,448, high-quality printer Answer: C Explanation: EAC = kNPV

EACdurable = 0.13 ($40,000)

, therefore the

= $13,447.77

EACshort-term = 0.13 ($30,000)

= $12,705.66, since we are analyzing costs,

we should choose the lowest cost per year, which is the lesser quality printer. Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

77) When to harvest an asset: Cleveland Millicrum is considering when to harvest its moldy bread supply for antibiotics. It has calculated that the current NPV dollars for harvesting the bread are increasing according to the following schedule. When should the firm harvest the bread? The cost of capital for the firm is 14 percent. NPV increase if harvested next year over that of harvesting now is 25% NPV increase if harvested year 2 over that of harvesting year 1 is 20% NPV increase if harvested year 3 over that of harvesting year 2 is 17% NPV increase if harvested year 4 over that of harvesting year 3 is 13% NPV increase if harvested year 5 over that of harvesting year 4 is 10% A) Harvest now B) Harvest year 2 C) Harvest year 3 D) Harvest year 4 Answer: C Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

78) When to harvest an asset: Farmer Ag owns a special species of cotton-producing plant that, if left unharvested, grows a bigger bowl of cotton through time. The NPV, at the beginning of the year that harvesting takes place, is as follows. When should Farmer Ag harvest its cotton? Assume a discount rate of 14 percent. NPV1 = $50,000 NPV2 = $60,000 NPV3 = $69,000 NPV4 = $77,280 NPV5 = $85,008 A) Harvest now B) Harvest in year 1 C) Harvest in year 2 D) Harvest in year 3 Answer: D Explanation: NPV1 = $50,000 ===> NPV0,1 = $50,000/(1.14) = $43,860 NPV2 = $60,000 ===> NPV0,2 = $60,000/(1.14)2 = $46,168 NPV3 = $69,000 ===> NPV0,3 = $69,000/(1.14)3 = $46,573 NPV4 = $77,280 ===> NPV0,4 = $77,280/(1.14)4 = $45,756 NPV5 = $85,008 ===> NPV0,5 = $85,008/(1.14)5 = $44,150 The current NPV is maximized with a harvest at year 3. Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

79) When to replace an asset: Nemo Haulers is considering whether to purchase a new mini tractor for moving furniture within its warehouse. Nemo calculates that its current mini tractor generates $3,100 of cash flow per year. A new mini tractor would cost $3,000 and would provide cash flow of $4,000 per year for five years. What is the equivalent annual cash flow for the new mini tractor (round to the nearest dollar), and should Nemo purchase the new tractor? Assume the cost of capital for Nemo is 10 percent. A) $3,000, do not purchase the new tractor B) $3,209, purchase the new tractor C) $4,000, purchase the new tractor D) $12,163, purchase the new tractor Answer: B

Explanation: NPV = -$3,000 + $4,000 × 0 = -$3,000 + $15,163 = $12,163 EAC = kNPV

= 0.1 × ($12,163) ×

= $3,209

Since this is greater than the annual cash flow of $3,100 produced by the old tractor, the new tractor should be purchased. Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

80) When to replace an asset: Burt's Pizzas is considering whether to purchase an oven. Burt's calculates that its current oven generates $4,000 of cash flow per year. A new oven would cost $15,000 and would provide cash flow of $6,000 per year for six years. What is the equivalent annual cash flow for the new oven (round to the nearest dollar), and should Burt's purchase the new oven? Assume the cost of capital for Burt's is 12 percent. A) $2,352, do not purchase the oven B) $6,000, purchase the oven C) $9,668, purchase the oven D) $24,668, purchase the oven Answer: A

Explanation: NPV = - $15,000 + $6,000 × 0 = -$15,000 + $24,668 = $9,668 EAC = kNPV

= 0.12 × ($9,668) ×

= $2,352

Since this is less than the annual cash flow of $4,000 produced by the old oven, the new oven should not be purchased. Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

81) The cost of using an existing asset: Small Appliances, Inc., is considering starting a new line of business with the excess capacity it currently has on its rivet machine. The current machine is expected to last four years at the current rate of production. However, if a new line of business is taken on, then the machine will have to be replaced in three years instead of four. A new machine that will last four years would cost $50,000. What is the cost of taking on the new line of business? Round to the nearest dollar and assume a 9 percent cost of capital. A) $11,917 B) $12,500 C) $15,433 D) $50,000 Answer: A Explanation: The EAC for the new machine is EAC = kNPV

= 0.09 × ($50,000) ×

= $15,433.43

Now the firm would have to economically incur this additional equivalent cost in year 3. Therefore, the present value of that cost is = $11,917.44 Diff: 3 Learning Objective: LO 5 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 82) Which of the following statements is correct? A) Incremental net operating profits after-tax should include sunk costs associated with a project. B) Incremental net operating profits after-tax should include the effects of financing costs associated with a project. C) Incremental net operating profits after-tax should exclude the effects of depreciation costs associated with a project. D) Incremental net operating profits after-tax should exclude the effects of financing costs associated with a project. Answer: D Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

83) Which of the following statements is true? A) The calculation of free cash flow does not include the impact of income taxes. B) Accounting earnings are an unreliable measure of the costs and benefits of a project. C) The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as the incremental principle. D) Depreciation expense should not be included in the calculation of incremental net operating profits after-tax. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 84) General Mills is undertaking an analysis on a new cereal. The firm realizes that if they come out with a new product, it would affect sales of existing products. What is the best course of action for General Mills in this analysis? A) Treat the reduction of sales from existing cereals as a sunk cost. B) Account for the reduction of sales from existing cereals in the projection of cash flows on the new product. C) Include the allocated costs of the new cereal in the sales of the pre-existing products. D) Ignore the fact that sales of other products will be affected. Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

85) Operating Cash Flow: Premier Steel, Inc. is considering the purchase of a new machine for $100,000 that has a useful life of 3 years. The firm's cost of capital is 11.0 percent and the tax rate is 40 percent. This machine will be sold for its salvage value of $20,000 at the end of 3 years. The machine will require an investment of $2,500 in spare parts inventory upon installation. The machine will cost $8,000 to ship and $4,000 to install and modify it. Sales are as follows: year 1 = $90,000; year 2 = $97,500; year 3 = $105,000. Operating expenses are year 1 = $25,000; year 2 = $27,000; year 3 = $29,000. The investment in working capital will be liquidated at termination of the project at the end of year 3. MACRS Rates 33% 45% 15% 7% Using MACRS, what is the operating cash flow in year 1? A) $53,784 B) $35,238 C) $86,999 D) $42,512 Answer: A Explanation:

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

86) Average versus Marginal Tax Rate: Suppose Franklin Corporation had pretax income of $300,000 in 2020 and that the firm would have paid $100,250.00 in federal income taxes. What is Franklin's average income tax rate? (Round to the nearest 0.1%.) A) 39.0% B) 34.7% C) 33.4% D) 38.6% Answer: C Explanation: Average Tax Rate =

= 0.3342, or 33.4%

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 87) Which of the following should NOT be included in a schedule of cash flows from operations when evaluating a capital project? A) Fixed costs B) Sunk costs C) Depreciation and amortization D) Variable costs Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 88) Which of the following is an example of a fixed cost? A) Cost of equipment purchased for an assembly line to be used in the production of a new product B) Assembly costs associated with the production of a new product C) Labor costs associated with the production of a new product D) Shipping costs associated with the sale of a new product Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective

89) Your firm is evaluating the merits of several different machines. Machine A has a useful life of 5 years, generates an NPV of $53,250, an IRR of 13.6 percent and an equivalent annual cost of $10,316. Machine B has a useful life of 3 years, an NPV of $61,051, an IRR of 12.5 percent, and an equivalent annual cost of $9,724. Machine C has a useful life of 4 years, generates an NPV of $55,225, an IRR of 15.2 percent and an equivalent annual cost of $7,535 Machine D has a useful life of 7 years, generates an NPV of $64,020, an IRR of 11.4 percent and an equivalent annual cost of $8,885. Which machine should be purchased and why? A) Machine C, because it has the highest IRR B) Machine D, because it has the highest NPV C) Machine A, because it has the most positive EAC D) Machine B, because it has the shortest useful life Answer: C Diff: 3 Learning Objective: LO 4 Bloomcode: Evaluation AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

90) Equivalent Annual Cost: Your firm is considering an investment that will cost $750,000 today. The investment will produce cash flows of $250,000 in year 1, $400,000 in year 2, and $600,000 in year 3. The discount rate that your firm uses for projects of this type is 11.75 percent. What is the investment's equivalent annual cost? (Round to the nearest whole dollar.) A) $163,613 B) $225,008 C) $68,888 D) $92,845 Answer: D Explanation:

PV = $223,960; N = 3, I% = 11.75%; Thus PMT (EAC) = $92,845 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

91) When is the appropriate time to harvest an asset? A) That point in time where harvesting the asset yields the largest internal rate of return B) That point in time where harvesting the asset yields the smallest payback C) That point in time where harvesting the asset yields the largest accounting rate of return D) That point in time where harvesting the asset yields the largest net present value Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 92) Briefly explain the two methods of comparing projects with different useful lives. Answer: The first method involves analytically rolling over each project until the two projects have the same number of years in each. It is similar to finding a common denominator when adding fractions. For instance, if one was comparing a two-year and a three-year project, then one could roll the two-year project over two more times until it is a six-year project. At the same time one would roll over the three-year project one more time until it is a six-year project. Once the two projects are both six-year projects, then the NPV of each of the new adjusted projects can then be calculated so that the highest adjusted NPV project would be selected. The second method is called the equivalent annual cost (EAC) method. Using the two projects mentioned above with this method, each project's unadjusted NPV is divided by the appropriate present value interest factor of an annuity

to arrive at the EAC for the project. The project with the greatest positive value should be selected. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

93) Explain why in practice the cash flows associated with a project are not certain cash flows. Answer: The projected cash flows on a project are in fact based on estimates of cash flows in different scenarios that might develop over the future. In a best-case scenario those cash flows are derived from some probability-based distribution of outcome that will influence either the revenues or expenses, or both, involved in a project. In short, since the cash flows are projections about the future, which is by definition ripe with uncertainty, the projections cannot be 100 percent free of prediction error. Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 94) Why is depreciation and amortization added back when calculating free cash flows generated by a project? Answer: Depreciation and amortization are noncash expenses. Since we are interested in the cash flow produced by a project or a firm, then that means that the general income statement approach to calculating profitability has "over" deducted the expenses from a cash perspective. Since this over-deduction helps to reduce the firm's tax bill, it becomes necessary to add back the noncash expenses after taxes have been deducted from the income stream. Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 12 Evaluating Project Economics 1) Total variable costs for a firm do not vary directly with the number of units sold. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 2) A project with a higher proportion of fixed costs will have cash flows and accounting profits that are more sensitive to changes in revenues than an identical project with a lower proportion of fixed costs. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 3) Another term for pretax operating cash flow is EBIT. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 4) Distinguishing between fixed and variable costs will enable one to calculate the sensitivity of EBITDA to changes in revenue. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

5) The sensitivity of EBITDA to changes in revenue is higher than EBIT. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 6) Depreciation and amortization can be considered a fixed cost of the firm for accounting breakeven purposes. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 7) Operating leverage is a measure of the sensitivity of net income to changes in revenue. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 8) The degree of pretax cash flow operating leverage will change as the levels of revenue change. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

9) If a firm's degree of accounting operating leverage is 1.12, then a 10 percent increase in revenue should result in a 12.0 percent increase in EBIT. Answer: FALSE Explanation: 1% increase in revenue will increase the EBIT by 1.12%. For a 10% increase in revenue, it will increase the EBIT by 10 × 1.12=11.2%. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 10) Tunemony Craft has a degree of accounting operating leverage of 1.2. If EBIT increases by 24 percent, then the firm must have had a 20 percent increase in revenue if no other changes were involved. Answer: TRUE Explanation: 1% increase in revenue will increase the EBIT by 1.2 percent. If EBIT increases by 24 percent, the firm must have had a 24/1.2 = 20 increase in revenue. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 11) If The Tower of Pizza has a cash flow degree of operating leverage equal to 1.15, then a 20 percent increase in revenue should drive a 35 percent increase in pretax operating cash flow. Answer: FALSE Explanation: 1% increase in revenue will increase the pretax operating cash flow of EBITDA by 1.15 percent. Therefore, a 20 percent increase in revenue will drive a (1.15 × 20 =) 23 percent increase in pretax operating cash flow. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 12) Taxes do not enter into the equation for the degree of cash flow of operating leverage because both fixed costs and pretax operating cash flows are measured on a pretax basis. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 3

13) If there is no uncertainty regarding costs, volatility in pretax operating cash flows and accounting operating profits will be driven entirely by changes in revenue and operating leverage. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 14) Operating profits and operating cash flow describe the same item. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 15) A firm with zero fixed costs will have a degree of cash flow operating leverage equal to one. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 16) An increase in the proportion of a project's costs that are fixed will increase the degree of operating leverage for that project. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 17) Break-even analysis tells us how many units must be sold in order for a project to break even on a cash flow or an accounting basis. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 4

18) If a project fails to break even from a pretax operating cash flow perspective, then the firm is going to put more cash into the project to keep it going. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 19) The pretax operating cash flow (EBITDA) break-even point is the number of units that have to be sold in order to cover total fixed cost expenses. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 20) The per-unit contribution is defined as sales price less its total variable cost. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 21) The crossover level of unit sales is the level at which one fixed/variable cost combination of production will begin to generate higher levels of operating cash flows than another fixed/variable cost combination of production. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

22) The crossover level of unit sales can be calculated for any two project alternatives that employ the same level of operating leverage. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 23) The accounting operating profit (EBIT) break-even point is the numbers of units that must be sold to avoid an accounting operating loss. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 24) The accounting operating profit break-even points are smaller than the corresponding pretax operating cash flow break-even points for a project when costs are positive. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 25) An economic break-even point is the number of units that must be sold each year during the life of the project so that the difference of present value of cash inflows and cash outflows is one. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

26) The economic break-even point considers a single year rather than the entire life of the project. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 27) The economic break-even point focuses on the cash flows or profits from operations rather than after-tax free cash flows associated with the project. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 28) The NPV of a project will equal $0 when the present value of the annual FCFs from the project, equals the present value of net nonrecurring investments. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 29) An analysis in which a firm investigates the effect of a price change on the NPV of a project, holding all other variables and forecasts constant, is one type of sensitivity analysis. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

30) If a firm knows that a price change will have an effect on a number of other forecast variables, such as the sales forecast, then the firm might perform scenario analysis rather than sensitivity analysis. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 31) Within a simulation analysis, the firm will need to come up with some assumptions on the distribution of forecast inputs, such as the mean and variance of the sales forecast. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 32) Simulation analysis has the benefit of providing a pinpoint accurate forecast of a project's NPV. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 33) Sensitivity analysis involves examining the sensitivity of the output from an analysis, such as the NPV, to changes in individual assumptions. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

34) The economic break-even point focuses on the after-tax free cash flows associated with the project for its entire life. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 35) EBITDA stands for: A) earnings before interest, taxes, and amortized depreciation. B) earnings before interest, taxes, depreciation, and amortization. C) earnings before interest and taxes. D) earnings before interest, taxes, dividend, and accrued expenses. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 36) Revenue minus variable and fixed costs is best described by: A) EBIT. B) EBITDA. C) NOPAT. D) EAT. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 37) Another name for EBITDA is: A) pretax operating cash flow. B) accounting operating cash flow. C) net income before tax. D) net income after tax. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 9

38) Compared to an identical project with a lower proportion of fixed costs, a project with a higher proportion of fixed costs will have: A) a higher degree of sensitivity of EBITDA to a change in revenues. B) a lower degree of sensitivity of EBITDA to a change in revenues. C) no discernible difference of a change in sensitivity of EBITDA to a change in revenues. D) a stable net income stream as a function of revenues. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 39) If a firm is planning to operate in an environment in which there will be a great deal of variability in the level of revenues, then the firm should: A) structure its costs to have high fixed costs and higher total variable costs. B) structure its costs to have high fixed costs and consequently lower per unit variable costs. C) structure its costs to have low fixed costs and consequently higher per unit variable costs. D) leave the cost structure unchanged. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 40) The degree of pretax cash flow operating leverage provides us with a measure of how sensitive: A) pretax operating cash flows are to changes in revenue. B) accounting operating profits are to changes in revenue. C) NOPAT is to changes in tax rates. D) accounting operating profits are to changes in tax rates. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

41) ________ is a measure of the sensitivity of EBITDA or EBIT to changes in revenue. A) Total leverage B) Financial leverage C) Operating leverage D) Combined leverage Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 42) Depreciation and amortization are treated like fixed costs: A) in the calculation of the degree of pretax cash flow operating leverage. B) in the calculation of the degree of accounting operating leverage. C) for cash flow purposes. D) for computing a dividend. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 43) If the degree of accounting operating leverage is 1.3 for a firm, then a 10 percent increase in revenue should drive a: A) 12% increase in pretax operating cash flows. B) 13% increase in EBIT. C) 30% increase in EBIT. D) 1.3% increase in pretax operating cash flows. Answer: B Explanation: 1.3 × 10 = 13% increases in EBIT. Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

44) Which of the following statements is true? A) The degree of pretax cash flow operating leverage does not vary with different levels of revenue. B) The higher the proportion of fixed costs to variable costs in a project, the greater the sensitivity of pretax operating cash flows to changes in revenue. C) Depreciation and amortization are deducted to get pretax operating cash flows. D) The lower the proportion of fixed costs to variable costs in a project, the more pretax operating cash flows will vary as revenue varies. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 45) The higher a project's operating leverage: A) the lower the sensitivity of EBIT to changes in revenue. B) the greater the sensitivity of EBITDA to changes in revenue. C) the lower the sensitivity of net profit to changes in variable costs. D) the greater the sensitivity of net profit to changes in variable costs. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 46) Which is the term used to define how many units must be sold for pretax operating cash flow to be equal to zero? A) Pretax accounting operating profit break-even point B) Pretax operating financial leverage break-even point C) Pretax accounting sensitivity break-even point D) Pretax operating cash flow break-even point Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

47) Which of the following differentiates accounting operating profit break-even point from pretax operating cash flow break-even point? A) Accounting operating profit break-even point includes interest expense in the numerator, whereas pretax operating cash flow does not. B) Pretax operating cash flow break-even point includes income taxes in the denominator, whereas accounting operating profit break-even point does not. C) Accounting operating profit break-even point includes depreciation & amortization in the numerator, whereas pretax operating cash flow does not. D) Pretax operating cash flow break-even point includes interest expense in the numerator, whereas accounting operating profit break-even point does not. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 48) The economic break-even point is the number of units that must be sold each year during the life of a project so that the NPV of that project equal to: A) $0. B) $1. C) the present value of cash inflows. D) the present value of investment. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 49) The difference between revenue and variable cost is called: A) total contribution. B) net profit. C) EBIT. D) EAT. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

50) Which of the following statements is true of the economic break-even point? A) It is the number of units that must be sold for accounting operating profit to equal $0. B) It is the level of unit sales at which cash flows or profitability for one project alternative switches from being lower than that of another alternative to being higher. C) It is the number of units that must be sold each year during the life of a project so that the NPV of a project equals $0. D) It is the number of units that must be sold for pretax operating cash flow to be $0. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 51) Sancore Inc. decided to invest in a project costing $35,000. It is assumed that all of $8,000 working capital will be recovered at the end of the project, which is four years. The opportunity cost of capital is 10%. Compute the present value of net nonrecurring investment of the project. (Do not round intermediate calculation, but round the final answer to the nearest dollar.) A) $36,713 B) $40,464 C) $46,713 D) $35,657 Answer: B Explanation: PV(Net Nonrecurring Investments) = $35,000 + $8,000/(1.1)4 = $35,000 + $5,464.11 = $40,464 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 52) Astroscope Tours finds that if it were to increase its price by 10 percent, it would have a 6 percent reduction in the NPV of its new 3-Hour Tour. Assuming other things are unchanged, Astroscope's analysis could be described as a: A) Monte Carlo simulation. B) break-even analysis. C) sensitivity analysis. D) variance analysis. Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 14

53) If a firm were interested in knowing the effect of a single input change on the net present value of a project, then the firm would most likely want to perform: A) a Monte Carlo simulation. B) a scenario analysis. C) a sensitivity analysis. D) a break-even analysis. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 54) If a firm were interested in finding the effect of a change in the variable cost per unit of production on the net present value of a project, then the firm might perform: A) a sensitivity analysis. B) a scenario analysis. C) a Monte Carlo simulation. D) a cash flow simulation. Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 55) Which of the following describes the effect of changes in sets of interrelated variables? A) A sensitivity analysis B) A scenario analysis C) A Monte Carlo simulation D) A horizontal analysis Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

56) A firm is considering the effect of high inflation and low inflation environments on a project. In the high inflation environment, the price and costs per unit will be affected. If the lowinflation environment is considered as the baseline, then the analysis concerning the high inflation environment could be considered: A) a sensitivity analysis. B) a scenario analysis. C) a Monte Carlo simulation. D) a horizontal analysis. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 57) Scenario analysis can help a firm to: A) understand the degree of uncertainty that a different set of circumstances affecting a project may hold. B) eliminate all of the uncertainty that a different set of circumstances affecting a project may hold. C) transform a risky project into a risk-free project. D) understand the degree of certainty that a similar set of circumstances affecting a project may hold. Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 58) If a project has an 80 percent probability of high demand and a 20 percent probability of low demand, then the expected value of the net present value under two different demand assumptions would give us a weighted average net present value for the project. Such an analysis is called: A) a sensitivity analysis. B) a scenario analysis. C) a simulation analysis. D) a horizontal analysis. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 16

59) An analysis in which each of the inputs and assumptions for a project takes on a separate assumed distribution whereby a computer draws on each of those inputs and assumed distributions to create a distribution for the NPV of the entire project is called: A) a sensitivity analysis. B) a scenario analysis. C) a simulation analysis. D) a horizontal analysis. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 60) Ottomony is considering an all-in-one retail center where the expected value of the NPV of the project has a distribution that yields a standard deviation of $25 million. Ottomony came to this conclusion by analyzing the individual input distributions for the project. This analysis is called: A) a sensitivity analysis. B) a scenario analysis. C) a simulation analysis. D) a horizontal analysis. Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 61) If a firm is interested in determining the distribution of the NPV for a project that it is considering, then the firm should be most interested in performing: A) a sensitivity analysis. B) a scenario analysis. C) a simulation analysis. D) a horizontal analysis. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

62) Which of the following mathematical expressions is used to calculate the degree of pretax cash flow operating leverage? A) 1 + (FC/EBITDA) B) 1 + (FC/EBIT) C) 1 + [(FC + Depreciation and Amortization)/EBITDA] D) 1 + [(FC + Depreciation and Amortization)/EBIT] Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 63) Which of the following project risk analyses is best able to analyze the effect of a change of a single input, holding other inputs constant, on the NPV of a project? A) Sensitivity analysis B) Scenario analysis C) Simulation analysis D) Horizontal analysis Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 64) Which of the following project risk analyses is best able to analyze the effect of a change of a single set of circumstances, with other correlated inputs, on the change in NPV of a project? A) Sensitivity analysis B) Scenario analysis C) Simulation analysis D) Contribution analysis Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

65) A change in the price of a product sold by a firm usually involves less units sold and a change in the product's cost structure. If a firm were interested in the entire price change effect on the project's NPV, then it would conduct: A) sensitivity analysis. B) scenario analysis. C) simulation analysis. D) contribution analysis. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 66) An analytical method that uses a computer to quickly examine a large number of scenarios and obtain probability estimates for various values in a financial analysis is known as: A) risk analysis. B) credit analysis. C) capital structure analysis. D) simulation analysis. Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 67) Which of the following mathematical expressions is used to calculate the degree of accounting operating leverage? A) 1 + (FC/EBITDA) B) 1 + (FC/EBIT) C) 1 + [(FC + Depreciation and Amortization)/EBITDA] D) 1 + [(FC + Depreciation and Amortization)/EBIT] Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

68) Sparran Craft had sales of $2.24 million last year for which the total cost was $2 million. If the firm had fixed costs of $600,000 on sales of 56,000 books, what is the firm's per-unit contribution? (Round the final answer to the nearest whole dollar.) A) $20.00 B) $19.00 C) $15.00 D) $10.00 Answer: C Explanation: Unit sales = 56,000 units Sales = $2,240,000 Total fixed costs = $600,000 Total variable costs = Total costs -Total fixed costs = $2,000,000 - $600,000 = $1,400,000 Unit variable costs = $1,400,000/56,000 = $25.00 per unit Sale price/unit = $2,240,000/56,000 = $40 per unit Unit contribution margin = $40.00 - $25.00 = $15.00 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 69) Oeta Works has a degree of pretax cash flow operating leverage of 1.25. If the firm's EBITDA was $1,000 last year while its depreciation and amortization expense was $50 in the same year, what was the firm's degree of accounting operating leverage? A) 1.26 B) 1.30 C) 1.32 D) 1.35 Answer: C Explanation: Degree of pretax cash flow operating leverage = 1 + 1.25 = 1 +

⇒ FC = $250

Degree of accounting operating leverage = 1 +

= 1.315789 ≈ 1.32

Degree of accounting operating leverage = 1 + Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 20

70) Synthgration has a degree of pretax cash flow operating leverage equal to 1.266. If the firm's EBITDA was $1,500 last year while its depreciation and amortization expense was $100 in the same year, what was the firm's degree of accounting operating leverage? A) 1.29 B) 1.33 C) 1.36 D) 1.39 Answer: C Explanation: Degree of pretax cash flow operating leverage = 1 + 1.266 = 1 +

⇒ FC = $399

Degree of accounting operating leverage = 1 +

= 1.35642857 ≈ 1.36

Degree of accounting operating leverage = 1 + Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

71) Mussubsound Audotec Inc. had EBIT of $1,850 last year with fixed costs equal to $500 (depreciation and amortization not included) and depreciation and amortization equal to $150. What was Mussubsound Audotec's degree of accounting operating leverage? A) 1.25 B) 1.35 C) 1.38 D) 1.40 Answer: B Explanation: Degree of accounting operating leverage = 1 + =1+ =1+ = 1.35 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 72) Dupaudio Inc. had EBITDA of $3,000 and EBIT of $2,750, with fixed cash expense of $600 last year. What was Dupaudio's degree of accounting operating leverage? A) 1.20 B) 1.25 C) 1.28 D) 1.31 Answer: D Explanation: EBITDA = $3,000 and EBIT = $2,750 ==> D&A = $250 Degree of accounting operating leverage = 1 + =1+ =1+ = 1.31 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 22

73) Metkia Inc. had a degree of accounting operating leverage equal to 1.841 during the most recent period. If the firm's EBITDA was $4,800 and depreciation and amortization was equal to $600, what was Metkia's fixed cash expenses during the same period? (Round your answer to the nearest whole dollar.) A) $1,548 B) $2,932 C) $2,324 D) $2,886 Answer: B Explanation: Degree of accounting operating leverage = 1 + Degree of accounting operating leverage = 1 +

= 1.841 = 1.841

FC = $2,932 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 74) Ergotone Audio had a degree of accounting operating leverage equal to 1.60 during the most recent period. If the firm's EBITDA was $3,000 and its cash fixed costs were equal to $1,250, what was Ergotone 's depreciation and amortization expense during the same period? (Round the final answer to the nearest whole dollar.) A) $344 B) $507 C) $377 D) $404 Answer: A Explanation: Degree of accounting operating leverage = 1 + Degree of accounting operating leverage = 1 +

= 1.60 = 1.60

Depreciation and amortization = $344 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

75) Resoneffect Inc. has a degree of pretax cash flow operating leverage equal to 1.12. If the firm's EBITDA was $2,000 last year while its depreciation and amortization expense was $150 in the same year, what was the firm's degree of accounting operating leverage? (Round the final answer to two decimal places.) A) 1.09 B) 1.21 C) 2.09 D) 2.18 Answer: B Explanation: Degree of pretax cash flow operating leverage = 1 + 1.12 = 1 +

= FC = $240

Degree of accounting operating leverage = 1 +

≈ 1.21

Degree of accounting operating leverage = 1 + Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

76) Silevector has a degree of pretax cash flow operating leverage equal to 1.341. If the firm's EBITDA was $2,500 last year while its depreciation and amortization expense was $200 in the same year, what was the firm's degree of accounting operating leverage? (Do not round the intermediate calculations. Round your final answer to two decimal places) A) 2.54 B) 1.96 C) 1.46 D) 2.39 Answer: C Explanation: Degree of pretax cash flow operating leverage = 1 + 1.341 = 1 + FC = $852.50 Degree of accounting operating leverage = 1 +

Degree of accounting operating leverage = 1 +

= 1.46

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 77) Treguard Inc. has total fixed costs of $8,500 per month. It sells rib plates for $15 each and the variable cost of providing each plate is $10. What is the pretax operating cash flow breakeven point for Treguard? A) 567 plates B) 1,700 plates C) 1,900 plates D) 1,622 plates Answer: B Explanation: EBITDABreak-Even =

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

= 1,700 plates

78) SileCuatro has produced 22,000 tins in a year. The pretax operating cash flow (EBITDA) break-even point is 22,000 tins. If the fixed costs for the product is $1,500,000 and the variable cost per tin are $298, what price can SileCuatro charge per tin if the firm needs to break even on a pretax operating cash flow basis? (Round to nearest whole dollar.) A) $366 B) $298 C) $268 D) $372 Answer: A Explanation: EBITDABreak-even = 22,000 = Price = $366 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 79) AchtTre has found that its pretax operating cash flow break-even number of glasses sold is 550,000 pairs. If each pair is sold for $15 and the variable cost per unit is $10, what is the amount of AchtTre's fixed costs? A) $887,000 B) $1,558,000 C) $2,750,000 D) $1,582,000 Answer: C Explanation: EBITDABreak-even = 550,000 = FC = $2,750,000 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

80) Ranbow Inc. is about to introduce a new LED clock and has determined that it will charge $35 per clock. The firm must decide whether or not to purchase a high-capacity clock-making machine. If the high-capacity machine is selected, the fixed costs for the firm will be $4,000 per year, with variable costs of $6 per clock. A low-capacity clock-making machine alternative has the fixed costs of $800, and variable costs of $16 per clock. Above what level of expected sales should Ranbow Inc. choose the high-capacity clock-making machine alternative to maximize pretax operating cash flow? A) 320 units B) 352 units C) 3,200 units D) 500 units Answer: A Explanation: COEBITDA = = = 320 units Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

81) Dreiphosis Corp. is in the process of determining whether to purchase a high-capacity machine to make textbooks for the upcoming school year. The high-capacity machine will generate fixed costs of $12,000 per year versus the $3,000 fixed costs of using a low-capacity machine. The variable costs per unit when using the high-capacity machine will be $33. The firm will charge $66 for each textbook and has determined that the high-capacity machine will maximize pretax operating cash flow if sales are greater than 1,000 books. What is the contribution margin under the low-capacity machine scenario? A) $41 B) $24 C) $32 D) $46 Answer: B Explanation: COEBITDA = 1,000 = Unit ContributionAlt 2 = $24 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

82) ElecHuit Inc. is in the process of determining whether to purchase a high-capacity machine to make textbooks for the upcoming school year. The high-capacity machine will generate fixed costs of $11,000 per year versus the $2,500 fixed costs of using a low-capacity machine. The variable costs per unit when using the high-capacity machine will be $32. The firm will charge $62 for each textbook and has determined that the high-capacity machine will maximize pretax operating cash flow if sales are greater than 850 books. What is the variable cost per unit under the low-capacity machine scenario? A) $25 B) $42 C) $35 D) $89 Answer: B Explanation: COEBITDA = 850 = Unit ContributionAlt 2 = $20 VClow capacity = $62 - $20 = $42 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

83) A cement contractor has determined that he will maximize pretax operating cash flow buying a large cement truck if he is able to sell more than 550 yards of cement per month. The price of a yard of cement is $62, and the variable costs for a large truck are $22 per yard. The variable costs for a small truck are $44 per yard, and the fixed costs for the small truck are $12,000. What are the fixed costs associated with the large truck? A) $20,000 B) $12,000 C) $24,100 D) $35,000 Answer: C Explanation: COEBITDA = =

= 550 yards

FCAlt1 = $24,100 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 84) CoTres's Brakes is introducing a new revolutionary vehicle brake pad that will never wear out. CoTres's will sell the pads for $150 a pair and they will cost $100 in variable costs to produce. If cash fixed expenses are $2,500 per year and the depreciation and amortization expenses are $900 per year, what is the accounting operating profit break-even point for the company? A) 86 pairs B) 28 pairs C) 57 pairs D) 68 pairs Answer: D Explanation: EBITBreak-even = =

= 68 pairs

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

85) Mexmagnet is introducing a new game system that promises to never become outdated. Mexmagnet will sell the systems for $225, and it will accrue $150 in variable costs to produce. If cash fixed expenses are $30 million per year and the depreciation and amortization expenses are $7.5 million per year, what is the accounting operating profit break-even point for Mexmagnet? A) 621,000 units B) 415,077 units C) 200,000 units D) 500,000 units Answer: D Explanation: EBITBreak-even = = = 500,000 units Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 86) EpicSept is about to introduce a new employee monitoring tool which it will sell for $100 per unit. The firm must decide whether or not to purchase a high-capacity manufacturing machine. If the high-capacity machine is selected, then the cash fixed costs will be $5,000 per year, with variable costs of $50 per unit and depreciation and amortization expenses of $2,000. Otherwise, the fixed costs will be $2,000, with variable costs of $75 per unit and depreciation and amortization expenses of $500 for a low-capacity manufacturing machine. If EBIT Breakeven is how the firm evaluates its projects, above what level of expected sales should EpicSept choose the high-capacity manufacturing machine? A) 60 units B) 90 units C) 120 units D) 180 units Answer: D Explanation: COEBIT = = = 180 tools Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 31

87) Sechssonic has found that it is indifferent between purchasing a high-capacity vacuum sealing machine or a lower capacity machine as long as sales are 200 units per month. The price of each final product is $50. The high-capacity machine has fixed cash expenses of $10,000 per month, while the low capacity alternative has fixed cash expenses of $5,000 per month and depreciation and amortization expenses of $2,000 per month. Under high capacity, the variable costs per unit are $10; and they are $40 for the other alternative. If the firm bases its decisions on the accounting operating profit break-even, what are the depreciation and amortization expenses under the high-capacity alternative? A) $3,000 B) $4,000 C) $9,000 D) $5,000 Answer: A Explanation: COEBIT =

= 200 units

D & AAlt1 = $3,000 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

88) SeptSeven has found that it is indifferent between purchasing a high-capacity vacuum component assembly machine or a lower capacity machine as long as sales are 1,900 units per month. The price of each final product is $70. The high-capacity machine has fixed cash expenses of $100,000 per month and depreciation and amortization expenses of $30,000 per month, while the alternative has fixed cash expenses of $30,000 per month and depreciation and amortization expenses of $5,000 per month. Under the low-capacity alternative, variable costs per unit are $60. If the firm bases its decisions on the accounting operating profit break-even, what is the variable cost per unit under the high-capacity alternative? A) $10 B) $47 C) $60 D) $70 Answer: A Explanation: COEBIT =

= 1,900 units ⇒

= Unit ContribAlt 1 = $60 ⇒ Unit VC = $70 - $60 = $10 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

89) OutCinq manufactures snow boards. The firm has fixed costs of $1,500,561. The snow boards sell for $235 each and have a variable cost of $92 each. What is the pretax operating cash flow break-even point for OutCinq? (Round to the nearest unit) A) 9,566 units B) 10,493 units C) 11,565 units D) 6,565 units Answer: B Explanation: EBITDABreak-even = = = 10,494 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 33

90) Cino Inc. earned revenue of $560,000 and depreciation and amortization for the year was $50,000. The company sells its product to customers at a price of $100. Further, the financial statement reveals that the EBIT for the year was $80,000. The variable cost for each unit is $60. What is the amount of fixed cost that leads to the EBIT as provided in the financial statement? A) $88,000 B) $90,000 C) $94,000 D) $105,000 Answer: C Explanation: EBIT = Revenue - VC - FC - D & A $80,000 = $560,000 - ($60 × 5,600 units) - FC - $50,000 FC = $94,000 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 91) The management of Dior Corp. is planning to invest in a machine which has a four-year life. The initial investment of the project is $8,000, the annual addition to working capital is equal to $4,000. The fixed cost would be $4,000. The unit contribution margin is $15. The firm's marginal tax rate is 35%. The present value of net nonrecurring investments would be $18,928. FCFt is $5,971. Compute the economic break-even point. (Round your intermediate calculation to whole dollar amount and final answer to the nearest whole unit.) A) 1,218 units B) 1,305 units C) 1,280 units D) 1,880 units Answer: A Explanation: EBITt = (FCFt - D&At + Cap Expt + Add WCt ) ÷ (1 - t) = ($5,971 - $2,000 + $0 + $4,000) ÷ (1 - 0.35) = $12,263 Revenuet - VCt = EBITt + D&At + FCt = $12,263 + $2,000 + $4,000 = $18,263 Economic Break-Event = (Revenue - VC) / Unit contribution = $18,263/$15 = 1,218 units Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

92) Soleon, Inc. had the following financial data for the fiscal year ending September 30, 2021. Sales Depreciation and amortization Fixed costs Earnings before interest and taxes

$1,937,813 $70,657 $132,456 $564,441

Calculate the firm's degree of pretax cash flow operating leverage during fiscal 2021. A) 1.21 B) 1.46 C) 1.17 D) 1.85 Answer: A Explanation: Degree of Pretax Operating Leverage = 1 + = 1 + FC/EBITDA =1+ = 1.21 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

93) Briefly explain the difference between the degree of pretax cash flow operating leverage and the degree of accounting operating leverage. Also explain why someone might be interested in one or the other. Answer: The formulas for the two are as follows: Degree of pretax cash flow operating leverage = 1 + Degree of accounting operating leverage = 1 + The degree of pretax cash flow operating leverage measures the sensitivity of cash flow from operations (EBITDA) to changes in revenue, while the degree of accounting operating leverage measures the sensitivity of accounting operating profits (EBIT) to changes in revenue. The degree of pretax cash flow operating leverage, therefore, considers pretax operating cash flows (EBITDA), while the degree of accounting operating leverage considers accounting operating profits (EBIT). Since the difference between EBITDA and EBIT is depreciation and amortization, it is apparent that the accounting method considers a measure of pretax income that has depreciation and amortization removed from the starting point. However, since pretax cash flow does not include noncash items, such as depreciation and amortization, it does not consider those items. If a firm is replacing depreciated assets, then the accounting method might actually serve as a good measure of pretax cash flow. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives 94) Briefly discuss the advantages of knowing the economic break-even point. Answer: The economic break-even point accounts for both taxes and investments associated with the project, hence it is a more comprehensive measure. The economic break-even point helps a financial manager to assess the overall economic viability of a project. This measure tells the manager how low unit sales can get before a project decreases stockholders' value. Diff: 2 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

95) Discuss the differences between scenario analysis and sensitivity analysis. Answer: Sensitivity analysis is an examination of the sensitivity of the results from a financial analysis to changes in individual assumptions. Scenario analysis is an analytical method that concerned with how the results from a financial analysis will change under alternative scenarios. In sensitivity analysis, an analyst might examine how a project's NPV changes if there is a decrease in the value of individual cash inflow assumptions or an increase in the value of individual cash outflow assumptions. A scenario analysis helps in examining how the attractiveness of the project might vary under different economic scenario. To perform a sensitivity analysis, an input variable is changed one at a time to determine the effect on an output variable. On the other hands, a scenario analysis can be conducted where a set of related input variables can be changed to determine the effect on an output. Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Business Economics AICPA: Global and Industry Perspectives

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 13 The Cost of Capital 1) Systematic risk is the only risk that investors require compensation for bearing. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 2) Using a firm's overall cost of capital to evaluate a project's cash flows is problematic in that the firm is a collection of projects, with the possibility that each project has a different level of risk than the other projects. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3) The balance sheet item is based on market values, just like the accounting balance sheet. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 4) If the market value of a firm's assets is greater than the book value of its assets, then the market value of the firm's liabilities and equity must also be greater than the book value of the firm's liabilities and equity. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

5) The beta of a firm is equal to the weighted average of the betas of the individual projects that the firm is currently undertaking. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6) Due to the effect of diversification, the risk associated with the assets of a firm must be less than the risk associated with the financing methods such as debt and equity that a firm is utilizing to finance its assets. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 7) A firm is currently taking on two projects with an individual cost of capital of 10 percent and 12 percent for each of the projects. This means that the before-tax cost of capital for the firm must be between 10 and 12 percent. Answer: FALSE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 8) If a firm finances the purchase of an asset with cash, then it has zero financing cost to the firm. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

9) If one observes the market quoted price of a debt security with a certain maturity where the expected cash flows of that security are known, then one can calculate the current cost of that security to the firm. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 10) Long-term debt typically describes debt that will mature longer than one year. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 11) Long-term debt is generally viewed as a permanent financing source for a firm. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 12) With respect to the cost of capital, we are generally interested in the current cost of a source of financing. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 13) The historical cost of long-term debt is the appropriate cost of debt for WACC calculations. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3

14) Milton Corp. issued bonds 10 years ago with a coupon rate of 10 percent at a price of $1,000. The current price of the bonds is $980. The before-tax cost of the debt to the firm is still 10 percent. Answer: FALSE Explanation: $1,000 FV, 10 N, 100 PMT, -$980 PV, CPT I/Y 10.33% Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 15) The yield to maturity for an annual coupon paying bond will always be equal to the coupon rate. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 16) The yield to maturity is the discount rate that makes the present value of coupon and principal payments equal to the price of the bond. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 17) The current cost of bank debt of a firm can be determined by asking the firm's banker. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

18) If a firm is subject to income taxes, then the after-tax cost of debt for the firm will be less than the before-tax cost of debt. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 19) The issuance costs of new debt securities can be ignored since those costs will not be reflected in the yield to maturity of the debt in the future. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 20) Utilizing the CAPM to estimate the cost of capital for a project is difficult in practice because analysts do not have the stock returns from individual projects that can be used in a regression analysis for estimating a project's beta. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 21) Estimates of expected returns based on market security prices will be reliable in all types of markets, including those deemed less efficient than others. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

22) The cost of equity for a firm must take the cost of preferred stock that the firm has outstanding into account. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 23) The appropriate Treasury rate to use in calculating the cost of equity for a firm based on CAPM is a short-term rate. Answer: FALSE Diff: 2 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 24) When trying to estimate the cost of equity for a firm using the CAPM, it is possible to find the beta of a comparable, publicly traded firm whose primary business is closely related to the firm. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 25) The market risk premium for the future is always perfectly known, and it is 6.51 percent. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

26) If a firm is currently paying common share dividends to investors and those dividends are expected to grow at a low but steady rate in the future, then the cost of common equity for the firm can be calculated by using the current price of the firm's common stocks. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 27) The current cost of preferred equity can be found by taking the ratio of the annual dividend on the preferred stock to the current price of preferred stocks. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 28) The CAPM can only be used to determine the cost of common equity. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 29) The proportions of debt and equity used to determine the weighted average cost of capital for a firm is based on the market values of debt and equity outstanding. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

30) The weighted average cost of capital for a firm when correctly calculated can be used to discount the cash flows for any new project that the firm may undertake in the future. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 31) The estimated cost of capital the financial manager uses for efficiency projects tends to be higher than the cost of capital used to evaluate new projects. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 32) When using a single rate, such as the WACC, to discount cash flows for all projects of a particular company without considering the varying degree of risks, the discount rate could lead to accepting projects that will actually have negative NPVs. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 33) If a company's weighted average cost of capital is less than the required return on equity, then the firm: A) is financed with more than 50 percent debt. B) is perceived to be safe. C) has debt in its capital structure. D) must have preferred stock in its capital structure. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

34) Firms have no way to directly estimate the discount rate that reflects the risk of: A) a publicly traded security. B) its debt securities. C) the incremental cash flows from a particular project. D) None of these are correct. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 35) A firm's overall cost of capital is: A) less than its cost of debt. B) a weighted average of the costs of capital for the collection of individual projects that the firm is currently undertaking. C) best measured by the cost of capital of the riskiest projects that the firm is working on. D) None of these are correct. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 36) The finance balance sheet is: A) the same as the accounting balance sheet, but it is based on market values. B) the same as the accounting balance sheet, but it does not have to balance. C) based on cash rather than accrual accounting. D) the same as the accounting balance sheet, but it is based on historical values. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

37) The value of the cash flows that the assets of a firm are expected to generate must equal: A) the value of the cash flows claimed by the equity holders. B) the value of the cash flows claimed by the debt holders. C) the value of the cash flows claimed by both the equity holders and debt holders. D) the revenue produced by the firm. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 38) The beta for a firm can be estimated by: A) adding up the betas of the firm's individual projects. B) taking the weighted average of the betas for the firm's individual projects. C) taking the simple average of the betas for the firm's individual projects. D) None of these are correct. Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 39) A firm can be viewed as: A) a portfolio of individual projects with their own risks, cost of capital, and returns. B) a collection of equity shares used to finance the firm. C) a collection of debt instruments used to finance the firm.. D) a portfolio of all individual projects in the industry with its own risks, cost of capital, and returns. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

40) In order for a firm to estimate its cost of debt from observing the price of its debt instruments, the: A) firm must depend on markets being reasonably efficient. B) debt must be privately held by the firm. C) beta of the debt must be greater than the beta of the firm's equity. D) None of these are correct. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 41) If markets are not reasonably efficient, then: A) the estimates of expected returns are not needed. B) the need for a discount rate to analyze project cash flows is not needed. C) the estimates of expected returns based on security prices will not be reliable. D) None of these are correct. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 42) When estimating the cost of debt for a firm, we are primarily interested in: A) the weighted average cost of capital. B) the cost of long-term debt. C) the coupon rate of the debt. D) None of these are correct. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

43) Long-term debt typically describes: A) debt with a maturity greater than one year. B) coupon debt only. C) publicly traded debt. D) None of these are correct. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 44) Which of the following need to be excluded from the calculation of a firm's amount of permanent debt? A) Long-term debt B) Revolving lines of credit C) Mortgage debt D) None of these are correct Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 45) When analyzing a firm's cost of debt, we are typically interested in: A) the cost of the debt on the date that the analysis is being completed. B) the coupon rate on the firm's bonds. C) the cost of the debt and cost of preferred stock on the date that the analysis is being completed. D) None of these are correct. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

46) If a firm has bonds outstanding and the firm would like to calculate its current cost of debt, then the firm would: A) use the coupon rate of the bonds to estimate the cost. B) use the current yield to maturity of the bonds to estimate the cost. C) use the current yield of the bonds to estimate the cost. D) None of these are correct. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 47) A bond has a coupon rate of 6 percent and the bond makes semiannual coupon payments. The dollar amount of coupon interest received every six months is: A) $60. B) $30. C) $30 plus or minus the prorated portion of the discount or premium that the bond was purchased for. D) $60 plus or minus the prorated portion of the discount or premium that the bond was purchased for. Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 48) Bond issuance costs include: A) investment banking fees. B) legal fees. C) accountant fees. D) All of these are correct. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

49) Income taxes have the effect of: A) increasing the cost of debt for a firm. B) decreasing the cost of debt for a firm. C) decreasing the cost of equity for a firm. D) decreasing both the cost of debt and equity for a firm. Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 50) Bellamee, Inc. has semiannual bonds outstanding with five years to maturity, and the bonds are priced at $920.87. If the bonds have a coupon rate of 7 percent, then what is the YTM for the bonds? Round your final percentage answer to one decimal place. A) 4.5% B) 7.0% C) 9.0% D) 9.2% Answer: C Explanation: Semiannual coupon payment = $1,000 × 7% ÷ 2 = $35 The semiannual YTM can be calculated as 4.5 percent by entering the following data in a financial calculator. PMT = 35, PV = -920.87, FV = 1,000, N = 10 Hence, the YTM = 2 × 4.5% = 9% Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

51) Dynamo Corporation has semiannual bonds outstanding with 12 years to maturity, and the bonds are currently priced at $1,080.29. If the bonds have a coupon rate of 8 percent, then what is the equivalent annual return (EAR) to the investor for purchasing the bonds at the stated price? Round your final percentage answer to two decimal places. A) 3.5% B) 7.00% C) 7.12% D) 8.00% Answer: C Explanation: Using the formula for pricing bonds, we have $1,080.29 = $40 × PVIFA(YTM / 2,24) + $1,000 × PVIF(YTM / 2,24) and after solving for YTM / 2 = 3.5%, we find that YTM = 7.0%. or Using BA II Plus PMT = 40, PV = -1,080.29, FV = 1,000, N = 24 Hence, the YTM = 2 × 3.5% = 7% Note that we assume semiannual coupons for the bond. Now, we adjust for EAR

- 1 = 0.0712 = 7.12%

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

52) Beckham Corporation has semiannual bonds outstanding with 13 years to maturity and the bonds are currently priced at $746.16. If the bonds have a coupon rate of 8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 35 percent? Round your intermediate calculation to two decimal places and the final percentage answer to three decimal places. A) 6.250% B) 8.125% C) 12.500% D) 12.890% Answer: B Explanation: Using the formula for pricing bonds, we have $746.16 = $42.50 × PVIFA(YTM / 2,26) + $1,000 × PVIF(YTM / 2,26) and after solving for YTM / 2 = 6.25%, we find that YTM = 12.50%. Note that we assume semiannual coupons for the bond. Using BA II plus PMT = 42.50, PV = -746.16, FV = 1,000, N = 26 Hence, the YTM = 2 × 6.25% = 12.50% Now, we adjust taxes: 12.50% × (1 - 0.35) = 8.125% Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

53) PackMan Corporation has semiannual bonds outstanding with nine years to maturity and the bonds are currently priced at $754.08. If the bonds have a coupon rate of 7.25 percent, what is the after-tax cost of debt for PackMan if its marginal tax rate is 30 percent? Round your intermediate calculation to two decimal places and the final percentage answer to three decimal places. A) 7.050% B) 8.225% C) 11.750% D) 12.095% Answer: B Explanation: Using the formula for pricing bonds, we have $754.08 = $36.25 × PVIFA(YTM / 2,18) + $1,000 × PVIF(YTM / 2,18) and after solving for YTM / 2 = 5.875%, we find that YTM = 11.75%. Note that we assume semiannual coupons for the bond. Using BA II Plus PMT = 36.25, PV = -754.08, FV = 1,000, N = 18 Hence, the YTM = 2 × 5.875% = 11.75% Now, we adjust taxes: 11.75% × (1 - 0.3) = 8.225% Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 54) A recent leveraged buyout was financed with $50M: $12M in equity capital, $20M in unsecured debt borrowed at 7 percent from one bank, and the remaining debt from another bank at 8.5 percent. What is the overall after-tax cost of the debt if the firm's marginal tax rate is 33 percent? A) 2.55% B) 3.34% C) 5.17% D) 7.71% Answer: C Explanation: Total debt = $50M - $12 = $38M Weighted average pretax cost of debt = 7% × (20/38) + 8.5% × (18/38) = 7.71% After-tax cost of debt = 7.71% × (1 - 0.33) = 5.17% Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

55) The appropriate risk-free rate to use in calculating the cost of equity for a firm is: A) a long-term Treasury rate. B) a short-term Treasury rate. C) an equal mix of short-term and long-term Treasury rates. D) None of these are correct. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 56) The average risk-premium for the market from 1926 to 2019 was: A) 8.00%. B) 7.50%. C) 6.11%. D) 6.51% + the Treasury rate. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 57) The recommended model to estimate the cost of common equity for a firm is: A) the one-stage constant growth dividend model. B) the multistage-growth dividend model. C) the capital asset pricing model (CAPM). D) None of these are correct. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

58) Jacque Ewing Drilling, Inc. has a beta of 1.3. If the risk-free rate is 8 percent and the expected return on the market is 12 percent, what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 40 percent? A) 7.92% B) 13.20% C) 15.57% D) 23.60% Answer: B Explanation: The equation for CAPM is: E(Ri) = Rrf + βi[E(Rm) - Rrf]. If βi = 1.3, Rrf = 0.08, and E(Rm) = 0.12, then we have E(Ri) = 0.08 + 1.3 × [0.12 - 0.08] = 0.132 = 13.20% Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives 59) TeleNyckel, Inc. has a beta of 1.4. If the risk-free rate of return is 9 percent and the market risk premium is 5 percent, what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 30 percent? A) 11.20% B) 10.60% C) 15.14% D) 16.00% Answer: D Explanation: The equation for CAPM is: E(Ri) = Rrf + βi[E(Rm) - Rrf]. If βi = 1.4, Rrf = 0.09, and E(Rm) - Rrf = 0.05, then we have E(Ri) = 0.09 + 1.4 [0.05] = 0.16 =16.00% Diff: 2 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives

60) Radical VenOil, Inc. has a cost of equity capital equal to 22.8 percent. If the risk-free rate of return is 10 percent and the expected return on the market is 18 percent, what is the firm's beta if the marginal tax rate is 35 percent? A) 1.0 B) 1.28 C) 1.60 D) 4.10 Answer: C Explanation: The equation for CAPM is: E(Ri) = Rrf + βi[E(Rm) - Rrf]. If E(Ri) = 0.228, Rrf = 0.10, and E(Rm) = 0.18 then we have 0.228 = 0.10 + βi [0.18 - 0.10] 0.128 = βi [0.08] 0.128/.08 = βi => βi =1.60 Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives 61) Gangland Water Guns, Inc. is expected to pay a dividend of $2.10 one year from today. If the growth in dividends is expected to remain at a flat rate of 3 percent forever, what is the cost of equity capital for Gangland if the price of its common shares is currently $17.50? A) 12.00% B) 14.65% C) 15.00% D) 15.36% Answer: C Explanation: Since the price of common shares is given as well as the expected growth in dividends and the next expected dividend, we can use the following: kcs =

+g=

+ 0.03 = 0.15 = 15%

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

62) UltraFlex Diving Boards, Inc. just paid a dividend of $1.50. If the firm's growth in dividends is expected to remain at a flat rate of 4 percent forever, what is the cost of equity capital for Ultra Flex Diving Boards if the price of its common shares is currently $26.00? A) 5.77% B) 6.00% C) 9.77% D) 10.00% Answer: D Explanation: Since the price of common shares is given as well as the expected growth in dividends and the last paid dividend, we can use the following: kcs =

+g=

+ 0.04 = 0.10 = 10%

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 63) Turquoise Electronics, Inc. paid a dividend of $1.87 last year. If the firm's growth in dividends is expected to be 10 percent next year and then zero thereafter, what is its cost of equity capital if the price of its common shares is currently $25.71? A) 7.27% B) 8.00% C) 18.00% D) The problem is not solvable with the information that is given. Answer: B Explanation: D1 = D0 × (1 + g1) = $1.87 × 1.10 = $2.057 kcs = (D1 / P0 ) + gc = (2.057 / $25.71) + 0 = 8% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

64) The Dedus Shoes, Inc. has common shares with a price of $28.76 per share. The firm paid a dividend of $1.00 yesterday. If dividends are expected to grow at 10 percent for two years and then at 5 percent thereafter, what is the implied cost of common equity capital for Dedus? Round your final percentage answer to the nearest percentage. A) 7% B) 8% C) 9% D) 10% Answer: C Explanation: $28.76 =

Trial and error gives us kcs = 0.09 Diff: 3 Learning Objective: LO 3 Bloomcode: Application AACSB: Evaluation IMA: Corporate Finance AICPA: Global and Industry Perspectives 65) Tranquility, Inc. has common shares with a price of $18.37 per share. The firm paid a dividend of $1.50 yesterday. If dividends are expected to grow at a rate of 9 percent for three years and then at 2 percent thereafter, what is the implied cost of common equity capital for Tranquility? Round your final percentage answer to one decimal place. A) 9.5% B) 10.5% C) 12.0% D) 12.5% Answer: C Explanation: We can use the common stock pricing equation to solve for the cost of common equity capital. $18.37 =

$18.37 = [$1.50(1.09)/(1.12)] + [$1.50(1.09)2/(1.12)2] + [$1.50(1.09)3/(1.12)3] + [$1.50(1.09)3(1.02)/((1.12)3)(0.12 - 0.02)] $18.37 = $1.4598 + $1.4207 + $1.3826 + $14.10317 By trial and error method, the value of kcs can be found out as 12.0 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

66) Oasis, Inc. has common shares with a price of $21.12 per share. The firm is expected to pay a dividend of $1.75 one year from today. Dividends are expected to grow at the rate of 10 percent for two years and then at 5 percent thereafter. What is the implied cost of common equity capital for Oasis? Round your final answer to the nearest percentage. A) 13% B) 14% C) 15% D) 16% Answer: B Explanation: We can use the common stock pricing equation to solve for the cost of common equity capital. $21.12 =

By trial and error method, the value of kcs can be found out as 14 percent. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 67) Billy's Goat Coats has a preferred share issue outstanding with a current price of $38.89. The firm last paid a dividend on the issue of $3.50 per share. What is the firm's cost of preferred equity? Round your final answer to the nearest percentage. A) 7% B) 8% C) 9% D) 10% Answer: C Explanation: We start with the pricing equation for preferred shares and rearrange to solve for the cost of preferred equity. kps = Dps/Pps = $3.50/$38.89 = 9%. Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

68) Wally's War Duds has a preferred share issue outstanding with a current price of $26.57. The firm is expected to pay an annual dividend of $1.86 per share a year from today. What is the firm's cost of preferred equity? Round your final answer to two decimal places. A) 6.50% B) 7.00% C) 7.50% D) 8.00% Answer: B Explanation: We start with the pricing equation for preferred shares and rearrange to solve for the cost of preferred equity. kps = Dps/Pps = $1.86/$26.57 = 7%. Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 69) Melba's Toast has a preferred share issue outstanding with a current price of $19.50. The firm is expected to pay an annual dividend of $2.34 per share a year from today. What is the firm's cost of preferred equity? Round your final answer to two decimal places. A) 11.50% B) 11.75% C) 12.00% D) 12.25% Answer: C Explanation: We start with the pricing equation for preferred shares and rearrange to solve for the cost of preferred equity. kps = Dps/Pps = $2.34/$19.50 = 12%. Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

70) In order to use a firm's WACC to evaluate its future project's cash flows, which of the following must hold? A) The project will be financed with the same proportion of debt and equity as the firm. B) The systematic risk of the project is the same as the overall systematic risk of the firm. C) The project should have conventional cash flows. D) The project will be financed with the same proportion of debt and equity as the firm, and the systematic risk of the project is the same as the overall systematic risk of the firm. Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 71) If the market risk premium is currently 6 percent and the risk-free rate of return is 4 percent, then what is the expected return on a common share with a beta of 2? A) 8.0% B) 10.0% C) 12.0% D) 16.0% Answer: D Explanation: E(Ri) = Rrf + βi[E(Rm) - Rrf] = 0.04 + 2.0 × 0.06 = 0.04 + 0.12 = 0.16 = 16.0% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives 72) What is the beta of a firm whose equity has an expected return of 21.3 percent when the riskfree rate of return is 7.0 percent and the expected return on the market is 18.0 percent? A) 0.79 B) 1.30 C) 1.57 D) None of these are correct Answer: B Explanation: E(Ri) = Rrf + βi [E(Rm) - Rrf] → 0.213 = 0.07 + βi [0.18 - 0.07] 0.143 = βi [0.11] 0.143/.11 = βi → βi = 1.30 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives 25

73) Stryder, Inc. has 3 million shares outstanding at a current price of $15 per share. The book value of the shares is $10 per share. The firm also has $30 million (based on par value) in bonds outstanding. The bonds are selling at a price equal to 101 percent of par. What is the market value of the firm? A) $30.0 million B) $45.0 million C) $75.0 million D) $75.3 million Answer: D Explanation: MV of assets = MV of liabilities + MV of equity = (1.01 × $30,000,000) + (3,000,000 × $15) = $75,300,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 74) The Diverse Co. has invested 40 percent of the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with a beta of 1.8. What is the beta of the firm? A) 0.96 B) 1.24 C) 1.28 D) None of these are correct Answer: B Explanation: βn Asset portfolio =

= 0.4(0.4) + 0.6(1.8) = 1.24

Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives

75) You are analyzing the cost of capital for a firm that is financed with 65 percent equity and 35 percent debt. The cost of debt is 8 percent, while the cost of equity is 20 percent for the firm. What is the overall cost of capital for the firm? Assume that the firm pays no tax. A) 12.2% B) 14.0% C) 15.8% D) 20.0% Answer: C Explanation: kFirm = xDebt kDebt + xEquity kEquity = (0.35 × 0.08) + (0.65 × 0.2) = 0.158 = 15.8% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 76) You are analyzing the cost of capital for a firm that is financed with $300 million of equity and $200 million of debt. The cost of debt for the firm is 9 percent, while the cost of equity is 19 percent. What is the overall cost of capital for the firm? Assume the firm pays no tax. A) 13.0% B) 14.0% C) 15.0% D) 16.0% Answer: C Explanation: xDebt = 200/500 = 0.4, xEquity = 300/500 = 0.6 kFirm = xDebtkDebt + xEquitykEquity = (0.4 × 0.09) + (0.6 × 0.19) = 0.15 = 15% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

77) The WACC for a firm is 19.75 percent. You know that the firm is financed with $75 million of equity and $25 million of debt. The cost of debt is 7 percent. What is the cost of equity for the firm? Assume the firm pays no tax. A) 19.75% B) 24.00% C) 32.50% D) 58.00% Answer: B Explanation: xDebt = 25/100 = 0.25, xEquity = 75/100 = 0.75 kFirm = xDebtkDebt + xEquitykEquity → 0.1975 = (0.25 × 0.07) + (0.75 × kEquity) 0.18 = 0.75 kEquity → kEquity = 0.2400 = 24% 0.18/0.75 = kEquity Diff: 3 Learning Objective: LO 13 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 78) The WACC for a firm is 13.00 percent. You know that the firm's cost of debt is 10 percent and the cost of equity is 20 percent. What proportion of the firm is financed with debt? Assume the firm pays no tax. A) 30% B) 33% C) 50% D) 70% Answer: D Explanation: xDebt = Y, xEquity = (1 - Y) kFirm = xDebtkDebt + xEquitykEquity → 0.13 = (Y × 0.1) + ((1 - Y) × 0.20) 0.13 = 0.1Y + 0.20 - 0.2Y -0.07 = -0.1Y →Y = 0.7 = 70% Diff: 4 Learning Objective: LO 1 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

79) Swirlpool, Inc. has found that its cost of common equity is 18 percent, and its cost of debt is 8 percent. The firm is financed with 60 percent common shares and 40 percent debt. What is the after-tax weighted average cost of capital for Swirlpool, if it is subject to a 40 percent marginal tax rate? A) 10.37% B) 12.00% C) 12.72% D) 14.00% Answer: C Explanation: The formula for WACC is: WACC = xDebt kDebt pretax(1 - t) + xpskcs = 0.4 × 0.08 × (1 - 0.4) + 0.6 × 0.18 = 0.1272 = 12.72% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 80) Maloney's, Inc. has found that its cost of common equity is 17 percent and its cost of debt is 6 percent. The firm is financed with $3,000,000 of common shares (market value) and $2,000,000 of debt. What is the after-tax weighted average cost of capital for Maloney's, if it is subject to a 40 percent marginal tax rate? A) 8.96% B) 11.16% C) 11.64% D) 12.60% Answer: C Explanation: Noting that the proportion of debt and equity is xDebt = $2,000,000/($3,000,000 + $2,000,000) = 0.4,

xcs =$3,000,000/($3,000,000 + $2,000,000) = 0.6 The formula for WACC is: WACC = xDebt kDebt pretax(1 - t) + xpskcs = 0.4 × 0.06 × (1 - 0.4) + 0.6 × 0.17 = 0.1164 = 11.64% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

81) Ronnie's Comics has found that its cost of common equity is 15 percent and its cost of debt is 12 percent. The firm is financed with $250,000,000 of common shares (market value) and $750,000,000 of debt. What is the after-tax weighted average cost of capital for Ronnie's, if it is subject to a 35 percent marginal tax rate? A) 6.05% B) 9.60% C) 8.75% D) 13.65% Answer: B Explanation: The weightage for debt and equity are calculated as follows: xDebt = $750,000,000/($750,000,000 + $250,000,000) = 0.75 xcs = $250,000,000/($750,000,000 + $250,000,000) = 0.25 WACC = xDebt kDebt pretax × (1 - t) + xps kcs = 0.75 × 0.12 × (1 - 0.35) + 0.25 × 0.15 = 0.096 = 9.60% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

82) Poly's Parrot Shops has found that its cost of common equity is 17 percent. It has 7-year maturity semiannual bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Poly's, if it is subject to a 35 percent marginal tax rate? Round your final percentage answer to two decimal places. A) 10.20% B) 11.76% C) 11.88% D) 13.32% Answer: D Explanation: xDebt = $80,000,000 / ($120,000,000 + $80,000,000) = 0.4 xcs = $120,000,000 / ($120,000,000 + $80,000,000) = 0.6 Coupon payment = $1,000 × 7%/2 = $35 By entering the following data in a financial calculator, the YTM, which is the cost of debt, of the bond can be calculated as 12 percent. PMT = 35, PV = -767.03, FV = 1,000, N = 14, CPT I/Y = 6.00*2 = 12.00% WACC = xDebt kDebt pretax × (1 - t) + xps kcs = 0.4 × 0.12 × (1 - 0.35) + 0.6 × 0.17 = 0.1332 = 13.32% Diff: 3 Learning Objective: LO 1, 2 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

83) Marley's Pipe Shops has found that its common equity shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. Its cost of debt is 12 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Marley's, if it is subject to a 35 percent marginal tax rate? A) 10.20% B) 11.76% C) 11.88% D) 13.32% Answer: D Explanation: Noting that the proportion of debt and equity is xDebt = $80,000,000 / ($120,000,000 + $80,000,000) = 0.4 xcs = $120,000,000 / ($120,000,000 + $80,000,000) = 0.6 The return on common shares can be found with the CAPM: The equation for the CAPM: E(Ri) = Rrf + βi [E(Rm) - Rrf] ⇒ E(Ri) = 0.08 + 1.5 × [0.14 - 0.08] = 0.17 The formula for WACC is: WACC =:xDebt kDebt pretax × (1 - t) + xps kcs = 0.4 × 0.12 × (1 - 0.35) + 0.6 × 0.17 = 0.1332 = 13.32% Diff: 3 Learning Objective: LO 1, 3 Bloomcode: Evaluation AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives

84) Droz's Hiking Gear, Inc. has found that its common equity capital shares have a beta equal to 1.0 while the risk-free return is 8 percent and the expected return on the market is 14 percent. It has 7-year semiannual maturity bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Droz's, if it is subject to a 35 percent marginal tax rate? Round your final percentage answer to two decimal places. A) 10.20% B) 11.52% C) 11.88% D) 13.32% Answer: B Explanation: Noting that the proportion of debt and equity is xDebt = $80,000,000 / ($120,000,000 + $80,000,000) = 0.4 xcs = $120,000,000 / ($120,000,000 + $80,000,000) = 0.6 The return on common shares can be found with the CAPM: The equation for the CAPM: E(Ri) = Rrf + βi [E(Rm) - Rrf] ⇒ E(Ri) = 0.08 + 1.0 × [0.14 - 0.08] = 0.14 The price of the bonds can be used to find the YTM: $767.63 = $35 × PVIFA(YTM / 2,14) + $1,000 × PVIF(YTM) / 2,14) ⇒ YTM / 2 = 6% ⇒ YTM = 12% = kDebt pretax Using BA II Plus PMT = 35, PV = -767.03, FV = 1,000, N = 14., CPT I/Y = 6.00*2 = 12.00% The formula for WACC is: WACC =:xDebt kDebt pretax × (1 - t) + xps kcs = 0.4 × 0.12 × (1 - 0.35) + 0.6 × 0.14 = 0.11.52 = 11.52% Diff: 3 Learning Objective: LO 1, 2, 3, and 4 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives

85) Which type of project do financial managers typically use the highest cost of capital when evaluating? A) Extension projects B) New product projects C) Efficiency projects D) Market expansion projects Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 86) Briefly explain why the book value of debt might not reflect the current cost of debt for a firm, with respect to a single issuance of debt. Answer: The book value of debt or bonds will be reflective of the market and firm risks at the time the bonds were issued. If market or firm conditions have changed materially since that time, then the market price of the bonds will reflect the current cost of debt equity for the firm rather than the book value of that debt. Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 87) Explain the conditions under which the constant-growth dividend formula for the cost of common stock can be used to find the cost of common equity capital for a firm. Answer: The first condition that must hold is that the growth rate in dividends must be constant for the foreseeable future of a firm. This condition does not generally hold for growing or contracting firms. The second condition is that the growth rate in dividends must be less than the cost of equity capital for the firm. Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

88) Discuss the two major conditions for when a firm may use its current weighted average cost of capital to evaluate a new project's cash flows. Answer: a) The first condition is that the proportions of capital (debt, common shares, and preferred shares) that a firm is relying on to finance the firm must also be utilized to finance the new project. Any material deviation from that mix will alter the individual cost of each type of financing. b) The second condition is that the level of systematic risk inherent in the overall portfolio of projects a firm is currently taking on must be the same as the level of systematic risk for the new project. Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 14 Working Capital Management 1) The appropriate mix of current assets is not a working capital management decision. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 2) Net working capital is important because it is a measure of a firm's liquidity and represents the net short-term investment the firm retains after paying its short-term debts. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 3) Working capital management involves making decisions regarding the uses and sources of current assets. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 4) Working capital efficiency refers to the length of time it takes for a firm to convert raw material to a finished product. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

5) Liquidity is the ability of a company to convert real or financial assets into cash quickly without suffering a financial loss. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6) The operating cycle begins when the firm receives raw materials and ends when the firm collects cash payments on its credit sales. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 7) The cash conversion cycle is the length of time between the cash outflow for materials and the cash inflow from sales. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 8) Days' payables outstanding (DPO), which tells how long, on average, a firm takes to pay off its suppliers for the cost of inventory, is used to measure the operating cycle. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

9) Day's payables outstanding (DPO) is computed as number of days in a year divided by accounts payable turnover. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 10) An efficient firm with good working capital management should have a high average collection period relative to other firms in its industry. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 11) The flexible current asset management strategy calls for management to hold large amounts in cash, short-term investments, and inventory. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 12) The flexible current asset management strategy is perceived to be a high-risk, low-return course of action for management to follow. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

13) The restrictive current asset management strategy is a high-risk, high-return alternative to a flexible strategy. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 14) If shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 15) If carrying costs are less than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 16) Trade credit, which is short-term financing, typically comes with an explicit interest charge. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

17) An offer of 3/10, net 40 means that the selling firm offers a 10 percent discount if the buyer pays the full amount of the purchase in cash within 3 days of the invoice date. Otherwise, the buyer has 40 days to pay the balance in full from the date of delivery. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 18) Trade credit is a cheap loan from the supplier. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 19) The aging schedule shows the breakdown of the firm's accounts receivable by their date of sale. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 20) The conflict between carrying costs and shortage costs is called the working capital trade-off. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 21) A firm that employs just-in-time management has to increase its investment in working capital. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 5

22) Float refers to how long it takes a credit customer to pay the firm. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 23) A lockbox system allows geographically dispersed customers to send their payments to a post office box close to them. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 24) Under the maturity matching strategy, a firm funds all seasonal working capital needs with short-term borrowing. Answer: TRUE Diff: 1 Learning Objective: LO 7 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 25) A short-term funding strategy calls for all seasonal working capital and a portion of the permanent working capital and fixed assets to be funded with short-term debt. Answer: TRUE Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 26) An informal line of credit is short term debt promissory notes issued by large financial firms. Answer: FALSE Diff: 1 Learning Objective: LO 7 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6

27) A factor is an individual or financial institution that buys accounts receivable without recourse. Answer: TRUE Diff: 1 Learning Objective: LO 7 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 28) Which of the following statements is NOT true? A) Gross working capital refers to the funds invested in a company's current liabilities. B) Net working capital (NWC) refers to the difference between current assets and current liabilities. C) Working capital efficiency refers to the length of time between when a working capital asset is acquired and when it is converted into cash. D) Working capital management involves making decisions regarding the use and sources of current assets. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 29) Which of the following statements is NOT true? A) If cash balances become too small, it may lead the firm to bankruptcy. B) The lower the cash balance, the better the ability of a firm to meet its short-term financial obligations. C) The level of the cash balance has no bearing on a firm's ability to meet its short-term financial obligations. D) The downside of holding too much cash is that the returns on cash are low. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

30) Which of the following is the definition of net working capital? A) Total assets minus total liabilities B) Current assets minus current liabilities C) Current assets divided by current liabilities D) Total assets divided by total liabilities Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 31) The cash conversion cycle: A) shows how long a firm keeps its inventory before selling it. B) begins when a firm invests cash to purchase the raw materials that would be used to produce goods. C) begins when a firm receives raw materials using credit and ends when the firm collects cash payments on the sale of its finished goods. D) estimates how long it takes on average for a firm to collect its outstanding accounts receivable balance. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 32) Which of the following statements is NOT true? A) The cash conversion cycle begins when a firm invests cash to purchase the raw materials that would be used to produce goods. B) The cash conversion cycle begins when the firm uses its cash to purchase raw materials and ends when the firm collects its credit sales. C) To measure the cash conversion cycle, we need another measure called the days' payables outstanding. D) The cash conversion cycle ends not with the finished goods being sold to customers and the cash collected on the sales; but when a firm pays for its purchases of raw materials. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

33) The operating cycle: A) begins when a firm receives the raw materials that would be used to produce goods. B) begins when a firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales. C) cannot be measured without knowing the days' payables outstanding. D) does not end with the finished goods being sold to customers and the cash collected on the sales; but when you take into account the time taken by the firm to pay for its purchases. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 34) Which of the following statements is true when managing working capital accounts? A) Maintain extra raw material inventories to prevent causing manufacturing delays. B) Delay collecting accounts receivables from customers. C) Pay accounts payable immediately even if suppliers do not offer high discounts for early payment. D) Use as little labor as possible to manufacture the product while producing a quality product. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 35) Which of the following statements is true? A) Cash conversion cycle = DSO + DSI + DPO B) Cash conversion cycle = DSO + DSI - DPO C) Cash conversion cycle = DSO - DPO D) Cash conversion cycle = DSO + DPO - DSI Answer: B Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

36) Which of the following statements is correct? A) Cash conversion cycle = DSO - DSI + DPO B) Operating cycle = DSO + DPO C) Operating cycle = Cash conversion cycle + DPO D) Cash conversion cycle = Operating cycle - DSO Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 37) Trend Foods distributes its products to more than 100 restaurants and delis. The company's collection period is 32 days, and it keeps its inventory for 10 days. What is Trend's operating cycle? A) 22 days B) 32 days C) 42 days D) 52 days Answer: C Explanation: Operating cycle = DSO + DSI = 32 + 10 = 42 days Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

38) Stamp, Inc. has an operating cycle of 81 days and takes 47 days to collect on its receivables. What is its level of inventory if the firm's cost of goods sold is $312,455? Round your final answer to the nearest dollar. A) $9,190 B) $14,685 C) $29,105 D) $69,339 Answer: C Explanation: Operating cycle = DSO + DSI DSI = OC - DSO = 81 - 47 = 34 days DSI = 34 days =

Inventory = 34 × 856.04 = $29,105.40 Diff: 3 Learning Objective: LO 2 Bloomcode: Application AACSB: Evaluation IMA: Strategic Planning AICPA: Global and Industry Perspectives 39) Le Baron Company has an operating cycle of 123 days. The firm's days' sales in inventory is 73 days. How much does the firm have in receivables if it has credit sales of $433,450? Round your final answer to the nearest dollar. A) $59,377 B) $71,252 C) $47,501 D) $64,233 Answer: A Explanation: Operating cycle = DSO + DSI DSO = OC - DSI = 123 - 73 = 50 days Credit sales = $433,450 DSO =

Accounts receivables = 50 × $1,187.53 = $59,376.71 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

40) All Stars, Inc. has inventory of $44,233 and cost of goods sold of $512,902. The company has an operating cycle of 74 days. What is the firm's days' sales outstanding (DSO)? Round your answers to the nearest whole number. A) 43 days B) 32 days C) 49 days D) 26 days Answer: A Explanation: DSI =

= 31.5 days

Operating cycle = DSO + DSI DSO = Operating cycle - DSI = 74 - 31.5 = 42.5 days OR 43 days Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

Reference 14-1 Use the following information to answer the questions below: You are provided the following working capital information for the Ridge Company: Ridge Company Account Inventory $12,890 Accounts receivable 12,800 Accounts payable 12,670 Credit sales Cost of goods sold

$124,589 99,630

41) Refer to Reference 14-1. What is the operating cycle for Ridge Company? Round your final answer to the nearest whole number. A) 47 days B) 85 days C) 36 days D) 51 days Answer: B Explanation: DSO =

DSI =

= 37.5 days

= 47.2 days

Operating cycle = DSO + DSI = 37.5 + 47.2 = 84.7 days OR 85 days. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

42) Refer to Reference 14-1. What is the cash conversion cycle for Ridge Company? Round your final answers to one decimal place. A) 83.5 days B) 38.3 days C) 129.9 days D) 46.4 days Answer: B Explanation: DSO =

DSI =

= 37.5 days

= 47.2 days

Operating cycle = DSO + DSI = 37.5 + 47.2 = 84.7 days DPO =

= 46.4 days

Cash conversion cycle = DSO + DSI - DPO = 37.5 + 47.2 - 46.4 = 38.3 days Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 43) Wolfgang Electricals estimates the company takes 31 days on average to pay off its suppliers. It also knows that it has days' sales in inventory of 54 days and days' sales outstanding of 34 days. What is its cash conversion cycle? A) 119 days B) 34 days C) 57 days D) 46 days Answer: C Explanation: Cash conversion cycle = DSO + DSI - DPO = 34 + 54 - 31 = 57 days Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

44) Renald Corp. estimates that the company takes 27 days on average to pay off its suppliers. It also knows that it has days' sales in inventory of 43 days and days' sales outstanding of 45 days. What is its cash conversion cycle? A) 61 days B) 115 days C) 57 days D) 46 days Answer: A Explanation: Cash conversion cycle = DSO + DSI - DPO = 45 + 43 - 27 = 61 days Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 45) Your boss asks you to compute the company's cash conversion cycle. Looking at the financial statements, you see that the average inventory for the year was $126,300, accounts receivable were $97,900, and accounts payable were at $115,100. You also see that the company had credit sales of $324,000 and that cost of goods sold was $282,000. What is your firm's cash conversion cycle? Round to the nearest day. A) 119 days B) 34 days C) 57 days D) 125 days Answer: D Explanation: DSO =

DSI =

DPO =

= 110.3 days

= 163.5 days

= 149 days

Cash conversion cycle = DSO + DSI - DPO = 110.3 + 163.5 - 149 = 124.8 days OR 125 days Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

46) West Handicrafts, Inc. has net sales of $423,000 with 30 percent of it being credit sales. Its cost of goods sold is $324,000. The firm's cash conversion cycle is 47.9 days. The firm's operating cycle is 86.3 days. What is the firm's accounts payable? Round to the nearest dollar. Do not round your intermediate calculations. A) $34,087 B) $126,900 C) $71,203 D) $56,322 Answer: A Explanation: Net sales = $423,000 Credit sales = (0.3 × $423,000) = $126,900 Cash conversion cycle = (DSO + DSI) - DPO 47.9 = 86.3 - DPO DPO = 38.4 days DPO =

= AP/($324,000/365) = 38.4 days

Accounts payables = 38.4 × $887.67 = $34,086.57 OR $34,087 Diff: 3 Learning Objective: LO 2 Bloomcode: Evaluation AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 47) The flexible current asset investment strategy: A) has a high percent of current assets to total assets, and is generally perceived to be a low-risk and high-return course of action. B) calls for management to hold small amounts in cash, short-term investments, and inventory. C) leads to high levels of accounts payables. D) has a high percent of current assets to sales, and is generally perceived to be a low-risk and low-return course of action. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

48) Which of the following is NOT true about the flexible current asset investment strategy? A) The strategy promotes a liberal trade credit policy for customers. B) The strategy calls for management to hold large balances in cash, short-term investments, and inventory. C) The strategy is perceived be a high-risk and high-return course of action for management to follow. D) The strategy's downside is the high inventory carrying cost. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 49) A restrictive current asset investment strategy calls for: A) levels of current assets kept to a minimum. B) a firm barely investing in cash, marketable securities, and inventory. C) tight terms of sale intended to curb credit sales and accounts receivable. D) All of the above. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 50) A restrictive current asset management strategy is a high-risk, high-return alternative to a flexible strategy because of: A) financial shortage costs. B) production shortage costs. C) human resources shortage costs. D) equipment shortage costs. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

51) Which of the following statements is true? A) Financial shortage costs arise mainly from converting accounts receivables into cash. B) Operating shortage costs result from added expenses for increased production and sales. C) Operating shortage costs are generally inconsequential, especially if the product markets are competitive. D) Financial shortage costs arise mainly from illiquidity–shortage of cash or a lack of marketable securities to sell for cash. Answer: D Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 52) Operating shortage costs that result from lost production and sales are caused by: A) having too much inventory being purchased with supplier credit. B) an excess amount of finished goods. C) liberal, non-restrictive credit policies. D) not holding enough raw materials in inventory. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 53) Which of the following statements about working capital trade-off is true? A) Financial managers need to balance operating shortage costs against financial shortage costs to find an optimal management strategy. B) If carrying costs are greater than shortage costs, then the firm will maximize value by adopting a more flexible strategy. C) If shortage costs dominate carrying costs, the firm will need to move toward a more restrictive policy. D) Financial managers need to balance shortage costs against carrying costs to find an optimal management strategy. Answer: D Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

54) Which of the following statements about working capital trade-off is NOT true? A) Financial managers need to balance shortage costs against carrying costs to find an optimal management strategy. B) If carrying costs are smaller than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. C) If shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy. D) Management will try to find the level of current assets that minimizes the sum of the carrying costs and shortage costs. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 55) The aging schedule: A) shows the breakdown of a firm's accounts receivable by their date of payment. B) cannot identify delinquent accounts until they are paid. C) is an important financial tool for analyzing the quality of a company's payables. D) is an important financial tool for analyzing the quality of a company's receivables. Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 56) Which of the following statements is NOT true? A) Accounts payable (trade credit), bank loans, and commercial paper are common sources of short-term financing. B) An informal line of credit is a verbal agreement between the firm and the bank, allowing the firm to borrow up to an agreed-upon limit. C) An informal line of credit is a special type of collateralized loan. D) A formal line of credit is also known as "revolving credit." Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

57) Senter Corp. sells its goods with terms of 2/10 EOM, net 30. What is the implicit cost of the trade credit? Round your final percentage answer to two decimal places. Do not round your intermediate calculations. A) 18.50% B) 30.00% C) 44.59% D) 21.89% Answer: C Explanation: Credit terms = 2/10 EOM, net 30 Effective annual rate = (1 + (Discount/Discounted price))365/days credit - 1 = (1 + 2/98)365/20 - 1 = (1.0204)18.2500 - 1 = 1.4459 - 1 = 0.4459, or 44.59% Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 58) Kearns, Inc. sells its goods with terms of 3/15 EOM, net 60. What is the implicit cost of the trade credit? Do not round your intermediate calculations, and round your final answer to the nearest whole percent. A) 15% B) 45% C) 34% D) 28% Answer: D Explanation: Credit terms = 3/15 EOM, net 60 Effective annual rate= (1 + (Discount/Discounted price))365/days credit - 1 = (1 + 3/97)365/45 - 1 = (1.0309)8.1111 - 1 = 1.2800 - 1 = 0.28, or 28% Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 59) Which of the following statements is true of economic order quantity (EOQ)? A) The EOQ mathematically determines the maximum total inventory cost. B) The EOQ takes into account inventory reorder costs, but not the inventory carrying costs. C) The EOQ takes into account inventory carrying costs, but not the inventory reorder costs. D) The optimal order size is determined by the EOQ model. Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 20

60) Which of the following statements is NOT true of economic order quantity (EOQ)? A) The economic order quantity (EOQ) mathematically determines the minimum total inventory cost. B) The EOQ ignores inventory reorder costs and inventory carrying costs. C) The optimal order size is determined by the EOQ model. D) The EOQ is directly proportional to the sales per period. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 61) Which of the following statements about just-in-time inventory management policy is NOT true? A) It calls for the exact day-by-day, or even hour-by-hour raw material needs to be delivered by the suppliers. B) If the supplier fails to make the needed deliveries, then production shuts down. C) A big disadvantage in this system is that there are high raw inventory costs. D) It mitigates obsolescence or loss to theft. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

Reference 14-2 Use the following to answer the questions below: Jensen Autos, one of the largest car dealers in Eau Claire, sells about 700 vehicles a year. The cost of placing an order with their supplier is $1,100, and the inventory carrying costs are $120 for each car. Most of their sales are in late fall of each year. 62) Refer to Reference 14-2. What is the number of cars per order? Round your final answer to the nearest whole number. A) 80 cars B) 101 cars C) 58 cars D) 113 cars Answer: D Explanation: EOQ = = The number of cars per order = 113 cars. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 63) Refer to Reference 14-2. How many orders will the dealer need to place this year? Round your answer to the nearest whole number. A) 4 orders B) 5 orders C) 6 orders D) 7 orders Answer: C Explanation: EOQ = =

Number of orders = 700 / 113 = 6 orders. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 22

64) Ticktock Clocks sells 10,000 alarm clocks each year. If the total cost of placing an order is $65 and it costs $85 per year to carry the alarm clock in inventory, calculate the optimal order size using the EOQ formula. Round your final answer to the nearest whole number. A) 124 clocks B) 161 clocks C) 15,294 clocks D) 26,154 clocks Answer: A Explanation: EOQ = =

The optimal order size = 124 clocks. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 65) Which of the following statements about collection time is NOT true? A) Collection time, or float, is the time between when a customer makes a payment and when the cash becomes available to the firm. B) Collection time can be broken down into three components. C) Delivery time or mailing time is not part of the collection time. D) Processing delay is one of the components of the collection time. Answer: C Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

66) Porter Corp. has just signed up for a lockbox. Management expects the lockbox to reduce the mail float by 2.3 days. The firm's sales on average are $41,250 a day, with the average check being $165. The bank charges $0.39 per processed check. Assume that there are 270 business days in a year and the opportunity cost of funds is 5 percent. What will the firm's savings be from using the lockbox? A) $3,427.50 B) $975.50 C) $2,632.50 D) $94,875.00 Answer: A Explanation: Average daily sales = $41,250 No. of business days = 270 Average check amount = $165 No. of checks processed per day = $41,250/$165 = 250 Collection time saved = 2.3 days Per check processing fee = $0.39 Opportunity cost of funds = 0.05 The cost of a lockbox = 250 checks × $0.39 per check × 270 days = $26,325 Savings from mail float = 2.3 days × $41,250 = $94,875 Savings from lockbox = ($94,875 - $26,325) × 0.05 = $68,550 × 0.05 = $3,427.50 Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 67) Rocky Corp. has daily sales of $18,100. The financial manager determined that a lockbox would reduce the collection time by 2.2 days. Assuming the company can earn 6 percent interest per year, what are the savings from the lockbox? Round your final answer to the nearest dollar. A) $3,621 B) $2,389 C) $39,820 D) $1,100 Answer: B Explanation: Average daily sales = $18,100 Collection time saved = 2.2 days Savings from mail float = 2.2 days × $18,100 = $39,820 Savings from the lockbox = $39,820 × 0.06 = $2,389 Diff: 2 Learning Objective: LO 6 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

68) Which of the following statements about maturity matching strategy is true? A) All working capital needs are funded with long-term borrowing. B) Even if the level of sales varies seasonally, short-term borrowing is set to the maximum level possible to prevent any possible lack of working capital throughout the year. C) All assets are funded with long-term financing. D) All seasonal working capital needs are funded with short-term borrowing. Answer: D Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 69) Which of the following statements about short-term funding strategy is true? A) Only permanent working capital and fixed assets are funded with short-term debt. B) The upside to this strategy is that a portion of a firm's long-term assets are periodically refinanced over their working lives. C) It can take advantage of a downward-sloping yield curve and lower a firm's overall cost of funding. D) All seasonal working capital needs and a portion of permanent working capital and fixed assets are funded with short-term debt. Answer: D Diff: 2 Learning Objective: LO 7 Bloomcode: Analysis AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 70) Which of the following statements is NOT true? A) Firms using maturity matching strategy fund all working capital needs with long-term borrowing. B) Long-term financing strategy relies on long-term debt to finance both capital assets and working capital. C) All permanent working capital and fixed assets are funded with long-term debt when firms use a maturity matching strategy. D) Firms using a maturity matching strategy fund all seasonal working capital needs with shortterm borrowing. Answer: A Diff: 1 Learning Objective: LO 7 Bloomcode: Comprehension AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

71) Serengeti Travels has borrowed $50,000 at a stated APR of 8.5 percent. The loan calls for a compensating balance of 8 percent. What is the effective interest rate for this company? Round your final percentage answer to two decimal places. A) 9.24% B) 8.50% C) 8.00% D) 16.50% Answer: A Explanation: Amount to be borrowed = $50,000 Stated annual interest rate = 8.5% Compensating balance = 8% Amount deposited as compensating balance = $50,000 × 0.08 = $4,000 Effective borrowing amount = $50,000 - $4,000 = $46,000 Interest expense = $50,000 × 0.085 = $4,250 Effective interest rate = Interest expense/Effective borrowing amount = $4,250/$46,000 = 9.24% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 72) Sun Prairie Traders borrowed $63,000 at an APR of 10 percent. The loan called for a compensating balance of 10 percent. What is the effective interest rate on the loan? Round your final percentage answer to two decimal places. A) 10.00% B) 11.11% C) 8.00% D) 12.50% Answer: B Explanation: Amount to be borrowed = $63,000 Stated annual interest rate = 10% Compensating balance = 10% Amount deposited as compensating balance = $63,000 × 0.10 = $6,300 Effective borrowing amount = $63,000 - $6,300 = $56,700 Interest expense = $63,000 × 0.10 = $6,300 Effective interest rate = $6,300 ÷ $56,700 = 11.11% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

73) Good Homes Furnishings is borrowing $225,000. The loan requires a 10 percent compensating balance, and the effective interest rate on loan is 8.25 percent. What is the stated APR on this loan? Do not round your intermediate calculations, and round your final percentage answer to two decimal places. A) 10.00% B) 11.11% C) 7.43% D) 8.25% Answer: C Explanation: Amount to be borrowed = $225,000 Effective interest rate = 8.25% Compensating balance = (0.10 × $225,000) = $22,500 Effective borrowed amount = $225,000 - $22,500 = $202,500 Interest expense = Effective interest rate × Effective borrowing amount = 0.0825 × $202,500 = $16,706.25. Stated interest rate = $16,706.25/$225,000 = 7.43% Diff: 2 Learning Objective: LO 7 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 74) Maggie's Bistro is borrowing $375,000. The loan requires an 8 percent compensating balance, and the effective interest rate on the loan is 10.326 percent. What is the stated APR on this loan? Do not round your intermediate calculations, and round your final percentage answer to two decimal places. A) 10.0% B) 9.5% C) 7.4% D) 8.5% Answer: B Explanation: Amount to be borrowed = $375,000 Compensating balance = (0.08 × $375,000) = $30,000 Effective interest rate = 10.326% Effective borrowed amount = $375,000 - $30,000 = $345,000 Interest expense = Effective interest rate × Effective borrowing amount = 0.10326 × $345,000 = $35,625. Stated interest rate = $35,625/$375,000 = 9.5% Diff: 2 Learning Objective: LO 7 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

75) Gibbs, Inc. has just set up a formal line of credit of $1 million with First National Bank. The line of credit is good for up to five years. The bank will be charging them an interest rate of 6.25 percent on the loan, and in addition the firm will pay an annual fee of 50 basis points on the unused balance. The firm borrowed $600,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round your final percentage answer to two decimal places. A) 8.00% B) 7.25% C) 6.58% D) 8.25% Answer: C Explanation: Line of credit limit = $1,000,000 Loan rate = 6.25% Annual fee on unused balance = 0.5% Amount borrowed = $600,000 Unused balance = $400,000 Annual fee = $400,000 × 0.005 = $2,000 Interest expense = $600,000 × 0.0625 = $37,500 Effective interest rate = (Interest expense + Annual fee)/Borrowed amount = ($37,500 + $2,000)/$600,000 = 6.58% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

76) Trend, Inc. has just set up a formal line of credit of $5 million with First National Bank. The line of credit is good for up to three years. The bank will be charging them an interest rate of 7.5 percent on the loan, and in addition, the firm will pay an annual fee of 50 basis points on the unused balance. The firm borrowed $2,300,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round your final percentage answer to one decimal place. A) 8.5% B) 7.2% C) 9.0% D) 8.1% Answer: D Explanation: Line of credit limit = $5,000,000 Loan rate = 7.5% Annual fee on unused balance = 0.5% Amount borrowed = $2,300,000 Unused balance = $2,700,000 Annual fee = $2,700,000 × 0.005 = $13,500 Interest expense = $2,300,000 × 0.075 = $172,500 Effective interest rate = (Interest expense + Annual fee) / Borrowed amount = ($172,500 + $13,500)/$2,300,000 = 8.09% OR 8.1% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

77) Storm Electronics has set up a formal line of credit of $2 million with First Kentucky Bank. The line of credit is good for up to three years. The bank will be charging them an interest rate of 6.25 percent on the loan, and in addition the firm will pay an annual fee of 60 basis points on the unused balance. The firm borrowed $1,500,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round your final percentage answer to two decimal places. A) 7.50% B) 6.45% C) 6.25% D) 7.15% Answer: B Explanation: Line of credit limit = $2,000,000 Loan rate = 6.25% Annual fee on unused balance = 0.6% Amount borrowed = $1,500,000 Unused balance = $500,000 Annual fee = $500,000 × 0.006 = $3,000 Interest expense = $1,500,000 × 0.0625 = $93,750 Effective interest rate = (Interest expense + Annual fee)/Borrowed amount = ($93,750 + $3,000)/$1,500,000 = 6.45%. Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 78) Pride, Inc. sells $150,000 of its accounts receivable to factors at 2.875 percent discount. The firm's average collection period is 75 days. What is the simple annual interest cost of the factors loan? Round your percentage answer to one decimal place. A) 35.5% B) 32.9% C) 27.8% D) 31.1% Answer: A Explanation: Accounts receivables sold = $150,000 Factor discount = 2.875% Simple monthly interest cost of factoring = 2.875/(100 - 2.875) = 2.875/97.125 = 0.0296 Simple annual interest cost of factors loan = 0.0296 × 12 = 35.5%. Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

79) A firm sells $125,000 of its accounts receivable to factors at 3 percent discount. The firm's average collection period is one month. What is the dollar cost of the factoring service? A) $3,000 B) $4,500 C) $3,750 D) $4,250 Answer: C Explanation: Accounts receivables sold = $125,000 Factor discount = 3% Average collection period = 30 days Dollar cost of factoring per month = $125,000 × 0.03 = $3,750 Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 80) Which of the following is a short-term financing instrument? A) Accounts receivable B) Bank loans with a maturity of more than 1 year C) Medium term bonds D) Accounts payable Answer: D Diff: 1 Learning Objective: LO 7 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 81) What are some strategies that financial managers can follow in managing their working capital accounts? Answer: When managing working capital accounts, financial managers need to do the following: • Delay paying accounts payable as long as possible without suffering any penalties. • Maintain minimal raw material inventories without causing manufacturing delays. • Use as little labor as possible to manufacture the product while producing a quality product. • Maintain minimal finished goods inventories without losing sales. • Offer customers the most attractive credit terms possible on trade credit to maximize sales while minimizing the risk of nonpayment. • Collect cash payments on accounts receivable as fast as possible to close the loop. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives 31

82) Explain working capital trade-off. Answer: The optimal current asset management strategy of a firm will depend on the relative magnitudes of carrying costs versus shortage costs. This conflict is often referred to as the working capital trade-off. Financial managers need to balance shortage costs against carrying costs to find out an optimal strategy. If carrying costs are larger than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. On the other hand, if shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy. Overall, management will try to find the level of current assets that minimizes the sum of the carrying costs and shortage costs. Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 83) How does a just-in-time inventory management work? Answer: In a just-in-time system, the exact day-by-day or even hour-by-hour raw material needs are delivered by the suppliers, who deliver the goods just-in-time for them to be used on the production line. A big advantage in this system is that there are essentially no raw material inventory costs and no chance of obsolescence or loss to theft. On the other hand, if the supplier fails to make the needed deliveries, then production shuts down. If the system works for a firm, it cuts down their investment in working capital dramatically. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Strategic Planning AICPA: Global and Industry Perspectives

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 15 How Firms Raise Capital 1) Most businesses are started when an entrepreneur is given seed funding by institutional investors. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 2) The process by which many entrepreneurs raise seed money and obtain other resources necessary to start their businesses is often called bootstrapping. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3) The initial seed money usually comes from the entrepreneur or other founders. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 4) The bootstrapping period usually lasts for at least five years. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

5) Venture capitalists are individuals or firms that help privately held businesses by providing funds in the bootstrapping process. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6) Angel investors are investors who come to the rescue of firms threatened by takeovers. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 7) A significant number of venture capital firms focus on high-technology investments. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8) A significant number of venture capital firms focus on mature businesses. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 9) Traditional sources of funding, such as from financial and insurance firms, work for new or emerging businesses despite the presence of only intangible assets. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

10) The key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firm's financial performance. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 11) A principal way for venture capitalists to exit is to sell part of the firm's equity back to the entrepreneur. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 12) A venture capitalist may exit an investment by offering common stock to the public. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 13) The amount of equity capital that can be raised in the public equity markets is typically smaller than the amount that can be raised through private sources. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 14) Privately held firms find it easier to attract top management talent and to better motivate current managers. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3

15) To complete an IPO, a firm will need the services of investment bankers, who are experts in bringing new securities to market. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 16) To complete an IPO, a firm will need the services of angel investors, who are experts in bringing new securities to market. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 17) Underwriting is the risk-bearing part of investment banking. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 18) In the firm-commitment underwriting, which is more typical, the investment banker guarantees the issuer a fixed amount of money from the stock sale. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

19) With a firm-commitment underwriting, the investment banking firm makes no guarantee to sell the securities at a particular price. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 20) In a best-effort offering, the underwriter promises to make its "best effort" to sell all securities at a certain price. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 21) Underpricing is defined as offering new securities for sale at a price below their true value. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 22) In a firm-commitment offering, the underwriters will suffer a financial loss if the offer price is set too high. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 23) If the offer price is set too high, the issuing firm will lose under a best-effort agreement. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 5

24) A general cash offer is a sale of debt or equity, open to all investors, by a registered public company that has previously sold stock to the public. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 25) Bootstrapping and venture capital financing are part of the public market operations of a business. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 26) Private placement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 27) The biggest drawback of private placements involves restrictions on the resale of the securities. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

28) PIPE transactions refer to transactions in which a public company sells unregistered stock to a hedge fund or some other institutional investor. Answer: TRUE Diff: 1 Learning Objective: LO 6 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 29) The major disadvantage of a PIPE transaction to issuers is that the funding cost is higher as compared to making a public offer. Answer: FALSE Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 30) Term loans are defined as business loans with maturities greater than one month but less than one year. Answer: FALSE Diff: 1 Learning Objective: LO 7 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 31) The initial seed money for a start-up usually comes from: A) public investors. B) investment banks. C) the entrepreneur or other founders. D) commercial banks. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

32) Bootstrapping is the process by which: A) many entrepreneurs raise seed money and obtain other resources necessary to start their businesses. B) the entrepreneur often fleshes out his or her ideas and makes them operational. C) most businesses are started by an entrepreneur. D) an entrepreneur starts a company with large amount of capital and without relying on money other than outside investments. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 33) Which of the following statements is NOT true? A) The process by which many entrepreneurs raise seed money and obtain other resources necessary to start their businesses is often called bootstrapping. B) Most businesses are started by an entrepreneur who has a vision for a new business or product and a passionate belief in the concept's viability. C) The initial seed money usually comes from the entrepreneur or other founders. D) The seed money is spent on developing an initial public offering. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 34) Which of the following statements is NOT true? A) The venture capital industry as we know it today emerged in the late 1960s with the formation of the first venture capital limited partnerships. B) Modern venture capital firms tend to specialize in a specific line of business, such as hospitality, food manufacturing, or medical devices. C) A significant number of venture capital firms focus on high-technology investments. D) Venture capital firms tend to manage one fund at a given time. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

35) Which of the following statements is NOT true? A) Venture capitalists bear a substantial amount of risk when they fund a new business. B) Venture capitalists' sole function is to provide financing for new firms. C) Modern venture capital firms tend to specialize in a specific line of business, such as hospitality, food manufacturing, or medical devices. D) A significant number of venture capital firms focus on high-technology investments. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 36) Tactics that venture capitalists use to reduce the risk of their investment include: A) funding the ventures in stages, requiring entrepreneurs to take charge of all important business decisions. B) funding the ventures completely in the beginning, requiring entrepreneurs to make personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize. C) funding the ventures in stages, requiring entrepreneurs to make personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize. D) funding the ventures in stages, and without any in-depth knowledge about the industry. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 37) Which of the following statements is NOT true? A) Venture capitalists often require an entrepreneur to make a substantial personal investment in the business. B) Syndication occurs when the originating venture capitalist buys off other venture capitalists involved in the venture. C) A factor that reduces risk is the venture capitalist's in-depth knowledge of the industry and technology. D) The key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firm's financial performance. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 9

38) Provisions that are part of venture capital agreements include: A) timing of exit, number of board positions after exit, and what price is acceptable. B) timing of exit, the method of exit, and what price is acceptable. C) the method of exit, number of board positions after exit, and what price is acceptable. D) the method of exit, number of board positions after exit, and timing of exit. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 39) The three principal ways in which venture capital firms exit venture-backed companies are: A) selling to a strategic buyer, buying out the founder, and offering stock to the public. B) selling to a strategic buyer, selling to a financial buyer, and buying out the founder. C) selling to a strategic buyer, selling to a financial buyer, and offering stock to the public. D) selling to a strategic buyer, buying out the funder, and selling to a financial buyer. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 40) A typical venture capital fund may generate annual returns of: A) 15 to 25 percent on the money that it invests, compared with an average annual return for the S&P 500 of almost 12 percent. B) 12 percent on the money that it invests, compared with an average annual return for the S&P 500 of about 20 percent. C) 12 percent on the money that it invests, compared with an average annual return for the S&P 500 of about 25 percent. D) 5 to 10 percent on the money that it invests, compared with an average annual return for the S&P 500 of almost 4 percent. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

41) Advantages of going public include all EXCEPT: A) a larger amount of capital can be raised this way than the amount that can be raised through private sources. B) the cost of going public is less in comparison with debt financing. C) going public can enable an entrepreneur to fund a growing business. D) additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 42) Which of the following statements is true? A) After the IPO, there is a less active secondary market for the firm's shares. B) Only smaller amounts of capital can be raised through an IPO than the amount that can be raised through private sources. C) Publicly traded firms find it easier to attract top management talent. D) Going public can enable an entrepreneur to fund a growing business at the expense of giving up control. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 43) Disadvantages of going public include all EXCEPT: A) managers' tendency to focus on long-term profits. B) the high cost of the IPO itself. C) the costs of complying with ongoing SEC disclosure requirements. D) the transparency that results from this compliance can be costly for some firms. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

44) All of the following about a firm-commitment underwriting is true EXCEPT: A) the investment banker guarantees the issuer a fixed amount of money from the stock sale. B) the investment banker actually buys the stock from the firm. C) the issuer bears the risk that the resale price might be lower than the price the underwriter pays. D) the underwriter bears the risk that the resale price might be lower than the price the underwriter pays. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 45) With a best-effort underwriting, the: A) investment banking firm guarantees to sell the securities at a particular price. B) investment banker bears the price risk associated with underwriting the issue. C) compensation is based on the price of the securities sold. D) underwriters do not want to accept the risk of guaranteeing the offering price. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 46) Which of the following statements is NOT true? A) In a best-effort offering, the underwriters will suffer a financial loss if the offer price is set too high. B) In a best-effort agreement, the issuing firm will lose if the offer price is set too high. C) If the underpricing is significant, the investment banking firm will suffer a loss of reputation for failing to price the new issue correctly and raising less money for its client than it could have. D) Underpricing is defined as offering new securities for sale at a price below their true value. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

47) Basic services provided by investment bankers bringing securities to market do NOT include: A) origination. B) underwriting. C) distribution. D) confirmation. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 48) Which of the following statements is NOT true? A) Investment bankers provide three basic services when bringing securities to market– origination, underwriting, and distribution. B) During the origination phase, the investment banker helps the firm determine whether it is ready for an IPO. C) Origination is the risk-bearing part of investment banking. D) Origination includes giving the firm financial advice and getting the issue ready to sell. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 49) The three costs associated with issuing stock in an IPO are: A) price premium, out-of-pocket expenses, and underpricing. B) underwriting spread, out-of-pocket expenses, and underpricing. C) underwriting spread, price premium, and underpricing. D) price premium, out-of-pocket expenses, and underwriting spread. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

50) Data from the marketplace show that the shares sold in an IPO are typically: A) priced between 2 and 5 percent below the price at which they close at the end of the first day of trading. B) priced between 10 and 15 percent above the price at which they close at the end of the first day of trading. C) priced between 10 and 15 percent below the price at which they close at the end of the first day of trading. D) priced between 2 and 5 percent above the price at which they close at the end of the first day of trading. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 51) Stump, Inc. issues a $66 million IPO priced at $17 per share, and the offering price to the public is $22 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $350,000. The firm's stock price increases 15 percent on the first day. What is the underpricing spread? A) $51 million B) $15 million C) $66 million D) $30 million Answer: B Explanation: Underwriter's gross spread ($22 - $17) = $5 per share Number of shares sold = ($66 million ÷ $22 per share) = 3 million shares Underwriting cost = ($5 per share × 3.0 million shares) = $15.0 million Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

52) Stump, Inc. issues a $66 million IPO priced at $17 per share, and the offering price to the public is $22 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $350,000. The firm's stock price increases 15 percent on the first day. What is the underpricing on this issue? A) $9,900,000 B) $24,900,000 C) $15,000,000 D) $9,000,000 Answer: A Explanation: Stock price at end of the first day = $22(1.15) = $25.30 First-day underpricing = ($25.30 - $22) = $3.30 per share Total underpricing = ($3.30 per share × 3,000,000 shares of stock) = $9,900,000 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 53) Stump, Inc. issues a $66 million IPO priced at $17 per share, and the offering price to the public is $22 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $350,000. The firm's stock price increases 15 percent on the first day. What is the firm's total cost of issuing the securities? A) $24.9 million B) $15.35 million C) $25.25 million D) $9.9 million Answer: C Explanation: Underwriter's gross spread ($22 - $17) = $5 per share Number of shares sold = ($66 million ÷ $22 per share) = 3 million shares Underwriting cost = ($5 per share × 3.0 million shares) = $15.0 million Stock price at end of the first day = $22(1.15) = $25.30 First-day underpricing = ($25.30 - $22) = $3.30 per share. Total underpricing = ($3.30 per share × 3,000,000 shares of stock) = $9,900,000 Total cost to the firm of selling the IPO = $15,000,000 + $350,000 + $9,900,000 = $25,250,000 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

54) Pau, Inc. issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the underpricing cost of issuing the securities to the firm? (Round your intermediate calculations to two decimal places.) A) $13.60 million B) $20.60 million C) $6.94 million D) $7.57 million Answer: C Explanation: Stock price at end of the first day = $19.30 × (1.18) = $22.77 First-day underpricing = ($22.77 - $19.30) = $3.47 per share Number of shares outstanding = ($38.6 million ÷ $19.3 per share) = 2 million shares Total underpricing = ($3.47 per share × 2,000,000 shares of stock) = $6,940,000 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 55) Pau, Inc. issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the underwriting cost? A) $13.6 million B) $20.6 million C) $6.94 million D) $38.6 million Answer: A Explanation: Underwriter's gross spread ($19.30 - $12.50) = $6.80 per share Number of shares outstanding = ($38.6 million ÷ $19.30 per share) = 2 million shares. Underwriting cost = ($6.80 per share × 2.0 million shares) = $13.6 million Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

56) Pau, Inc. issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the total cost of issuing the securities to the firm? A) $13,606,000 B) $20,818,000 C) $20,610,000 D) $6,948,000 Answer: B Explanation: Stock price at end of the first day = $19.30 (1.18) = $22.774 First-day underpricing = ($22.774 - $19.30) = $3.474 per share Number of shares sold = ($38.6 million ÷ $19.3 per share) = 2 million shares Total underpricing = ($3.474 per share × 2,000,000 shares of stock) = $6,948,000 Underwriter's gross spread ($19.30 - $12.50) = $6.80 per share Underwriting cost = ($6.80 per share × 2.0 million shares) = $13.6 million Total cost to the firm of selling the IPO = $13,600,000 + $270,000 + $6,948,000 = $20,818,000 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 57) When Geo Corp. went public, the offer price was $19.00 per share and the closing price at the end of the first day was $24.70. The firm issued 4 million shares. What was the loss to the company due to underpricing? A) $13.6 million B) $20.83 million C) $20.6 million D) $22.8 million Answer: D Explanation: Change in price on the first day = $24.70 - $19.00 = $5.70 Number of shares outstanding = 4.0 million shares Loss due to underpricing = $5.70 × 4,000,000 = $22.8 million Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

58) Bethesda Biosys issues an IPO on a best-efforts basis. The company's investment bank requires a spread of 18 percent of the selling price. The average selling price is expected to be $25 per share. Four million shares are issued. What are the net proceeds for the issuer? A) $82 million B) $92 million C) $100 million D) $102 million Answer: A Explanation: Underwriting spread = $25 × 0.18 = $4.5 Proceeds to issuer = ($25 - $4.5) × 4 million shares = $82 million Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 59) Fortune Hotels issues an IPO on a best-effort basis. The company's investment bank requires a spread of 20 percent of the selling price. Five million shares are issued. The average selling price is expected to be $31. What are the net proceeds per share for the issuer? A) $27.50 B) $22 C) $31 D) $24.8 Answer: D Explanation: Number of shares issued = 5 million shares Underwriting spread = 20% × $31 = $6.2 Proceeds to issuer = ($31 - $6.2) = $24.8 per share Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

60) Fortune Hotels issues an IPO on a best-effort basis. The company's investment bank requires a spread of 20 percent of the selling price. Five million shares are issued. The average selling price is expected to be $31. How much did the investment bank receive? A) $22.0 million B) $27.5 million C) $31.0 million D) $20.0 million Answer: C Explanation: Underwriting spread = 20% × $31 per share × 5 million shares = $31 million Proceeds to underwriter = $31 million Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 61) Dienz Pharma plans to issue an IPO on a best-effort basis. The company's investment bank requires a spread of 16 percent of the selling price. The selling price is expected to be $32 per share. Three million shares are issued. What are the proceeds for the issuer? A) $96.00 million B) $78.75 million C) $80.64 million D) $90.00 million Answer: C Explanation: Number of shares issued = 3 million shares Underwriting spread = $32 × 0.16 = $5.12 Proceeds to issuer = ($32 - $5.12) × 3 million shares = $80.64 million Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 62) The most likely reason that underpricing of new issues occurs more frequently than overpricing is the: A) underwriters' desire to reduce the risk of a firm commitment. B) 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 Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 19

63) A firm is making an initial public offering. The investment bankers agree to a firm underwriting commitment of 500,000 shares priced to the public at $50 a share. The underwriter's spread is 12 percent. In addition, the underwriter charges $600,000 in legal fees. On the first day of trading, the firm's stock closed at $61. What were the total costs of the issue? A) $3,000,000 B) $3,600,000 C) $8,500,000 D) $9,100,000 Answer: D Explanation: Stock price at end of the first day = $61.00 First-day underpricing = ($61.00 - $50.00) = $11.00 per share. Total underpricing = ($11.00 per share × 500,000 shares of stock) = $5,500,000 Underwriter's gross spread ($50.00 ×.12) =$6.00 per share Underwriting cost = ($6.00 per share × 500,000 shares) = $3 million Total cost to the firm of selling the IPO = $3,000,000 + $600,000 + $5,500,000 = $9,100,000 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 64) Which of the following statements is NOT true? A) In a competitive sale, the firm specifies the type and amount of securities it wants to sell. B) In a negotiated sale, the issuer selects the underwriter at the beginning of the origination process. C) In a general cash offer, management must decide whether to sell the securities on a competitive or a negotiated basis. D) For equity securities, competitive sales generally provide the lowest-cost method of sale. Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

65) Which of the following statements is NOT true of shelf registration? A) Shelf registration gives firms less flexibility in bringing securities to market. B) During a two-year window, the firm can take the securities "off the shelf" and sell them as needed. C) Shelf registration allows firms to periodically sell small amounts of securities. D) A shelf registration statement can cover multiple securities, and there is no penalty if authorized securities are not issued. Answer: A Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 66) Benefits from shelf registration include all EXCEPT: A) greater flexibility in bringing securities to market. B) the ability for firms to periodically sell small amounts of securities and raise capital as needed. C) a shelf registration statement can cover multiple securities, but there is a penalty if authorized securities are not issued. D) costs associated with selling the securities are reduced because only a single registration statement is required. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

67) Star Corporation, an auto fuel cell maker, is planning a new plant and needs to raise $30 million to finance it. The company plans to raise the money through a general cash offering priced at $23.50 a share. Star's underwriters charge a 6 percent spread. How many shares does the company need to sell to achieve its goal? (Round your final answer to the nearest unit of share.) A) 1,358,081 shares B) 1,276,596 shares C) 1,200,000 shares D) 1,080,473 shares Answer: A Explanation: Underwriter's spread = 6% Price per share the firm gets = $23.50 × (1 - 0.06) = $22.09 Therefore, to raise $30 million, the company needs to issue: $30,000,000 ÷ $22.09 = 1,358,081 new shares Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 68) Why is the total cost of bringing a general cash offer to the market lower than an IPO? A) General cash offer includes a large underpricing. B) Underwriting spreads are larger with a general cash offer. C) There is more risk involved with a general cash offer than an IPO. D) There is a higher cost of distributing the shares in an IPO. Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

69) Which of the following statements is NOT true? A) For firms that have limited access to the public capital markets, the cheapest source of external funding is often the private markets. B) Bootstrapping and venture capital financing are not part of the private market. C) The biggest drawback of private placements involves restrictions on the resale of the securities. D) Many private companies that are owned by entrepreneurs, families, or family foundations and are sizable companies of high credit quality prefer to sell their securities in the private markets. Answer: B Diff: 1 Learning Objective: LO 1, 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 70) Which of the following statements is NOT true? A) Private placement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals. B) In private placements, there are no restrictions on the resale of the securities. C) About half of all corporate debt is sold through the private placement market. D) Investment banks and money center banks often assist firms with private placements. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 71) Disadvantages of private placements include: A) lower cost of funds. B) more willingness among private lenders to negotiate changes to a bond contract. C) the speed of private placement deals and flexibility in issue size. D) Private placements do not have to be registered with the SEC. Answer: D Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

72) Which of the following statements is NOT true? A) Private equity firms pool money from wealthy investors, pension funds, insurance companies, and other sources to make investments. B) Private equity firms invest in more mature non-public companies. C) Agency problems tend to be more in firms owned by private equity investors than in public firms. D) Private equity investors focus on firms that have stable cash flows because they use a lot of debt to finance their acquisitions. Answer: C Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 73) Private equity firms improve the performance of firms in which they invest by NOT: A) making sure that the firms have the best possible management teams. B) closely monitoring each firm's performance and providing advice and counsel to the firm's management team. C) facilitating mergers and acquisitions that help improve the competitive positions of the companies in which they invest. D) replacing the management team. Answer: D Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 74) Which of the following statements is NOT true of PIPE transactions? A) PIPE transactions are registered with the SEC. B) PIPE transactions give issuers faster access to capital. C) In a PIPE transaction, investors purchase securities (equity or debt) directly from a publicly traded company in a private placement. D) The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets. Answer: A Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

75) Which of the following statements is true of PIPE transactions? A) Under federal securities law, they can be resold to investors in the public markets immediately even if they are not registered. B) As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC, usually within 90 days of the PIPE closing. C) As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC after 90 days of the PIPE closing. D) PIPE transactions involving a healthy firm can also be executed without the use of an investment bank but result in a cost increase of 7 to 8 percent of the proceeds. Answer: B Diff: 1 Learning Objective: LO 6 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 76) Jasper, Inc. is looking for a five-year term loan of $3 million. The firm will have to pay a premium of 1.5 percent for default risk to its bank and another 0.75 percent for maturity risk. The current prime rate is 7.5 percent. What is the loan rate on this bank loan? A) 9% B) 8.25% C) 9.75% D) 9.25% Answer: C Explanation: Prime rate = PR = 7.5% Maturity risk premium = MAT = 0.75% Default risk premium = DRP = 1.5% The loan rate = k = PR + DRP + MAT = 7.5% + 1.5% + 0.75% = 9.75% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

77) Suppose two firms want to borrow money from a bank for a period of 10 years. Firm A has excellent credit and can borrow at the prime rate, whereas Firm B's credit standing is prime rate plus 2 percent. The current prime rate is 5.75 percent, the 30-year Treasury bond yield is 4.35 percent, the three-month Treasury bill yield is 3.54 percent, and the 10-year Treasury note yield is 4.24 percent. What are the appropriate loan rates for both the firms? A) 6.45% for Firm A, 7.75% for Firm B B) 6.45% for Firm A, 8.45% for Firm B C) 5.75% for Firm A, 8.45% for Firm B D) 5.75% for Firm A, 7.75% for Firm B Answer: B Explanation: Prime rate = PR = 5.75%; Maturity risk premium = MAT = y10-year - yT-bill = 4.24% - 3.54% = 0.70% Borrowing rate for Firm A = kA = Prime rate + MAT = 5.75% + 0.70% = 6.45% Borrowing rate for Firm B = kB = Prime rate + 2% + MAT = 5.75% + 2% + 0.70% = 8.45% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 78) Marigold Corp. wants to borrow money from Howard Bank for a period of five years. The firm's credit standing calls for a premium of 1.5 percent over the prime rate. The current prime rate is 6.5 percent, the 30-year Treasury bond yield is 5.375 percent, the three-month Treasury bill yield is 3.525 percent, and the 5-year Treasury note yield is 4.25 percent. What is the appropriate loan rate for this customer? A) 8.725% B) 7.225% C) 6.500% D) 10.025% Answer: A Explanation: Prime rate = PR = 6.5%; Default risk premium = DRP = 1.5% Maturity risk premium = MAT = y5-year - yT-bill = 4.25% - 3.525% = 0.725% Borrowing rate for firm A = ki = PR + DRP + MAT = 6.5% + 1.5% + 0.725% = 8.725% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

79) Castle Co. needs to borrow $10 million for process improvement upgrades. Management decides to sell 20-year bonds. They determine that the 3-month Treasury bill rate is 2.75 percent, the firm's credit rating is A, and the yield on 20-year Treasury bonds is 1.80 percent higher than that for 3-month Treasury bills. Bonds with an A rating are selling for 50 basis points above the 20-year Treasury bond rate. What is the loan rate for this transaction? A) 4.55% B) 5.05% C) 7.75% D) 9.55% Answer: B Explanation: ki = 2.75 + 1.80 + 0.50 = 5.05% Diff: 2 Learning Objective: LO 7 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

80) Why do traditional sources of funding not work for new or emerging businesses? Answer: New firms cannot resort to traditional sources of funding for three main reasons. First, starting a new business is a risky proposition. The fact is that most new businesses fail, and it is difficult to identify which firms will be successful. Most suppliers of capital, such as banks, pension funds, and insurance companies, are averse to undertaking high-risk investments, and much of their risk-averse behavior is mandated in regulations that restrict their conduct. Second, most commercial loans are made to firms that have tangible assets, such as machines, equipment, and physical inventory. Lenders understand the operations of these "traditional" firms and their inherent risks; thus, they are comfortable making loans to them. New firm whose primary assets are often intangibles, such as patents or trade secrets, find it difficult to secure financing from traditional lending sources. The third reason is the information gap that exists between the entrepreneur and potential investors. An entrepreneur knows more about his or her company's prospects than a lender does. When dealing with highly specialized technologies or companies emerging in new business areas, most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs. As a result, they are reluctant to invest in these firms. For these reasons, many investors—such as pension funds, insurance companies, endowment funds, and university foundations—find it difficult to participate directly in the venture capital market. Instead, they invest in venture capital funds that specialize in identifying attractive investments in new businesses, managing those investments, and selling them at the appropriate time Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

81) What are the advantages and disadvantages of going public? Answer: Going public has a number of potential advantages. • The amount of equity capital that can be raised in the public equity markets is typically larger than the amount that can be raised through private sources. • Once an IPO has been completed, additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost. • Going public can enable an entrepreneur to fund a growing business without giving up control. • After the IPO, there is an active secondary market in which stockholders can buy and sell their shares. • Publicly traded firms find it easier to attract top management talent and to better motivate current managers if a firm's stock is publicly traded. There are also several disadvantages of going public. • The high cost of the IPO itself. • The costs of complying with ongoing SEC disclosure requirements also represent a disadvantage of going public. • The transparency that results from this compliance can be costly for some firms. • Some investors argue that the SEC's requirement of quarterly earnings forecasts and quarterly financial statements encourages managers to focus on short-term profits rather than long-term wealth maximization. Diff: 3 Learning Objective: LO 3 Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

82) What are PIPE transactions and how do they help firms raise capital? Answer: Private investment in public equity (PIPE) transactions are transactions in which a public company sells unregistered stock to an investor. In a PIPE transaction, investors purchase securities (equity or debt) directly from a publicly traded company in a private placement. The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets to compensate the buyer for limits on the liquidity associated with these securities and, often, for being able to provide capital quickly. Because the securities sold in a PIPE transaction are not registered with the SEC, they are restricted securities. As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC, usually within 90 days of the PIPE closing. If the registration is delayed past a deadline date, the issuer might be required to pay the investor liquidity damages, usually 1 or 1.5 percent per month, as compensation for the loss of liquidity. The major advantages of a PIPE transaction to issuers are that it gives them faster access to capital and a lower funding cost than a registered public offering. PIPE transactions involving a healthy firm can also be executed without the use of an investment bank, resulting in a cost saving of 7 to 8 percent of the proceeds. A PIPE transaction can be the only way for a small financially distressed company to raise equity capital. Diff: 2 Learning Objective: LO 6 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 16 Capital Structure Policy 1) A higher proportion of debt indicates a lower degree of financial leverage. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 2) Minimizing the cost of a firm's financing activities also maximizes the overall value of the firm. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3) When calculating free cash flow, it is important to include interest and principal payments. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 4) M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does not affect real investment policy of the firm. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

5) The enterprise value of a firm is the value of equity minus the value of debt. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6) A financial restructuring will have some effect on the value of a firm's real assets, such as plant and equipment. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 7) M&M Proposition 2 states that the required rate of return on a firm's common stock is directly related to the debt-to-equity ratio. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 8) M&M Proposition 1 states that the capital structure of a firm does not affect the required rate of return on a firm's assets, while M&M Proposition 2 shows that the required rate of return on firm's equity does change with capital structure decisions. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

9) Under the M&M assumptions with taxes, the value of a firm with debt is the value of the firm without debt plus the present value of the interest tax shield. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 10) With no debt, the WACC is the cost of equity plus the required rate of return on the firm's underlying assets. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 11) If a firm has debt and pays taxes, the present value of the tax shield is the amount of debt outstanding times the tax rate. Answer: TRUE Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 12) Issuing debt is usually less expensive than issuing stock. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 13) Bankruptcy and agency costs both act as limits on the amount of debt in the capital structure. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3

14) Direct bankruptcy costs are considered transactions costs and occur when a firm must navigate the bankruptcy process. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 15) When a firm gets closer to financial distress causing expected bankruptcy costs to increase, lenders will often charge the firm a lower interest rate in order to reduce the chance of an actual bankruptcy occurring. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 16) Direct bankruptcy costs are considered small when compared to indirect bankruptcy costs. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 17) Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 18) Unlike direct bankruptcy costs, indirect costs are not considered transaction costs. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 4

19) Indirect bankruptcy costs will often increase when a firm is in financial distress and it may even push the company into bankruptcy. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 20) More debt in a firm's capital structure provides managers with an incentive to maximize cash flows, but also makes them want to take on negative NPV projects. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 21) Dividends reduce the value of lender claims, and this is why bondholders often limit a firm's ability to distribute cash to equity holders. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 22) Borrowing money and paying out a special dividend to shareholders is an example of the asset substitution problem. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

23) When a firm is in financial distress, stockholders would like the manager to overinvest in positive NPV projects. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 24) When the firm uses no debt in financing activities, there will not be any asset substitution or underinvestment problems. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 25) The trade-off theory of capital structure states that leverage should be increased until the marginal cost of debt is equal to the marginal benefit. Answer: TRUE Diff: 1 Learning Objective: LO 2, 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 26) Under the pecking order theory, debt is the cheapest source of financing due to the interest tax shield. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

27) The pecking order theory says that instead of trying to achieve a specified target capital structure, firms use the cheapest form of capital available at any given time. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 28) Firms have a difficult time selling equity when they are in financial distress. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 29) Industries with large amounts of tangible assets typically use little debt. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 30) More profitable firms have less debt, which supports the trade-off theory. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 31) Managers often focus on cash flows, but reported accounting earnings are a better indicator of a firm's economic health. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

32) An operating lease is treated like a purchase for accounting purposes. Answer: FALSE Diff: 1 Learning Objective: LO Appendix Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 33) A firm's capital structure is the mix of financial securities used to finance its activities and can include all of the following EXCEPT: A) common stock. B) bonds. C) equity options. D) preferred stock. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 34) The optimal capital structure of a firm: A) minimizes the cost of financing the firm's projects. B) minimizes interest payments to creditors. C) maximizes overall value of the firm. D) minimizes the cost of financing the firm's projects and maximizes overall value of the firm. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 35) M&M Proposition 1 assumes all of the following EXCEPT that: A) there are no taxes. B) there are no costs to acquire information. C) there are no transactions costs. D) the real investment policy of a firm is affected by its capital structure decisions. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 8

36) A firm's enterprise value is given as: A) the market value of equity plus the market value of debt. B) the market value of equity minus the market value of debt. C) the market value of equity minus the market value of debt plus the market value of future projects. D) the market value of equity plus the market value of future projects plus the market value of debt. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 37) A financial restructuring: A) will not change the value of a firm's real assets under M&M Proposition 1. B) includes financial transactions that change the capital structure of the firm. C) means that a firm has issued equity to retire debt. D) Both A and B. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 38) The weighted average cost of capital (WACC) includes: A) the required return on equity and required return on underlying firm assets. B) the cost of any long-term debt and the cost of equity. C) the cost of any long-term debt and required return on underlying firm assets. D) the required return on equity only. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

39) M&M Proposition 2 states that the cost of a firm's common stock is directly related to: A) the debt-to-equity ratio. B) the required rate of return on the firm's underlying assets. C) the return of the market index. D) the debt-to-equity ratio and the required rate of return on the firm's underlying assets. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 40) According to M&M Proposition 2, the cost of a firm's equity: A) increases as the debt-to-equity ratio increases. B) decreases as the debt-to-equity ratio decreases. C) increases as the cost of debt increases. D) decreases as the required rate of return on the firm's underlying assets increases. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 41) Financial risk: A) refers to the effect that a firm's financing decisions have on the riskiness of the cash flows that the stockholders will receive. B) increases a firm's business risk. C) decreases a firm's business risk. D) is related to how debt affects the business decisions of a firm. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

42) Which one of the following considerations are NOT a concern of managers when they make capital structure decisions? A) Financial flexibility B) Net income risk C) Systematic risk D) Earnings impact Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 43) What control implications do a firm's capital structure decisions have? A) Issuing too much equity as to cause financial distress B) only impacts debt financing C) only impacts equity financing D) Dilution issues Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 44) Which of the following is a reason financial policy might matter? A) More important for firms exempt from paying corporate income taxes than firms that pay corporate taxes. B) Can affect transaction costs, but not information costs. C) Can affect information costs, but not transaction costs. D) Capital structure choices can affect firm's real investment decisions, such as R&D and PP&E. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

45) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much is Dynamo worth today? A) $1,765 B) $1,500 C) $2,143 D) $1,900 Answer: B Explanation: VFirm =

= $1,500

Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 46) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much are your cash flows today? (Round the answer to two decimal places.) A) $12.38 B) $15 C) $4.50 D) $150 Answer: A Explanation: VFirm =

= $1,500

Cash flows to stockholders = Cash flows - Interest payments = $150 - ($1,500) × (0.25) × (0.07) = $123.75 Therefore, your 10% share = $123.75 × 0.1 = $12.375 OR $12.38 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

47) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity and use the debt proceeds to pay a special dividend to stockholders, how much debt should they issue? A) $321 B) $375 C) $600 D) $225 Answer: D Explanation: VFirm =

= $1,500

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 - $375 = $225 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 48) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much does Dynamo currently pay as interest, and how much will it have to pay after the restructuring in the prior problem, assuming that the cost of debt is constant? A) $42 and $26.25 B) $26.25 and $42 C) $160 and $37.50 D) $37.50 and $60 Answer: B Explanation: VFirm =

= $1,500

Debt today = 0.25 × $1,500 = $375 Interest payment on debt before restructuring = $375 × 0.07 = $26.25 Total debt after restructuring = 0.4 × $1,500 = $600 Interest payment on debt after restructuring = 0.07 × $600 = $42 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 13

49) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, how much of the special dividend do you receive, and how much do you receive in regular dividends per year after the restructuring according to M&M Proposition 1? A) $15 and $60 B) $60 and $15 C) $10.80 and $22.50 D) $22.50 and $10.80 Answer: D Explanation: VFirm =

= $1,500

50) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, what transaction do you need to take in order to undo the restructuring according to M&M Proposition 1? A) Sell $22.50 of stock B) Sell $10.80 worth of stock C) Buy $22.50 worth of debt D) Buy $10.80 worth of debt Answer: C Explanation: VFirm =

= $1,500

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 - $375 = $225 Portion of special dividend received = 0.10 × $225 = $22.50 M&M Proposition 1 says to take your portion of the special dividend ($22.50) and buy that much of the new debt issuance. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

51) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, according to M&M Proposition 1, what are the interest payments that you receive after you undo the restructuring, and what are your total cash flows? (Do not round intermediate calculations. (Round the final answer to two decimal places.) A) $1.58 and $12.38 B) $23.55 and $75 C) $1.125 and $12.38 D) $23.55 and $12.38 Answer: A Explanation: VFirm =

= $1,500

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 - $375 = $225 Portion of special dividend received = 0.10 × $225 = $22.50 Interest payment on debt after restructuring = 0.07 × $600 = $42 Cash flows to you after restructuring = 0.10 × ($150 - $42) = $10.80 Since you have purchased $22.50 worth of debt, then you will receive $22.50 × 0.07 = $1.575 in interest payments. Since you will receive $10.80 in dividends after the restructuring, your total cash flows are $1.575 + $10.80 = $12.38, the same as before the restructuring. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 52) Cadmium Electronics Inc. currently has a capital structure that is 40 percent debt and 60 percent equity. If the firm's cost of equity is 12 percent, the cost of debt is 8 percent, the risk-free rate is 3 percent and the firm pays no tax, what is the appropriate WACC? A) 8.4% B) 9.6% C) 10.4% D) 9.2% Answer: C Explanation: WACC = xDebtkDebt + xEquitykEquity = (0.40 × 0.08) + (0.60 × 0.12) = 0.104 OR 10.4% Diff: 2 Learning Objective: LO 1, 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 16

53) Gangland Water Guns, Inc. has a debt-to-equity ratio of 0.5. If the firm's cost of debt is 7 percent, its cost of equity is 13 percent and it pays no tax, what is its WACC? A) 9% B) 10% C) 11% D) 12% Answer: C Explanation: Using the debt-to-equity ratio, you can solve for the percentage of the capital structure that is debt and the percentage that is equity. If D/E = 0.5, then let's assume that D = 1 and E = 2. Therefore, D + E = 3. This gives a debt percentage of 33.33 percent and an equity percentage of 66.66 percent. Then, WACC = xDebtkDebt + xEquitykEquity = (1/3) × 0.07 + (2/3) × 0.13 = 0.11 OR 11% Diff: 2 Learning Objective: LO 1, 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 54) Swirlpool, Inc. has a WACC of 11 percent, cost of debt of 8 percent, and a cost of equity of 12%. What must the debt-to-equity ratio be if the firm pays no tax? A) 1/2 B) 1/4 C) 1/6 D) 1/3 Answer: D Explanation: WACC = xDebtkDebt + xEquitykEquity = xDebt × 0.08 + xEquity × 0.12 = 11% Also, D + E = 1 by definition. Therefore, substituting gives you: xDebt × 0.08 + (1 - xDebt) × 0.12 = 0.11. 0.08xDebt +0.12 - 0.12xDebt = 0.11 -0.04 xDebt = -0.10xDebt = 1/4 Solving for xDebt gives you 1/4 or 0.25, which means that xEquity must be 3/4 or 0.75. 0.25/0.75 = 1/3 Therefore, the D/E is 1/3. Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

55) Melba's Toast has a capital structure with 30 percent debt and 70 percent equity. Its pretax cost of debt is 6 percent, and its cost of equity is 10 percent. The firm's marginal corporate income tax rate is 35 percent. What is the appropriate WACC? A) 8.17% B) 6.35% C) 8.80% D) 7.44% Answer: A Explanation: WACC with taxes = xDebtkDebt pretax(1 - t) + xEquitykEquity = (0.30 × 0.06 × (1 - 0.35)) + (0.70 × 0.10) = 0.0817 OR 8.17% Diff: 2 Learning Objective: LO 1, 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 56) A firm has $300 million in outstanding debt and $900 million in outstanding equity. Its cost of equity is 11 percent, its cost of debt is 7 percent, and it pays no tax. What is the WACC? A) 6% B) 8% C) 9% D) 10% Answer: D Explanation: WACC = xDebtkDebt + xEquitykEquity = (300/1,200) × 0.07 + (900/1,200) × 0.11 = 0.10 OR 10% Diff: 2 Learning Objective: LO 1, 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

57) A firm has a WACC of 8.5 percent, a pretax cost of debt of 5 percent, a cost of equity of 12 percent, and a marginal corporate income tax rate is of 35 percent. About what percent of the firm's capital structure is financed with equity? A) 50% B) 60% C) 70% D) 80% Answer: B Explanation: WACC = 0.085 = (1 - xEquity)kDebt(1 − t) + xEquitykEquity 0.085 = (1 - xEquity) × 0.05 × (1 − 0.35) + (xEquity × 0.12) Solving for xEquity gives you 0.588 or about 60%. Diff: 2 Learning Objective: LO 1, 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 58) Bellamee, Inc. has a required rate of return on its assets of 12 percent and a cost of debt of 6.25 percent. Its current debt-to-equity ratio is 1/5. What is the required rate of return on its equity? A) 12.15% B) 13.15% C) 14.15% D) 15.15% Answer: B Explanation: kcs = kAssets + (D/E)(kAssets - kDebt) = 0.12 + (1/5) × (0.12 - 0.0625) = 0.1315 OR 13.15% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

59) Bellamee, Inc. has a required rate of return on its assets of 12 percent and a cost of debt of 6.25 percent. Its current debt-to-equity ratio is 1/5. What is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on its debt to 7 percent? A) 14.00% B) 14.25% C) 14.50% D) 15.00% Answer: A Explanation: kcs = kAssets + (D/E)(kAssets - kDebt) = 0.12 + (2/5) (0.12 - 0.07) = 0.14 OR 14% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 60) Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14 percent, and the risk-free rate is 5 percent. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5 percent and an YTM of 7.9 percent to its capital structure. What percent of the firm's costs are fixed, and what percent of costs are variable with the added debt? (Round the percentage answer to two decimal places.) A) 27.9% and 72.1% B) 72.1% and 27.9% C) 25.23 and 74.77% D) 74.77% and 25.23% Answer: C Explanation: With the debt, fixed cost percentage is: (SG&A + Interest payments)/(SG&A + Interest payments + COGS) = ($100 + ($700)(0.05))/($100 + ($700)(0.05) + $400) = 25.23% Therefore, variable cost percentage is: $400/($100 + ($700)(0.05) + $400) = 0.747664 OR 74.77% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

61) Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14 percent, and the risk-free rate is 5 percent. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5 percent and an YTM of 7.9 percent to its capital structure. What is the net income of Banana without and with the debt? A) $500 and $484.20 B) $484.20 and $500 C) $500 and $465 D) $490 and $500 Answer: C Explanation: Without debt, net income = $1,000 - $400 - $100 = $500 With debt, net income = $1,000 - $400 - $100 - ($700 × 5%) = $465 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 62) Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14 percent, and the risk-free rate is 5 percent. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5 percent and an YTM of 7.9 percent to its capital structure. Suppose, revenues fall by $300, due to a decrease in the selling price, what is the percent change in net income with and without the debt? Assume that the total variable production costs remain the same. (Round the answer to one decimal place.) A) 64.5% and 60% B) 60.0% and 64.5% C) 59.2% and 40.8% D) 40.8% and 59.2% Answer: B Explanation: Without debt, net income = $1,000 - $400 - $100 = $500 With debt, net income = $1,000 - $400 - $100 - ($700 × 5%) = $465 Without debt, the new net income = $700 - $400 - $100 = $200 Therefore, the percentage change = ($500 - $200)/$500 = 60% With debt, the new net income = $700 - $400 - $100 - $35 = $165 Therefore, the percentage change = ($465 - $165)/$465 = 64.5% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

63) Suppose a firm has a cost of equity of 12 percent, a D/E ratio of 1/6, and the YTM on its bonds is 7.5 percent. The risk-free rate is currently 3 percent. What is the current required rate of return on its assets and equity if the D/E ratio is changed to 1/3? (Round the answer to one decimal place of percentage.) A) 11.36% and 13.25% B) 11.36% and 8.25% C) 13.25% and 11.36% D) 11.36% and 12.65% Answer: D Explanation: kcs = kAssets + (D/E)(kAssets - kDebt) → 12% = kAssets + (1/6)( kAssets -7.5%) → kAssets = 11.36% Note that, if D/E ratio changes, kAssets does not change. The new cost of equity is then given as: kcs = 11.36% + (1/3)(11.36% - 7.5%) = 12.65% Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 64) Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35 percent tax bracket. The appropriate discount rate for its cash flows is 12 percent. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders. Using the perpetuity valuation model, calculate the value of the firm without debt in the capital structure. Assume that the pretax annual cash flows are perpetual. Round to the nearest dollar. A) $350 B) $650 C) $2,917 D) $5,417 Answer: D Explanation: VFirm = [CF × (1 - t)]/i = [$1,000 × (1 - 0.35)]/0.12 = $5,417 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

65) Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35 percent tax bracket. The appropriate discount rate for its cash flows is 12 percent. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders What is Millennium's value after the debt issuance? Assume that the pretax annual cash flows are perpetual. A) $5,417 B) $5,942 C) $6,392 D) $6,512 Answer: B Explanation: VFirm = [CF × (1 - t)]/i = [$1,000 × (1 - 0.35)]/0.12 = $5,417 PV of tax shield = $1,500 × 0.35 = $525 VFirm = VUnleveraged + PV of the tax shield = $5,417 + $525 = $5,942 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 66) The interest tax shield: A) does not affect the WACC. B) makes it less costly to distribute cash to investors through interest payments than through dividends. C) is given as: D × (1 - t). D) makes it less costly to distribute cash to investors through interest payments than through dividends, and is given as: D × (1 - t). Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 67) In order to calculate the present value of debt tax savings, the ________ is used as the discount rate. A) WACC B) risk-free rate C) required rate of return on debt D) market rate Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 23

68) Academic studies have estimated that the tax benefit of debt realized by firms is approximately: A) 10% of firm value. B) a 10% reduction in WACC. C) a 10% reduction in the cost of debt. D) 10% of debt value. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 69) The use of debt financing: A) causes a manager to take on riskier projects in order to make interest payments. B) is more expensive than issuing equity due to the use of covenants. C) allows managers to make discretionary interest payments. D) limits the ability of managers to waste stockholders' money. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 70) Which of these statements about direct bankruptcy costs is NOT true? A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and consultants. B) Direct bankruptcy costs are less than indirect bankruptcy costs. C) Direct bankruptcy costs include payments to suppliers on delivery. D) Direct bankruptcy costs can be reduced by negotiating with lenders. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

71) Which of these is NOT an example of indirect bankruptcy costs? A) A firm's customers become concerned about whether or not warranties will be honored. B) Employees begin to leave the firm. C) New accountants are brought in to help with the bankruptcy process. D) A bankruptcy judge orders new projects to be halted. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 72) The use of debt financing: A) reduces agency costs between the stockholders and management by increasing the amount of risk the managers take. B) increases agency costs between the stockholders and management by limiting the amount of risk the managers take. C) increases agency costs since managers prefer to keep less retained earnings to make dividend payments. D) increases agency costs between the stockholders and management by limiting the amount of risk the managers take, and increases agency costs since managers prefer to keep more retained earnings to make dividend payments. Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 73) The asset substitution problem occurs when: A) managers substitute more risky assets for less risky ones to the detriment of bondholders. B) managers substitute less risky assets for more risky ones to the detriment of bondholders. C) managers substitute more risky assets for less risky ones to the detriment of equity holders. D) managers substitute less risky assets for riskier ones to the detriment of equity holders. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

74) The underinvestment problem occurs in a financially distressed firm when: A) the value of investing in a positive NPV project is likely to go to debt holders instead of equity holders. B) the value of investing in a positive NPV project is likely to go to equity holders instead of debt holders. C) management invests in negative NPV projects to reduce their own risk. D) issuing equity becomes difficult due to increased risk. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 75) Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. The firm borrows $2,000, and its coupon rate is 8 percent. If the company's marginal tax rate is 30 percent and its average tax rate is 20 percent, what are its after-tax earnings? A) $238 B) $272 C) $259 D) $290 Answer: A Explanation: After-tax earnings = (Earnings - Interest payments) × (1 - t) Interest payment = $2,000 × 8% = $160 = ($500 - $160) × (1 - 0.3) = $238 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

76) A firm plans to issue $1 million worth of debt with a YTM of 9 percent. The debt is trading at par. The firm's marginal corporate tax rate is 25 percent, while its average tax rate is 15 percent. By how much will the new debt reduce the firm's annual tax liability? A) $13,500 B) $22,500 C) $32,500 D) $43,500 Answer: B Explanation: Tax shield = D × kDebt × t = $1,000,000 × 0.09 × 0.25 = $22,500 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 77) A firm plans to issue $1 million worth of debt with a YTM of 9 percent. The debt is trading at par. The firm's marginal corporate tax rate is 35 percent. What is the present value of the tax savings if the debt never matures? A) $11,025 B) $20,475 C) $350,000 D) $227,500 Answer: C Explanation: VTax-savings debt = D × t = $1,000,000 × 0.35 = $350,000 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

78) Suppose that UBM Corp. has invested $100 million in 8 percent risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM shareholders are considering selling $100 million in debt and investing in a project that has a 60 percent chance of returning $200 million and a 40 percent chance of returning $2 million. What will the equity value of UBM be in one-year without stockholders taking on the project? A) $100 million B) $80 million C) $20 million D) $8 million Answer: C Explanation: Value of Equity of UBM = Value of risk-free debt owner - Value of bonds maturing = $100 million - $80 million = $20 million Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 79) Suppose that UBM Corp. has invested $100 million in 8 percent risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60 percent chance of returning $200 million and a 40 percent chance of returning $2 million. What is the expected value of the bonds to the lenders if the stockholders sell the debt? A) $100 million B) $88.8 million C) $48.8 million D) $68.8 million Answer: C Explanation: E[VBonds] = (0.60 × $80 million) + (0.40 × $2 million) = $48.8 million Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

80) Suppose that UBM Corp. has invested $100 million in 8 percent risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60 percent chance of returning $200 million and a 40 percent chance of returning $2 million. What is the expected value of the equity if the stockholders sell the debt? A) $175 million B) $97.5 million C) $51 million D) $72 million Answer: D Explanation: E[VEquity] = (0.60 × ($200 million - $80 million) + (0.40 × $0 million) = $72 million Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 81) Suppose that UBM Corp. has invested $100 million in 8 percent risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60 percent chance of returning $200 million and a 40 percent chance of returning $2 million. Given the payoffs of the project, what does the percent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project? A) 1/3 B) 1/4 C) 1/5 D) 1/6 Answer: D Explanation: E[VEquity] = (PSuccess ×( $200 million - $80 million)) + ((1 - PSuccess) × $0) = $20 million (PSuccess × ($200 million - $80 million)) = $20 million Therefore, PSuccess must be 1/6. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

82) Suppose that JMK, Inc. has debt with a face value of $100 million and assets worth $70 million. The firm's management has identified a risk-free project that will require an initial outlay of $10 million and will return a NPV of $16 million. The firm currently has no cash. What would be the effect on stockholders' wealth if they took on this project? A) -$10 million B) $0 million C) $26 million D) $70 million Answer: A Explanation: If it takes on the project, the firm will receive its $10 million back, along with the $16 million. This gives the firm assets worth $96 million, which is still less than the value of outstanding debt. Therefore, the shareholders would be out the $10 million of equity that the firm had to sell in order to take on the project. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 83) Which of the following supports the trade-off theory of capital structure? A) Firms use cash on hand first, since issuing equity and debt is expensive. B) A firm's capital structure is the result of past equity and debt issuance decisions. C) Firms have a target capital structure that maximizes the value of firm. D) Firms use cash on hand first, since issuing equity and debt is expensive, and a firm's capital structure is the result of past equity and debt issuance decisions. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

84) A firm wishes to invest in a project that costs $150 million. It currently has $10 million in cash on hand and believes that it can raise $75 million in debt and $100 million in equity if needed. According to the pecking order theory of the capital structure, what percent of the project will be financed by debt? A) 0% B) 26.67% C) 50% D) 76.67% Answer: C Explanation: According to the pecking order theory, the firm will first use its available cash, which is $10 million. Next, the firm will turn to debt. Since the amount of debt it can raise plus the amount of cash on hand is less than the project cost, the entire amount of debt raised will be used. Therefore, $75 million / $150 million = 0.5 OR 50% Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 85) Which of the following should a company consider when deciding to buy or lease an asset? A) Transaction cost, but not information costs B) Information costs, but not transaction costs C) The effect of buy or lease decision on the firm's capital structure, but not its profitability D) Taxes Answer: D Diff: 1 Learning Objective: LO Appendix Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 86) Which of the following would arise if the lessee can have the incentive to use the asset more than the lessor would prefer? A) Operating lease conflict B) Capital lease conflict C) Intensity of use conflict D) Maintenance conflict Answer: C Diff: 1 Learning Objective: LO Appendix Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

87) Which of the following arises when the lessee can have the incentive to use the asset more than the lessor would prefer? A) Track the total services obtained from the asset and charge the lessee additional fees based on lack of usage. B) Make a service contract available, but not mandatory. C) Do not provide the lessee with the right to buy the asset when the lease expires. D) Bundle the lease contract with a service contract. Answer: D Diff: 1 Learning Objective: LO Appendix Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

88) LMNO Manufacturing needs a new laser and is comparing buying or leasing. Under either alternative, the company will only need the laser for 5 years. Assume LMNO's marginal tax rate is 30 percent. Purchase Alternative: It would cost $50,000 to purchase the laser and the amount could be financed with a five-year balloon loan at 9 percent. The laser will be depreciated on straight line and have no salvage value. Maintenance on the laser is expected to be $1,200 per year. Lease alternative: The company that manufactures the laser offers a 5-year leasing option with annual lease payments of $12,500. With this option, the lessor will be responsible for maintenance of the laser and will take it back after 5 years. The lease will be classified as an operating lease. Which is the best option for LMNO Manufacturing? (Do not round the intermediate calculation. Round final answer to the nearest dollar.) A) Purchase, the company will be $4,416 better off B) Lease, the company will be $4,416 better off C) Purchase, the company is $10,496 better off D) Lease, the company is $10,496 better off Answer: B Explanation: Purchase: After-tax annual interest expense = $50,000 × 0.09 × (1 - 0.3) = $3,150 Annual depreciation = $50,000/5 = $10,000, so annual tax savings = $10,000 × 0.3 = $3,000 After-tax annual maintenance cost = $1,200 × (1 - 0.3) = $840 So after-tax cash flow years 1 - 4 = ($3,150) + $3,000 + ($840) = ($990) After-tax cash flow year 5 = ($50,000) loan repayment + ($990)= ($50,990) After-tax cost of debt = 0.09(1 - 0.3) = 0.063 NPV of after-tax cash flows = (-$990/1.063) + (-$990/1.0632) + (-$990/1.0633) + ($990/1.0634) + (-$50,990/1.0635) = ($40,975.07) Lease: After-tax annual lease payment = $12,500 × (1 - 0.3) = $8,750 Interest rate pretax = 9% After-tax interest rate= 9% × (1 - 30%) = 6.3% PV of ($8,750) for 5 years at 6.3% = $36,559.31 So, the total benefit from leasing is $40,975.08 - $36,559.31 = $4,415.77 OR $4,416.00 (rounded) Diff: 3 Learning Objective: LO Appendix Bloomcode: Evaluation AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

89) One of the conditions that the M&M Propositions required was that the firm does not pay tax. Briefly discuss whether the introduction of taxes decreases or increases the value of the firm. Answer: The relaxation of the no tax assumptions actually increases the value of a firm by an amount equal to the present value of the tax shield on the firm's debt obligations. If we consider the debt to be infinitely outstanding, then we can approximate the present value of the tax shield by multiplying the amount of the debt by the tax rate. The tax saving on the interest payment of debt would allow the firm to distribute more total cash flow to the debt holders and equity holders. Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 90) Briefly explain how an increase in the amount of debt that a firm has outstanding may actually decrease the agency costs caused by the conflict between managers and stockholders. Answer: The manager-stockholder agency conflict is caused by a misalignment of interests between the two parties. When a firm has excess cash available for managers to waste–which is bad for stockholders–then an increase in debt, and consequently the level of interest service required of that debt, will make less cash available for the manager to waste. The managers will be more careful in selecting the projects that will maximize the shareholders' wealth. This has the effect of reducing manager-stockholder agency cost. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

91) The pecking order theory of capital structure suggests that managers will choose to utilize retained earnings before issuing additional debt when financing new projects. Does that imply anything about the flotation costs of issuing new securities? Answer: The answer to the question is no. It implies that managers perceive there to be a higher cost of issuing new debt versus stockholders' equity. It is a perception because even after considering flotation costs, new debt is still much cheaper than retained earnings, which belongs to stockholders. Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 17 Dividends, Stock Repurchases, and Payout Policy 1) When a firm distributes dividends to stockholders, the amount of equity capital invested in the firm is reduced. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 2) A liquidating dividend is a dividend that is paid to stockholders when a firm is liquidated. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3) Under U.S. bankruptcy rules, the proceeds from the sale of a company's assets are first used to pay a liquidating dividend to the shareholders before any other party has a claim on those assets. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 4) Suppose an investor purchases a dividend-paying stock of a public company the day prior to the dividend record date. This investor is entitled to the next dividend. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

5) Distributions to the stockholders in the form of a standing discount for products or services that a firm produces are often not thought of as dividends. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6) Stock prices react to dividend announcements because the amount of the dividend sends a signal to investors about management's view of the company's prospects. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 7) Dividends reduce the stockholder's claim to the firm's assets. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 8) Stock prices drop on the ex-dividend date, but usually the drop is less than the full amount of the dividend. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 9) If there are no taxes on dividends, then the price of a stock will not drop on the ex-dividend date. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 2

10) Private companies often do not announce dividend payments because private company shares are not frequently traded, and the list of shareholders is relatively small. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 11) The record date typically follows the ex-dividend date by two business days. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 12) Stockholders who do not choose to sell back their shares in a stock repurchase are losing money because the company is only distributing value to the participating shareholders. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 13) A Dutch auction tender offer stock repurchases always take place at a price higher than the market price of the stock. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

14) Targeted share repurchases always occur at a price higher than the current market quoted price for a stock. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 15) Open-market stock repurchases are a more convenient way for a company to distribute large amounts of cash compared to dividend payments. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 16) A firm's dividend policy does not affect the firm's value. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 17) A large regular dividend always denotes a firm with a low level of cash that also has many new project alternatives. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 18) Dividend policy can help a firm maintain a desired capital structure. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 4

19) Stock repurchases are a stronger indication of free cash flow than dividends. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 20) Compared to raising regular cash dividends, initiating an open-market stock repurchase is generally not as strong a positive signal to the investors because the repurchase can easily be canceled or scaled back before it is completed. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 21) In a world with no taxes, no information or transaction costs, and a fixed real investment policy, a dividend policy should not affect the value of a firm. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 22) Traditionally, capital gains taxes on repurchases have been higher than the taxes on dividends. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

23) Suppose that the government raises short and long-term capital gains taxes while leaving all other taxes unchanged. This tax rate change would encourage companies to increase the use of stock repurchases rather than issuing dividends. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 24) Dividend reinvestment programs allow investors to reinvest the dividends they receive into a company's stock without paying taxes on the dividends or a transaction fee on the stock purchase. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 25) Some companies have been known for paying dividends to current stockholders while simultaneously raising capital through a new equity issue. Generally, this behavior is explained by the need to discipline managers by regularly exposing the company to the extra scrutiny involved in an equity issue. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 26) It is unethical for a corporate board to conduct a large tender offer for stock repurchase when the board members have private information indicating that the company's share price is too low. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

27) Paying a stock dividend does not involve the distribution of any value to the company's stockholders. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 28) Although stock splits do not add any value to a firm, investors tend to react positively to stock splits because management is not likely to initiate a stock split if the firm's prospects are poor. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 29) A key distinction between stock dividends and stock splits is that stock dividends are typically regularly scheduled events, whereas stock splits tend to occur infrequently during the life of a company. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 30) Surveys conducted of managers tell us that they primarily use regular cash dividends to precisely adjust the leverage ratio to the target suggested by the trade-off theory of capital structure. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

31) The best way to convey to the market that a new level of cash flow is permanent is to increase (or commence) a regular cash dividend since a regular dividend comes with the expectation that it will not be reduced without unforeseen events occurring in the future. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 32) Which of the following types of dividend is most likely to be used to distribute the revenue from a one-time sale of a large asset? A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 33) Which of the following types of dividend is used to distribute any remaining value when a company's assets are being sold as the company is terminated? A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

34) Consider a company that had unexpected higher earnings last quarter, and it intends to pay out some additional value to shareholders. Which of the following types of dividend is the company likely to use? A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 35) Which of the following steps in the dividend payment process for a public company usually results in a change in the company's stock price? A) Public announcement B) Ex-dividend date C) Payable date D) Both Public announcement and Ex-dividend date Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 36) The shares of Milton, Inc. fell sharply today after the company announced that it is increasing its regular cash dividend distributions. Which of the following explanations may explain investors' negative reaction? A) Changes in regular cash dividends are made frequently so that the company's management can adjust for changes in short-term earnings. B) Investors previously believed the company had many lucrative growth opportunities. By announcing higher regular cash dividends, the company is sending a signal that it does not have enough positive NPV projects to use all the money. C) Investors expected that the company would announce a stock repurchase rather than a cash dividend increase. Since a change in dividend policy is commonly viewed as a weaker signal than a stock repurchase. The share price fell on the news of the dividend increase. D) None of these. Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 9

37) Which of these examples does NOT meet the strict definition for a dividend? A) Steel Gen Corp regularly distributes $0.05 to each shareholder for every share they own. B) Chalone Vineyards once offered their investors discounts on wine in proportion to the number of shares they owned. C) Churchill Downs, Inc. which operates several horse racing tracks, including the location for the Kentucky Derby, distributes two free general admission tickets to every investor who holds more than 100 shares in the company (as of 2012). D) Both Chalone Vineyards once offered their investors discounts on wine in proportion to the number of shares they owned and Churchill Downs, Inc. which operates several horse racing tracks, including the location for the Kentucky Derby, distributes two free general admission tickets to every investor who holds more than 100 shares in the company (as of 2012). Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 38) Jupiter, Co. will be distributing $40 million to shareholders through a special dividend. The company has 160 million shares outstanding. If you own 100 shares of Jupiter, Co. how much will you receive? Ignore taxes. A) $400 B) $100 C) $25 D) None of these Answer: C Explanation: The dividend payment will be ($40 million / 160 million shares) = $0.25 per share. With 100 shares, you will receive 100 × $0.25 = $25. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

39) Mercury, Co. has announced it will pay its regular cash dividend of $0.45 per share. If dividends are taxed, about how much do you expect the price of Mercury stock to drop on the ex-dividend day? The tax rate on dividends is 15 percent. (Round your final answer to two decimal places.) A) $0.07 B) $0.38 C) $0.45 D) $0.52 Answer: B Explanation: The price would be expected to drop by the amount investors receive after taxes $0.45 × (1 - 0.15) = $0.38 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 40) You own 10,000 shares of Mars, Co. which is currently trading for $11.50 per share. The company has announced that it will soon pay a special dividend of $1.50 per share. Tomorrow is the ex-dividend day. Ignoring taxes, what do you expect your block of shares will be worth tomorrow? A) $15,000 B) $100,000 C) $115,000 D) $200,000 Answer: B Explanation: With no taxes you expect that the company's stock will drop by $1.50 to $10.00. Your holdings will be worth 10,000 shares × $10 = $100,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

41) Doorstep, Co. stock is currently trading at $25.70 per share. The company pays a regular cash dividend of $0.40 every quarter. Tomorrow is ex-dividend day for the upcoming regular dividend. Assuming there is no new information released about the company, how much do you expect the company's stock to trade for tomorrow? Assume there are no taxes involved. A) $0.40 B) $25.24 C) $25.30 D) $25.36 Answer: C Explanation: The new stock price would be $25.70 - $0.40 = $25.30 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 42) Daniel, Co. stock is currently trading at $38.15 per share. The company pays a regular cash dividend of $0.80 every quarter. Tomorrow is ex-dividend day for the upcoming regular dividend. Assuming there is no new information released about the company. How much do you expect the company's stock to trade for tomorrow? Assume there are no taxes involved. A) $37.47 B) $37.35 C) $37.32 D) $37.23 Answer: B Explanation: The new stock price would be $38.15 - $0.80 = $37.35 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

43) Ferrico, Co. is currently trading at $37.00 per share. The company is paying a regular cash dividend of $0.40 per share and an extra dividend of $0.10 per share. Tomorrow is the exdividend day. The tax rate on dividends is 15 percent. Assuming there is no new information released about the company. How much do you expect the company's stock to trade for tomorrow? (Do not round the intermediate calculation. Round your final answer to two decimal places.) A) $36.43 B) $36.50 C) $36.58 D) $37.00 Answer: C Explanation: The price would be expected to drop by the amount investors receive after taxes ($0.40 + 0.10) × (1 - 0.15) = $0.425 The new stock price would be $37.00 - $0.425 = $36.58 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 44) Moon, Co. is currently trading at $22.00 per share. The company is paying a regular cash dividend of $0.30 per share, and an extra dividend of $0.05 per share. Tomorrow is the exdividend day. The tax rate on dividends is 15 percent. Assuming there is no new information released about the company, how much do you expect the company's stock to trade for tomorrow? (Do not round the intermediate calculation. Round your final answer to two decimal places) A) $21.70 B) $21.65 C) $21.60 D) $21.55 Answer: A Explanation: The price would be expected to drop by the amount investors receive after taxes ($0.30 + $0.05) × (1 - 0.15) = $0.2975 The new stock price would be $22.00 - $0.2975 = $21.70 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

45) Bright Capital, Inc. is being liquidated. The company's assets can be sold for $20 million. It will cost $18 million for the company to meet all its previous obligations and to pay-off debt holders. The company has 30 million shares outstanding. If you own 2,000 shares, how much do you expect to receive in liquidating dividends? Ignore taxes. (Round your final answer to two decimal places.) A) $0.00 B) $133.33 C) $266.66 D) $1,200.00 Answer: B Explanation: Shareholders will receive the residual claim after other claimholders have been paid $20 million - $18 million = $2 million This $2 million will be distributed on a pro-rata basis. As a holder of 2,000 shares, you will receive $2 million × (2,000 shares/30 million shares) = $133.33 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 46) You own 20,000 shares of stock in Casi-knows, Inc. which has just sold one of its large resort hotels for $300 million. Management intends to return the entire revenue from the sale to shareholders by issuing a special dividend. If Casi-knows has 20 million shares outstanding, what would you expect to receive as a dividend? A) $20,000 B) $200,000 C) $300,000 D) $1,000,000 Answer: C Explanation: The $300 million will be distributed on a pro-rata basis. You will receive $300 million × (20,000 shares / 20 million shares) = $300,000 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

47) Earmark, Co. has a policy of returning a minimum of 40 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.35 per share. In each of the first three quarters the company paid a regular cash dividend of $0.10 per share. What combination of dividends could the company's board approve to meet their target payout percentage? A) A regular cash dividend of $0.10 per share B) A regular cash dividend of $0.10 per share and an extra dividend of $0.56 per share C) A regular cash dividend of $0.10 per share and an extra dividend of $0.46 per share D) A regular cash dividend of $0.10 per share and an extra dividend of $0.16 per share Answer: D Explanation: The company earned $0.35 × 4 quarters = $1.40 per share this year. To achieve the 40 percent target, the firm must distribute $1.40 × 40% = $0.56 per share to shareholders. The company has already distributed $0.10 × 3 quarters = $0.30 per share. The company could meet the target by distributing another $0.26 per share through a regular dividend of 0.10 per share and an extra dividend of 0.16 per share. Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 48) Lithion, Co. has a policy of returning a minimum of 25 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.20 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. What combination of dividends could the company's board approve to meet their target payout percentage? A) A regular cash dividend of $0.05 B) A regular cash dividend of $0.05 per share and an extra dividend of 0.05 per share C) A regular cash dividend of $0.05 per share and an extra dividend of $0.10 per share D) A regular cash dividend of $0.05 per share and an extra dividend of $0.20 per share Answer: A Explanation: The company earned $0.20 × 4 quarters = $0.80 per share this year. To achieve the 25 percent target, the firm must distribute $0.80 × 25% = $0.20 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share. The company could meet the target by distributing another $0.05 per share through a regular dividend. Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

49) Which of the following is NOT a possible result of a stock repurchase? A) Removing a large number of shares from circulation can change the ability of certain shareholders to control the firm. B) If the number of remaining shares is relatively small, the remaining shares will be less liquid. C) The debt-to-equity ratio will be increased. D) By repurchasing stock when it is undervalued, managers can effectively transfer value from stockholders who choose to sell their shares to stockholders choose to remain invested in the company. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 50) Which type of stock repurchase often takes place at a price below the current market price of the stock? A) Open-market repurchase B) Fixed-price tender offer repurchase C) Dutch auction tender offer repurchase D) Targeted stock repurchase Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 51) Which type of stock repurchase allows management to set the repurchase price at the lowest level necessary to repurchase the desired number of shares? A) Open-market repurchase B) Fixed-price tender offer repurchase C) Dutch auction tender offer repurchase D) All of these Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

52) Which of these actions could by itself have an impact on the control of a firm? A) A tender offer stock repurchase B) A special dividend payment C) A stock split D) A regular cash dividend payment Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 53) Venus Co. has just announced that the board has reached a targeted stock repurchase agreement with a large stockholder. The company will repurchase all of the large investor's stock for 90 percent of the current market value. When the stock repurchase was announced, the shares of Venus Co. fell by 7 percent. Which of these explanations could reasonably explain the drop in share price? A) The willingness of the large investor to accept the targeted stock repurchase signals that the large investor believes the company will not do well in the future. B) A targeted stock repurchase essentially transfers value from the average investor to the targeted investor. C) The investor believes that the company's management is entrenching itself by buying off any large block shareholders. D) Both the willingness of the large investor to accept the targeted stock repurchase signals that the large investor believes the company will have poor future performance and the investor believes that the company's management is entrenching itself by buying off any large block shareholders. Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

54) Neonia, Co. has a policy of returning at least 25 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.25 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. The company has 2 million shares of common stock outstanding. What combination of dividends and stock repurchases could the company's board approve to meet their target payout percentage? A) A regular cash dividend of $0.05 B) A regular cash dividend of $0.05 per share and an open-market stock repurchase of $100,000 in stock C) A regular cash dividend of $0.05 per share and an open-market stock repurchase of $400,000 in stock D) A regular cash dividend of $0.05 per share and an open-market stock repurchase of 500,000 in stock Answer: B Explanation: The company earned $0.25 × 4 quarters = $1.00 per share this year. To achieve the 25 percent target, the firm must distribute $1.00 × 25% = $0.25 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share. If the company issues another regular dividend of $0.05 per share, it will still have $0.05 per share to remaining to be returned to shareholders. The stock repurchase required to return that value would be (0.05 per share × 2 million shares) = $100,000 of stock repurchase. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

55) Calciya, Co. has a policy of returning at least 40 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.20 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. The company has 8 million shares of common stock outstanding. What combination of dividends and stock repurchases could the company's board approve to meet their target payout percentage? A) A regular cash dividend of $0.05 B) A regular cash dividend of $0.05 per share and an open-market stock repurchase of $960,000 in stock C) A regular cash dividend of $0.05 per share and an extra dividend of $0.12 D) Both a regular cash dividend of $0.05 per share and an open-market stock repurchase of $960,000 in stock and a regular cash dividend of $0.05 per share and an extra dividend of $0.12 Answer: D Explanation: The company earned $0.20 × 4 quarters = $0.80 per share this year. To achieve the 40 percent target, the firm must distribute $0.80 × 40% = $0.32 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share. To meet the 40 percent target, the company must distribute another ($0.32 - $0.15) = $0.17 per share. The company could meet the target in two ways: 1. Either it could distribute another $0.17 per share through a regular dividend of $0.05 and an extra dividend of $0.12 per share, or; 2. The company could pay another $0.17 per share through a regular dividend of $0.05 and a stock repurchase of ($0.12 per share × 8 million shares) = $960,000 in stock. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 56) You purchased 3,000 shares of Space Apparition Co. four years ago at $40 per share. The company has announced a fixed-price tender offer stock repurchase at $70 per share. Capital gains are taxed at 20 percent. If you participate in the repurchase, how much will you receive? A) $31,500 B) $192,000 C) $178,000 D) $210,000 Answer: B Explanation: You will only be taxed on the capital gain. So you will receive 3,000 shares × ($40 + ($70 - $40) × (1 - 0.20)) = $192,000. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

57) You purchased 3,000 shares of Purple Stuff Beverage Co. four years ago at $30 per share. The company has announced a fixed-price tender offer stock repurchase at $36 per share. Capital gains are taxed at 15 percent. If you participate in the repurchase, how much will you receive? A) $18,000 B) $91,800 C) $105,300 D) $108,800 Answer: C Explanation: You will only be taxed on the capital gain. So you will receive 3,000 shares × ($30 + ($36 - $30) × (1 - 0.15)) = $105,300. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 58) You purchased 2,500 shares of Digital Vision, Corp. several years ago for $40 per share. The company is offering a fixed-price tender offer repurchase for $54 per share. What is the amount of after-tax proceeds you would receive from taking part in the repurchase, if capital gains are taxed at 15 percent? A) $120,000 B) $121,250 C) $129,750 D) $135,000 Answer: C Explanation: You will only be taxed on the capital gain. So you will receive 2,500 shares × ($40 + ($54 - $40) × (1 - 0.15)) = $129,750. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

59) Cosmic Crew & Co has 3 million shares outstanding. The shares are currently selling for $40. If the firm repurchases $10 million worth of shares at market prices, approximately how much will the stock be worth after the repurchase? Ignore taxes. A) $40 B) $38 C) $42 D) $50 Answer: A Explanation: Before the repurchase, the firm was worth $40 per share × 3 million shares = $120 million. The number of shares the firm repurchased for $10 million at the market price of $40 = $10 million/$40 = 250,000 shares. After the repurchase, the firm has $120 million - $10 million = $110 million. The number of remaining shares = 3,000,000 - 250,000 = 2,750,000. So each share is worth $110,000,000/2,750,000 = $40 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 60) You purchased 500 shares in Catalyst, Inc. several years ago for $20. The company previously announced it will be distributing cash to shareholders as follows. First, the company will have a tender offer stock repurchase at $30 per share. After the repurchase, it will issue a special dividend of $5.00 per share to the remaining stockholders. Suppose that you want to convert your holdings in Catalyst, Inc. into cash. Assume the tax on dividends is 30 percent and the tax on capital gains is 15 percent. The shares are currently trading for $30. Assume no new information comes out about the company. How much cash will you receive from taking part in the repurchase? A) You will receive $14,250 by taking part in the repurchase. B) You will receive $15,000 by taking part in the repurchase. C) You will receive $15,750 by taking part in the repurchase. D) You will receive $16,000 by taking part in the repurchase. Answer: A Explanation: If you take part in the repurchase, you will have to pay taxes on your capital gains. So, the amount you will receive = 500 shares × ($20 + ($30 - $20) × (1 - 0.15)) = $14,250. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

61) You purchased 500 shares in Div Choice, Inc. several years ago for $20. The company previously announced it will be distributing cash to shareholders as follows. First, the company will have a tender offer stock repurchase at $30 per share. After the repurchase, it will issue a special dividend of $5.00 per share to the remaining stockholders. Suppose that you want to convert your holdings in Div Choice, Inc. into cash. Assume the tax on dividends is 30 percent and the tax on capital gains is 15 percent. The shares are currently trading for $30. Assume no new information comes out about the company. Approximately, how much will you receive by waiting until after the ex-dividend day and then selling the shares in the market? (Do not round intermediate calculation. Round your final answer to the nearest dollar.) A) You will receive about $13,500 by selling after the ex-dividend day. B) You will receive about $14,775 by selling after the ex-dividend day. C) You will receive about $14,513 by selling after the ex-dividend day. D) You will receive about $15,000 by selling after the ex-dividend day. Answer: C Explanation: If you wait until the dividend payment, you will pay a 30 percent tax on the dividend, so you will receive $5 × (1 - 0.30) = $ 3.50 per share in dividends. However, we would expect the price of the stock to only fall by the after-tax amount of the dividend. So, the stock will be worth about $30 - $3.50 = $26.50. Thus, from selling the stock you will receive = ($20 + ($26.50 - $20) × (1 - 0.15)) = $25.525 per share. In total, you will receive ($25.525 + $3.50) × 500 shares = $14,512.50 or $14,513.00. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 62) Which of the following explanations is usually NOT a possible benefit of dividends? A) Some investors prefer dividend-paying stocks and will be willing to pay a higher price for stocks with regular dividends. B) Paying out large regular dividends can force management to regularly raise more capitals. The extra scrutiny involved in raising capital can increase the incentives of management to run the company efficiently. C) Dividends can be used to manage the capital structure of a company. D) Paying dividends reduces the probability that a firm will enter financial distress. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

63) Which of the following statements about the relative advantages of stock repurchases over dividends is NOT true? A) Since most ongoing stock repurchase programs are as visible as dividend programs, they can be used effectively to send a positive signal about a firm's prospects to investors. B) Open-market stock purchases allow management more flexibility because investors are less likely to react if the management cuts back or ends a stock repurchase as compared to cutting back on dividend payments. C) Stock repurchases allow stockholders to choose whether or not to participate in the stock repurchase. This allows stockholders to have more control over their tax burden. D) Historically, taxes on dividend payment have been higher than those on stock repurchases. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 64) In early 2003, the U.S. government cut the tax rate on dividends to a flat 15 percent instead of treating dividend payments as other income. All else being equal, how would we expect the number of companies paying dividends to change? A) We would expect the number of dividend-paying companies to increase. B) We would expect the number of dividend-paying companies to decrease. C) We would expect the number of dividend-paying companies to stay relatively constant. D) None of these. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

65) Suppose you are advising a retiree who holds 2,000 shares of LargeDiv Corp. The company is largely held by tax-paying institutional investors and has announced that it will shortly be issuing a large dividend. Because the shares are held in the retiree's Roth IRA, she will not incur taxes on either capital gains or dividends. The retiree has decided to sell the shares sometime this year, and use the money for living expenses. You expect the only upcoming change in the stock price will result from the dividend. Ignoring any discounting for time, what advice should you give? A) Sell the stock now–the stock price is likely to decline more than just the dividend amount. B) Sell the stock ex-dividend–the stock price is likely to decline, but by less than the dividend amount. C) Sell the stock–irrespective of when the stock is sold. D) Sell the stock now–it is always better to sell the stock immediately regardless of the tax consequences. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 66) You purchased 2,000 shares of Crimson Treat Technologies several years ago at $50 per share. The company does not pay a regular cash dividend. You want to manufacture your own dividend by selling a little bit of stock each quarter. The company's stock is currently trading at $75. If capital gains are taxed at 15 percent, how many shares would you have to sell to receive $3,420 in cash? A) 27 shares B) 46 shares C) 48 shares D) 51 shares Answer: C Explanation: The after-tax amount received per share = ($50 + ($75 - $50) × (1 - 0.15)) = $71.25. The number of shares to be sold = $3,420/$71.25 = 48 shares. Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

67) You purchased 8,000 shares of Wallflower Technologies several years ago at $20 per share. The company does not pay a regular cash dividend. You want to manufacture your own dividend by selling a little bit of stock each quarter. The company's stock is currently trading at $60. If capital gains are taxed at 15 percent, how many shares would you have to sell to receive $2,000 in cash? (Round your final answer to the nearest unit of shares.) A) 30 shares B) 33 shares C) 37 shares D) 39 shares Answer: C Explanation: The after-tax amount received per share = ($20 + ($60 - $20) × (1 - 0.15)) = $54. The number of shares to be sold = $2,000/$54 = 37 shares. Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 68) You purchased 4,000 shares of High-Div Co. several years ago at $50 per share. The company has decided to pay a special dividend of $2.00 per share. Dividend payments are taxed at 15 percent. You intend to reinvest in the company through the dividend reinvestment program. If the company's stock is trading at $48.20 following the dividend payment, how many additional shares can you buy through the dividend reinvestment program? (Round your final answer to the nearest unit of shares.) A) 166 shares B) 141 shares C) 134 shares D) 125 shares Answer: B Explanation: The after-tax amount received = ($2.00 × (1 - 0.15)) × 4,000 shares = $6,800. With the DRIP program, you will not have any transaction costs to reinvest. So, you can buy ($6,800/$48.20) shares = 141 shares Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

69) You own 7,000 shares of No-Drip Co. The company has decided to pay a special dividend of $1.00 per share. Dividend payments are taxed at 15 percent. You intend to reinvest your dividend back into the company, but the company does not have a dividend reinvestment program. To reinvest through your broker, you will have to pay a $46 commission. If the company's stock is trading at $12.43 following the dividend payment, how many additional shares will you be able to purchase? (Round your final answer to the nearest unit of shares.) A) 563 shares B) 481 shares C) 478 shares D) 475 shares Answer: D Explanation: The after-tax amount received = ($1.00 × (1 - 0.15)) × 7,000 shares = $5,950. You will also have to pay the $46 transaction fee, leaving you with $5,904 to invest. So, you can buy ($5,904/$12.43) shares = 475 shares Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 70) The Dimples Golf Ball, Co. has paid a regular dividend of $0.20 quarterly for the last three years. The company has 2 million shares outstanding. Over the next year the company will have to spend $800,000 to service its debt and spend $200,000 in capital expenditures. The company has $500,000 of cash and cash equivalents. Over the next year how much cash must be provided from operations to continue to make the same quarterly dividend payment and still have $500,000 in cash at the end of the year? A) 1,000,000 B) 1,600,000 C) 2,000,000 D) 2,600,000 Answer: D Explanation: To continue the current dividend pattern, the company will need to pay ($0.20 per quarter × 4 quarter) × 2 million shares = $1,600,000. The company will also need ($800,000 debt payments + $200,000 Capital Expenditure) = $1,000,000. The company must maintain $500,000 cash and cash equivalents. The result is that to meet the dividend payments and other requirements operations must provide ($1,600,000 + $1,000,000) = $2,600,000. Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

71) The Wyoming Boot, Co. has paid a regular dividend of $0.25 quarterly for the last several years. The company has 1 million shares outstanding. Over the next year, the company will have to spend $600,000 to service its debt and spend $500,000 in capital expenditures. The company has $600,000 of cash and cash equivalents. Over the next year, how much cash must be provided from operations to continue to make the same quarterly dividend payment and still have $250,000 in cash at the end of the year? A) 1,000,000 B) 1,100,000 C) 1,750,000 D) 2,100,000 Answer: C Explanation: To continue the current dividend pattern, the company will need to pay ($0.25 per quarter × 4 quarter) × 1 million shares = $1,000,000. The company will also need ($600,000 debt payments + 500,000 capital expenditures) = $1,100,000. The company can take ($600,000 - $250,000) = $350,000 from cash and cash equivalents and still have the necessary cash for next year. The result is that to meet the dividend payments and other requirements, operations must provide ($1,000,000 + $1,100,000 - $350,000) = $1,750,000. Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 72) Suppose you own shares of ThreeFor, Inc. which has just announced a 3-for-1 stock split. Immediately after the announcement, the price of the company's shares rose by 5 percent. You do not expect any new information about the company until after the stock split. Ignoring any discounting for time, if you intend to sell your shares soon, you should: A) sell the stock now–the single share you have now is likely to be worth more than the three shares you will have after the split. B) sell the stock after the split–typically, the marker reacts positively to stock splits. The three shares you will have after the split will be worth more than the single share you have now. C) sell the stock now–the stock is likely to be more liquid before the split when there are fewer shares. D) sell the stock–irrespective of when the stock is sold. If there is no new information about the stock, then the value of three shares after the split should be the same as the value of the single share you hold now. Answer: D Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

73) Generally, managers use a reverse stock split to: A) send a signal to investors that the company is expected to perform poorly. B) meet the minimum requirements to be listed on one of the major stock exchanges. C) increase the liquidity of shares by decreasing the number of share available. D) reduce the administrative costs associated with investor relations. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 74) Split-Gram, Inc. has announced a 4-to-1 stock split. If the company currently has 1 million shares outstanding, how many outstanding shares will it have after the split? A) 4 million shares B) 3 million shares C) 2 million shares D) 1 million shares Answer: A Explanation: The company had 1 million shares outstanding and is issuing a 4-for-1 stock split. The no. of outstanding shares after the split = 4 × 1 million = 4 million. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 75) You own 3,000 shares of Split-Holdings Co. The shares are currently selling for $48. The company has just announced a 4-for-1 stock split. How many shares will you own after the split, and approximately what will your holdings in Split-Holdings Co. be worth? A) 12,000 shares worth about $144,000 B) 12,000 shares worth about $576,000 C) 15,000 shares worth about $144,000 D) 15,000 shares worth about $720,000 Answer: A Explanation: You own 3,000 shares of a company that is undergoing a 4-for-1 split. You will have: 4 × 3,000 = 12,000 shares After the split, each share will be worth one-fourth of the original share price, so your total holding will be worth ($48/4 ) × 12,000 = $144,000. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 28

76) Split-Div, Inc. has issued quarterly dividends of $0.10 per share each quarter over the last few years. This quarter the company initiated a 2-for-1 stock split. What is the minimum quarterly dividend the company's board should approve to avoid sending a bad signal to the investors? A) $0.02 per share B) $0.05 per share C) $0.10 per share D) $0.20 per share Answer: B Explanation: To avoid sending a bad signal to the investors, the company needs to pay out the same dividend relative to the number of outstanding shares. After a 2-for-1 split, the equivalent regular cash dividend would be $0.10/2 = $0.05. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 77) You own 1,200 shares of Harry, Co. The company has recently announced a 1-for-3 reverse stock split. How many shares will you own after the reverse split? A) 300 shares B) 400 shares C) 3,600 shares D) 4,800 shares Answer: B Explanation: You own 1,200 shares. After a 1-for-3 reverse stock split, you would own 1,200/3 = 400 shares. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

78) Pluto, Co. stock is currently trading for $54. Assume there is no new information about the company. If the company issues a 10 percent stock dividend, what will the approximate price of the stock be after the stock dividend is issued? (Round your final answer to two decimal places.) A) $47.80 per share B) $48.60 per share C) $49.09 per share D) $54.00 per share Answer: C Explanation: After the stock dividend, there will be 110 percent more shares representing the same amount of assets: $54/110% = $49.09 per share. Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 79) Which of the following statements describes the finding from academic studies on corporate dividend policy? A) Managers tend to increase regular cash dividends in response to unexpectedly high earnings. B) Managers tend to maintain a level dividend payment at an amount that they are relatively certain they can maintain in the future. C) Managers tend to focus on dividends rather than stock repurchases because institutional investors tend to prefer regular dividends. D) Dividend policy does not matter because investors can re-create dividends by selling a fraction of their shares. Answer: B Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

80) Which of the following considerations should NOT be related to management's concerns when setting a stock repurchase policy? A) Over the long-term, how much does a company's level of earnings exceed its investment requirements? How certain is this level? B) Is the stock currently undervalued? Can the management add value to the company by initiating a stock repurchase? C) Does a firm have enough financial reserves to meet the short-term obligations in periods when earnings are down or investment requirements are up? D) Can a firm quickly raise equity capital if necessary? Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 81) GoodSignal Co. is currently trading for $10 with 1 million shares outstanding. Which of the following actions would be the strongest signal to investors that management believes that the long-term prospects for a company have improved? A) Pay a $0.20 extra dividend in addition to the company's $0.20 regular quarterly dividend B) Increase the company's regular quarterly dividend from $0.20 to $0.40 C) Initiate an open-market stock repurchase of 2 percent of the company's stock D) Pay a $0.20 special dividend by selling a major fixed asset Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

82) Describe the four general types of cash dividends and the purpose of each. Answer: The most common form of a dividend is known as the regular cash dividend, which is paid on a regular basis. It is typically set at a level that management generally expects the company to be able to maintain in the long run, barring major changes in the fortune of the firm. The extra dividend is generally paid when a firm has earnings that are higher than expected. The special dividend is a one-time payment to stockholders and is used to distribute large amounts of cash. It may be used to distribute the proceeds from the sale of a major asset or business or even to alter the capital structure of the firm. A liquidating dividend is paid to stockholders when a firm is liquidated and will no longer continue doing business. The proceeds from the liquidating dividend are available only after all creditors and priority claimants are paid. Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 83) Discuss why investor perception of a stock repurchase is weaker than that of a cash dividend. Answer: While repurchases give investors the flexibility to choose whether or not they would like to receive a dividend, the major weakness in a repurchase lies in the fact that when a company publicly announces an ongoing open-market repurchase program, investors know that management can cut back on the repurchase or end them at any time. This makes the commitment to pay out cash weaker than with a dividend, and it means that if cash flows are less certain, then managers are likely to prefer to distribute extra cash by repurchasing shares, where there is some flexibility in following through. Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

84) In the 2005 follow-up to the Lintner study, the researchers found that managers choose their firm's dividend policies in a way that enables them to continue making the investments necessary for a firm to compete in its product markets. What does this imply about a firm that operates in a low-growth industry? Answer: Since managers appear to be sensitive to not having the ability to take on positiveNPV projects because of a lack of financing, then it appears that managers would like to create a buffer of cash, causing a low-dividend payout, in order to be able to invest in these projects. On the other hand, if a firm does not have many growth prospects, and consequently no new positive-NPV projects, then the firm should have a higher dividend payout than a similarly successful firm in a higher growth industry. Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 18 Business Formation, Growth, and Valuation 1) Starting a business is less risky than buying and growing a business that someone else has already established. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 2) The founder of a company needs to be a part of many critical decisions taken by the board but does not need to be a part of any related to strategies to sell the firm's products. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3) A reason that businesses fail is management's inability to accurately estimate the amount of funds required to get their businesses up and running. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 4) Access to capital for a sole proprietorship is excellent compared to a C-corporation. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

5) A startup business has a better chance to succeed if calculated risks are taken into consideration. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6) A limited liability company (LLC) leads to unlimited liability for the people who make business decisions in the firm while enabling all investors to retain the tax advantages of a limited partnership. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 7) Limited liability partnerships are inexpensive to form compared to sole proprietorships. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 8) Limited partnerships are more costly to form than sole proprietorships because the partners must hire an attorney to draw up and maintain the partnership agreement. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

9) A drawback of raising equity capital from other people is that an entrepreneur must inevitably share control with other investors. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 10) An S-corporation allows the stockholders to avoid double taxation but places limits on the ownership of the firm's stock. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 11) An S-corporation can have no more than 50 stockholders. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 12) Corporations, which are "legal persons" under state law, automatically have a finite life. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 13) Two tools that are particularly useful in understanding the cash requirements of a business and in estimating how much financing a new business will require are the cash flow break-even analysis and the cash budget. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3

14) The cash flow break-even analysis helps identify how much money is required to launch a new product or business. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 15) A cash budget summarizes the cash flows into and out of a firm over a period of time. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 16) A business plan presents the results from a strategic planning process that focuses on how a business will be developed over time. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 17) A business plan includes a detailed discussion of the marketing and sales activities that will enable a business to achieve the sales and profit levels reflected in the financial forecasts. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

18) An important thing to remember in valuing a business is that the value of a business changes over time. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 19) Decision makers must understand business valuation concepts in order to identify the optimal capital structure and dividend payout policy. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 20) A strategic investor is interested in buying the firm and not just its financial performance. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 21) Cost approaches for valuing business include replacement cost and multiples analysis. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 22) The adjusted book value approach is useful in valuing holding companies whose main assets are publicly traded or other investment securities, but it is generally less applicable for operating businesses. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 5

23) In the transaction analysis approach, analysts use the information on what someone has paid for a comparable company in a merger or an acquisition to estimate a value for the firm. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 24) In the free cash flow to equity (FCFE) approach, an analyst values the free cash flows that the assets of the firm are expected to produce in the future. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 25) The free cash flow from the firm (FCFF) approach uses only the portion of the cash flows that are available for distribution to stockholders in valuing business. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 26) In contrast to the free cash flow to equity (FCFE) approach, which values cash flows that are available for distribution to stockholders, the dividend discount model (DDM) approach values the stream of cash flows that stockholders expect to receive through dividend payments. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

27) In contrast to the financial statements of publicly held firms, private company financials often include personal expenses of the owner and excess compensation expenses. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 28) Differences in marketability can result in premiums of 30 percent or more for shares of private companies. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 29) An important issue when valuing a business is whether a controlling ownership interest or a minority interest is being valued. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 30) In valuing a business, analysts must also consider whether it is appropriate to adjust the estimated value of the business for the likelihood that the "key people" may not remain with the firm as long as expected. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

31) During the startup of a company, the founder makes several critical decisions including which of the following? A) Innovating the product(s) to sell. B) Formulating the best marketing strategy for selling the products manufactured. C) Raising the funds necessary to develop the product(s). D) Formulating an efficient plan for its expansion. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 32) Which of the following forms of business organization have the least access to capital? A) A sole proprietorship B) A general partnership C) An S-corporation D) A C-corporation Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 33) The ability to make the life of a business independent of that of the founder increases the ________ of the ownership interests, making it easier for the business to raise capital. A) non convertibility B) liquidity C) limitation D) risk Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

34) A business's chances of success increase if you: A) jump into a business with capital that is just enough to set up a business. B) overanalyze opportunities to the point where you are just convincing yourself not to proceed. C) take reasonable risk into consideration. D) have a unique idea even if the strategy is poor. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 35) The life of an entity is flexible for: A) a general partnership. B) a sole proprietorship. C) an S-corporation. D) a C-corporation. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 36) A limited liability partnership is: A) a partnership agreement which can never be written for a fixed life. B) less costly to form than sole proprietorships. C) an agreement where partners face the possibility that their personal assets can be taken from them to satisfy claims on their businesses. D) less constrained than general partnerships because they can raise money from limited partners. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

37) Which of the following statements is true of a limited liability company? A) A limited liability company is not as costly to form as sole proprietorships. B) Like a corporation, an LLC provides limited liability for the people who make the business decisions in the firm while enabling all investors to retain the tax advantages of a limited partnership. C) The life of a limited liability company is not flexible. D) A limited liability company is more constrained than general partnerships because they can raise money only from members. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 38) Which of the following statements is true of a corporation? A) An S-corporation can have no more than 500 stockholders. B) All profits of an S-corporation do not pass directly to the stockholders as they would pass to the partners in a partnership. C) Profits earned in C-corporations are taxed only once at the corporate tax rate. D) C-corporations have better access to capital compared to S-corporations. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 39) Which of the following statements is true of an S-corporation? A) An S-corporation can have more than 100 stockholders. B) All profits of an S-corporation pass directly to the stockholders as they would pass to the partners in a partnership. C) An S-corporation is a variation of the LLC (limited liability company). D) Only foreign investors can own the shares of an S-corporation. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

40) Which of the following statements is true of a sole proprietorship? A) A sole proprietorship is the most expensive type of business to start. B) The life of a sole proprietorship is limited. C) Sole proprietorships must rely on equity contributions from the public. D) The liability of owners of a sole proprietorship is limited. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 41) Which of the following statements is true of a cash flow break-even analysis? A) It is useful in understanding the cash requirements of a business and in estimating how much financing a new business will require. B) As per the cash flow break-even analysis, the cash flow break-even point calculation usually focuses on the computation of costs of goods sold break-even. C) It summarizes the cash flows into and out of a firm, usually on a monthly basis. D) It helps an entrepreneur in understanding where the money is coming from and where it is going. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 42) Which of the following statements is true about a cash budget? A) A cash budget helps an entrepreneur understand the concept of EBITDA break-even and how to calculate this point for each product a business's produce. B) A cash budget focuses on the importance of maximizing a product's per-unit contribution. C) A cash budget provides a means of estimating how long it will take for a product to reach the break-even point and, therefore, how much money will be needed to launch a new product. D) A cash budget summarizes the cash flows into and out of a firm over a period of time. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

43) Which of the following statements is true about business plans? A) A well-prepared business plan always avoids contingent liabilities as the plan helps to predict and change the occurrence of a contingent liability. B) A business plan is useful only in case of exigency in the business environment otherwise a business plan is not important. C) A business plan is a trivial part in the overall strategy formulation and its impact on business operations in the long run is miniscule. D) A well-prepared business plan makes it easier for an entrepreneur to communicate to potential investors precisely what returns an investor might expect to receive. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 44) ________ is a road map for a business. A) A cash budget B) A cash flow break-even analysis C) A business plan D) A transaction analysis Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 45) Identify which one of the following statements is FALSE: A) A business plan is a tool that can help an entrepreneur set the goals and objectives for the company. B) A business plan serves as a benchmark for evaluating and controlling the company's performance. C) A business plan is a document that describes the details of how a business was developed. D) A business plans helps to communicate the entrepreneur's ideas to managers and stakeholders. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

46) Which of the following mathematical expressions reflects the value of a firm using the income approach? A) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years + The present value of all free cash flows after year T + The value of all of the nonoperating assets in the firm. B) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years - The present value of all free cash flows after year T - The value of all of the nonoperating assets in the firm. C) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years + The present value of all free cash flows after year T - The value of all of the nonoperating assets in the firm. D) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years - The present value of all free cash flows after year T + The value of all of the nonoperating assets in the firm. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 47) Decision makers must understand business valuation concepts in order to be able to: A) prepare the financial statements of the business. B) identify the optimal capital structure and the payout policy. C) identify the break-even point and the payout policy. D) calculate the deferred tax assets. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 48) Which of the following statements is true about business valuation? A) The valuation of business is solely about how much return a business provides to its stockholders. B) There is a single value for any business. C) There is no such thing as the value for a business. D) The value of a business is solely affected by the investment manager's decisions. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 13

49) The value of a business changes over time because: A) the impact of the business valuation is minimized when timed properly. B) the risk involved in operations do not change. C) the estimates reflect the timing of what economic, industry, and firm conditions are at the time of valuation. D) the factors influencing the valuation can be controlled. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 50) Which of the following statements is true of the business valuation principle? A) As per first valuation principle, the value of business does not change over time. B) The value of a business is solely affected by managers' financing decisions. C) The fair market value of a business is the value of that business to a hypothetical person who is knowledgeable about the business. D) Estimating the fair market value of a business includes the value of synergies or the effects of any investor-specific management style. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 51) Which of the following statements is true of the replacement cost approach to valuation? A) Replacement cost is an income-based valuation approach. B) This approach should include only tangible assets, whether they are actually included on the accounting balance sheet or not. C) The replacement cost of a business is the cost of duplicating the assets of the business in their present form as of the valuation date. D) The replacement cost valuation approach is generally used to value the whole of assets within a business when they are being insured. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

52) The adjusted book value approach involves: A) restating the value of the individual assets in a business to reflect their historical costs. B) valuing individual assets within a business when they are being insured, but it is rarely used to value an entire business. C) the cost of duplicating the assets of the business in their present form as of the valuation date. D) valuing all tangible and intangible assets. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 53) When using the multiples analysis approach to valuing a business, one must be aware: A) of the presence of a marketability premium that can be sizable. B) of the adjusted book value of a business which is the cost of duplicating the assets of the business in their present form as of the valuation date. C) of the stock value of similar companies whose shares are not publicly traded. D) of the presence of a potentially large marketability discount. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 54) The transaction approach is difficult to use because: A) transactions data are typically as reliable as the data available for multiples analysis, especially when they are associated with a private firm. B) transactions involving the purchase or sale of an entire business in an industry tend to occur frequently and hence the amount of data is immense. C) the terms of the transactions can be easy to assess. D) the terms of the transactions can be difficult to assess. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

55) Which of the following statements about the free cash flow from the firm (FCFF) approach is true? A) The present value of these cash flows exceeds the total value of the firm, or its enterprise value. B) We include the cash necessary to pay short-term liabilities that do not have interest charges associated with them, such as accounts payable and accrued expenses. C) The costs associated with noninterest-bearing current liabilities, which are included in the firm's cost of sales and other operating expenses, are added in the calculation of FCFF. D) The total value of the firm, VF, is computed as the present value of the FCFF, discounted by the firm's weighted average cost of capital, WACC. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 56) The costs associated with noninterest-bearing current liabilities, which are included in the firm's cost of sales and other operating expenses: A) are subtracted in the calculation of free cash flow from the firm (FCFF). B) are added in the calculation of FCFF. C) are not a factor in the calculation of FCFF. D) are added to the value of equity claims. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 57) In the free cash flow from the firm (FCFF) approach, the total value of the firm, VF, is computed as the present value of the FCFF using which of the following as a discount rate? A) The firm's cost of equity B) The firm's WACC C) The firm's cost of debt D) The inflation rate prevailing in the economy Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

58) The free cash flow to equity (FCFE) approach uses only the portion of the cash flows that are available for distribution to: A) bondholders. B) bondholders and stockholders. C) stockholders. D) board of directors. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 59) The three specific cash flows associated with lenders that are included in the free cash flow to equity (FCFE) approach are: A) the interest expense on existing debt, the repayment of debt principal, and the proceeds from new debt issues. B) the interest expense on existing term debt, the repayment of debt principal, and the proceeds from new equity issues. C) the interest expense on existing debt, the repayment of debt principal, and the payment of dividends. D) the interest expense on existing term debt, the repayment of debt principal, and the payment of dividends. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 60) In contrast to the FCFE approach, the dividend discount model (DDM) approach uses: A) cash flows that are available for distribution to stockholders. B) the stream of cash flows that stockholders expect to receive through dividend payments. C) the stream of cash flows that stockholders expect to receive through bonus issue. D) the stream of cash flows that stockholders expect to receive through stock repurchase. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

61) Important issues that one must consider in valuing young private firms include: A) whether key people remain in the firm, the amount of dividends that one may receive in the coming years, and whether a controlling ownership interest or a minority interest is being valued. B) the difficulty in valuing young, rapidly growing companies in contrast to mature, stable companies, the amount of dividends that one may receive in the coming years, and whether a controlling ownership interest or a minority interest is being valued. C) the difficulty in valuing young, rapidly growing companies in contrast to mature, stable companies, whether key people remain in the firm, and whether a controlling ownership interest or a minority interest is being valued. D) whether the key people remain in the firm, the pretax operating cash flows generated by the firm in the coming years, and whether a controlling ownership interest or a minority interest is being valued. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 62) Sonicmony Soft makes designer gold bracelets. Its annual costs include shop rent of $15,000, salaries for two jewelers of $125,000, design software costs of $12,000, and other overhead costs of $15,000. An average bracelet is priced at $6,500. It costs $2,200 in raw material, $1,500 in labor, and $400 in other expenses. What is the minimum number of bracelets that need to be sold to earn a profit? (Round to nearest whole unit.) A) 18 bracelets B) 47 bracelets C) 70 bracelets D) 14 bracelets Answer: C Explanation: Fixed costs = $15,000 + $125,000 + $12,000 + $15,000 = $167,000 Unit variable costs = $2,200 + $1,500 + $400 = $4,100 Unit selling price = $6,500 Therefore: Break-even point = = 69.58 bracelets

The firm needs to sell at least 70 bracelets annually before it can make a profit. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 18

63) Atamony makes circuit boards and markets them to electronic goods manufacturers. The firm has nonsalary fixed costs of $112,000 and salary costs of $64,250. Each circuit board is sold at a price of $69 and involves variable costs of $46 per unit. What is the break-even point for Atamony? (Round to nearest whole unit.) A) 5,105 circuit boards B) 7,663 circuit boards C) 6,237 circuit boards D) 2,714 circuit boards Answer: B Explanation: Fixed costs = $112,000 + $64,250 = $176,250 Unit variable costs = $46 Unit selling price = $69 Therefore: Break-even point = = 7,663.04 circuit boards

The firm needs to sell at least 7,663 circuit boards annually before it can make a profit. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

64) Warren Soft makes period pieces. The firm has total fixed costs of $500,000. The average piece is sold at a price of $2,500 and involves variable costs of $1,800 per unit. What is the break-even point for this firm? (Round to nearest whole unit.) A) 714 pieces B) 928 pieces C) 617 pieces D) 738 pieces Answer: A Explanation: Fixed costs = $500,000 Unit variable costs = $1,800 Unit selling price = $2,500 Therefore, Break-even point = = 714.29 pieces

The firm needs to sell at least 714 pieces of furniture annually before it can make a profit. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

65) Neucon company needs to sell 6,000 circuit breakers to break even. Its unit variable cost is $441, and each unit sells for $800. What is the fixed cost of this company? A) $1,497,250 B) $2,154,000 C) $2,855,250 D) $4,652,500 Answer: B Explanation: Break-even point = 6,000 units Unit variable costs = $441 Unit selling price = $800 Break-even point = 6,000 = Fixed costs = 6,000 × $359 = $2,154,000. The firm has fixed costs of $2,154,000. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

66) FifeSiete Corp. wants to break even at 15,000 units on its only product. Its unit variable cost is $55, and its fixed cost is $750,000. What should be each unit's selling price? A) $85 B) $92 C) $105 D) $78 Answer: C Explanation: Break-even point = 15,000 units Unit variable costs = $55 Fixed costs = $750,000 Break-even point = 15,000 = Unit selling price =

+ $55

The firm has to sell its product at $105 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 67) Settetocol, Inc., has cash of $12,000, receivables of $35,000, and inventory of $28,000. In addition, the firm has fixed assets of $120,000. Management believes that you can reasonably expect to collect 93 percent of the receivables, that the inventory could be sold to realize 84 percent of its book value, and that the sale of the property, plant, and equipment would yield $94,000. What is the liquidation value of this company? (Round to the nearest dollar.) A) $162,070 B) $139,695 C) $174,866 D) $138,695 Answer: A Explanation: The liquidation value is: Cash $12,000 × 100% = $12,000.00 Accounts receivable $35,000 × 93% = $32,550.00 Inventory $28,000 × 84% = $23,520.00 Net PP&E $120,000 $94,000.00 Total assets $195,000 $162,070.00 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 22

68) Foursonic Labs has cash of $26,000, receivables of $85,000, and inventory of $118,000. In addition, the firm has property, plant, and equipment of $165,000. Management has also told you that you can reasonably expect to collect 89 percent of the receivables, that the inventory could be sold to realize 85 percent of its book value, and that the sale of the property, plant, and equipment would yield $125,000. What is the liquidation value of this company? (Round to the nearest dollar.) A) $201,950 B) $229,000 C) $394,000 D) $326,950 Answer: D Explanation: The liquidation value is Cash $26,000 × 100% = $ 26,000 Accounts Receivable $85,000 × 89% = $ 75,650 Inventory $118,000 × 85% = $ 100,300 Net PP&E $165,000 $125,000 Total assets $394,000 $ 326,950 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

69) FifeSiete. has debt of $230 million and generated a net income of $121 million in the last fiscal year. In attempting to determine the total value of the firm, an investor identified a similar firm in Neuncon, Inc., an all-equity firm. This firm had 150 million shares outstanding, a share price of $14.25, and net income of $182 million. What is the implied total value of FifeSiete? (Round to the nearest million dollars.) A) $1,421 million B) $1,651 million C) $1,191 million D) $1,715 million Answer: B Explanation: The P/E multiple for Neuncon Inc. is: P/E =

= 11.745

Implied equity value for FifeSiete: VE = P/E × Net income = 11.745 × $121,000,000 = $1,421,145,000 Value of FifeSiete's debt = VD = $230 million Therefore, the implied total value of FifeSiete is: VF = VE + VD = $1,421.45 + $230.00 = $1,651.45 million Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

70) Cervil had an EBIT of $247 million in the last fiscal year. Its depreciation and amortization expenses amounted to $84 million. The firm has 135 million shares outstanding and a share price of $12.80. A competing firm that is very similar to Cervil has an enterprise value/EBITDA multiple of 5.40. What is the enterprise value of Cervil? (Round to the nearest million dollars.) A) $1,334 million B) $453 million C) $1,787 million D) $1,315 million Answer: C Explanation: The enterprise value/EBITDA multiple for Cervil's competitor = 5.40 Cervil's EBITDA = EBIT + D&A = $247 million + $84 million = $331 million Cervil's enterprise value is: VF = Multiple × EBITDA = 5.40 × $331 million = $1,787.4 million Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 71) Cervil had an EBIT of $247 million in the last fiscal year. Its depreciation and amortization expenses amounted to $84 million. The firm has 135 million shares outstanding and a share price of $12.80. A competing firm that is very similar to Cervil has an enterprise value/EBITDA multiple of 5.40. What is the value of Cervil's debt? (Round to the nearest million dollars.) A) $121 million B) $165 million C) $97 million D) $59 million Answer: D Explanation: No. of shares outstanding = 135 million shares Share price = $12.80 Value of Cervil's equity = VE = $12.80 × 135 million = $1,728 million The enterprise value/EBITDA multiple for Cervil's competitor = 5.40 Cervil's EBITDA = EBIT + D&A = $247 million + $84 million = $331 million Cervil's enterprise value is: VF = Multiple × EBITDA = 5.40 × $331 million = $1,787.4 million Cervil's enterprise value = $1,787.4 million Cervil's debt value = VD = VF - VE = $1,787.4 - $1,728 = $59.4 million Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 25

72) Factrack Inc., a biotech firm, is expected to grow rapidly in the next three years and then have a level growth rate for the foreseeable future. The firm expects free cash flows of $342.5 million, $512.3 million, and $750 million over the next three years, and thereafter its cash flows will grow at a steady rate of 8 percent per year. The company has no nonoperating assets (NOA). If the appropriate WACC is 11.25 percent, what is the enterprise value of this business? (Round to the nearest million.) A) $19,367 million B) $18,101 million C) $26,190 million D) $24,923 million Answer: A Explanation: Cost of capital = WACC = 11.25% The present value of the cash flows in the first three years is: PV(FCFF3) =

= $307.87 + $413.93 + $544.70 = $1,266.50 million Free cash flows in year 4 = $750 million × (1.08) = $810 million Terminal value = TV3 =

= $24,923.08

The present value of the terminal value is: PV(TV3) =

= 24,923.08/(1.1125)3 = $18,100.96 million

Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $1,266.5 + $18,100.96 + $0 = $19,367.46 million Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

73) ProtoSeis Corp. is expected to grow rapidly in the next four years and then have a zerogrowth rate for the foreseeable future. The firm expects free cash flows of $42.5 million, $64.3 million, $77.1 million and $92 million over the next four years, and thereafter its cash flows will stay constant. The company has cash to the tune of $23.4 million. If the appropriate WACC is 10 percent, what is the enterprise value of this business? (Do not round intermediate computations. Round final answer to the nearest million.) A) $628 million B) $864 million C) $811 million D) $818 million Answer: B Explanation: Cost of capital = WACC = 10.0% The present value of the cash flows in the first four years is: PV(FCFF3) =

= $38.6363 + $53.1405 + $57.9264 + $62.8374 = $212.5406 million Free cash flows in year 5 = $92 million Terminal value = TV =

= $920 million

The present value of the terminal value is: PV(TV4) =

= $628.3724 million

Nonoperating assets = NOA = $23.4 million Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $212.5406 + $628.3724 + $23.4 = $864.31 million Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

74) Symbyrec Phonic, an electronics manufacturer, is expected to grow rapidly in the next five years and then have a stable growth rate for the foreseeable future. The firm expects free cash flows of $262.5 million next year. These cash flows are expected to grow at a 30 percent rate over the following four years, and thereafter its cash flows will grow at a steady rate of 6 percent per annum. The company has nonoperating assets (NOA) of $31 million in the form of cash. If the appropriate WACC is 9 percent, what is the enterprise value of this business? (Do not round intermediate computations. Round final answer to the nearest million.) A) $26,490 million B) $22,222 million C) $19,014 million D) $22,191 million Answer: C Explanation: Cost of capital = WACC = 9.0% The present value of the cash flows in the first five years is: PV(FCFF5) =

= $240.8257 + $287.2233 + $342.5599 + $408.5577 + $487.2706 = $1,766.4372 million Free cash flows in year 6 = $749.7263 million × (1.06) = $794.7099 million Terminal value = TV5 =

= $26,490.3 million

The present value of the terminal value is: PV(TV5) =

= $17,216.87 million

Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $1,766.4372 + $17,216.87 + $31.00 = $19,014.3072 million Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

75) Simpltar Co. is expected to grow rapidly in the next three years and then have no growth for the foreseeable future. The firm expects free cash flows of $9.1 million, $11.4 million, and $17.7 million over the next three years, and thereafter its cash flows will stay constant. The company has no nonoperating assets. If the appropriate WACC is 12 percent and debt of 44.5 million, what is the equity value of this business? (Round final answer to the nearest million.) A) $135 million B) $105 million C) $45 million D) $90 million Answer: D Explanation: Cost of capital = WACC = 12.0% The present value of the cash flows in the first three years is: PV(FCFF3) =

Free cash flows in year 4 = $17.7 million Terminal value = TV3 =

= $147.5 million

The present value of the terminal value is: PV(TV3) =

= $104.99 million

Nonoperating assets = NOA = $0 Total enterprise value is, therefore, VF = PV(FCFT) + PV(TVT) + NOA = $29.81 + $104.99 + $0 = $134.8 million Value of debt = VD = $44.5 million Value of equity = VE = $134.8 - $44.5 = $90.3 million Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

76) You are using the FCFF approach to value a business. The estimated FCFF for next year will be $13.6 million, and it will increase at a rate of 6 percent for each of the following five years. After that point, the FCFF will increase at a rate of 3 percent forever. If the WACC for this firm is 8 percent, what is it worth? (Round final answer to the nearest million.) A) $301 million B) $354 million C) $241 million D) $144 million Answer: A Explanation: Value of the FCFF for the first five years using the growing annuity formula = FCFF for year 1 = $13.6 million Cost of capital = WACC = 8.0% PVAn =

= $680 × 0.008926 = $60.67 million Free cash flows in year 6 = FCFF1 × (1 + g)4 × (1 + gnormal) = $13.6 × (1.06)4 × (1.03) = $17.68 million Terminal value = TV5 =

= $353.70 million

The present value of the terminal value is: PV(TV5) =

= $240.72 million

and the value of the firm is therefore: VF = $60.67 million + $240.72 million = $301.39 million Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

77) Phosfranc Inc. is valuing the equity of a company using the free cash flow from equity, FCFE, approach and has estimated that the FCFE in the next three years will be $6.25, $7.70, and $8.36 million respectively. Beginning in year 4, the company expects the cash flows to increase at a rate of 4 percent per year for the indefinite future. Phosfranc estimates that the cost of equity is 12 percent. What is the value of equity in this company? (Do not round intermediate computations. Round final answer to the nearest million.) A) $77 million B) $95 million C) $109 million D) $60 million Answer: B Explanation: Cost of equity = kE = 12.0% The present value of the cash flows expected over the next five years is: PV(FCFF3) =

= $5.580 + $6.138 + $5.950 = $17.668 million FCFF3 = FCFE3 as there is no debt component. The terminal value is: TV3 =

= $108.68 million

The present value of the terminal value is: PV(TV3) =

= $77.356 million

Therefore, if there are no nonoperating assets, the value of the equity is VF = $17.668 + $77.356 = $95.024 million Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

78) You are valuing the equity of NewNil Corp. using the FCFE approach and have estimated that the FCFE in the next three years will grow at 8 percent rate from last year's FCFE of $2.1 million. Beginning in year 4, you expect the cash flows to increase at a constant rate of 5 percent per year for the indefinite future. The cost of equity for the firm is 10 percent. What is the value of equity in this company? (Round final answer to the nearest million dollars.) A) $42 million B) $56 million C) $48 million D) $6 million Answer: C Explanation: FCFE for year 1 = $2.1 million × (1.08) = $2.268 million Cost of equity = kE = 10.0% PV(FCFF3) =

= $2.062 + $2.024 + $1.987 = $6.07 million The terminal value is: TV3 =

= [(2.645)(1.05)]/(0.10 - 0.05) = $55.55 million

The present value of the terminal value is: PV(TV3) =

= $41.74 million

Therefore, if there are no nonoperating assets, the value of the equity is VF = $6.07 + $41.74 = $47.81 million Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

79) You are interested in investing in a private company. Based on earnings multiples of similar publicly traded firms, you estimate the value of the private company's stock to be $13.44 per share. You plan to acquire a majority of the shares in the company. The expected control premium is 12 percent, while the marketability discount for such a firm is 15 percent. The discount for the key person, one of the founders who may leave the firm upon your control of the firm, is 15 percent. What price should you be willing to pay for these shares? (Round final answer to two decimal places.) A) $14.92 per share B) $16.65 per share C) $11.80 per share D) $10.88 per share Answer: D Explanation: Value per share = Share value × (1 + Control premium) × (1 - Marketability discount) × (1 - Key person discount) = $13.44 × (1 + 12%) × (1 - 15%) × (1 - 15%) = $13.44 × (1.12) × (0.85) × (0.85) = $10.88 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 80) Shuman Wolf is interested in investing in a private company. Based on earnings multiples of similar publicly traded firms, he estimates the value of the private company's stock to be $20 per share. He plans to acquire a majority of the shares in the company. The expected control premium is 9 percent. Shuman estimates the marketability discount for such a firm to be 11 percent. The discount for the key person, one of the founders who may leave the firm upon Shuman's control of the firm, is 19 percent. What price should he be willing to pay for these shares? (Round final answer to two decimal places.) A) $16.47 per share B) $31.45 per share C) $15.72 per share D) $32.94 per share Answer: C Explanation: Value per share = Share value × (1 + Control premium) × (1 - Marketability discount) × (1 - Key person discount) = $20 × (1 + 9%) × (1 - 11%) × (1 - 19%) = $20 × (1.09) × (0.89) × (0.81) = $15.72 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 33

81) Alfred Sautin wants to invest in Dieciring, Inc., a private company. Based on earnings multiples of similar publicly traded firms, Alfred estimates the value of the private company's stock to be $19 per share. He plans to acquire a majority of the shares in the company. The expected control premium is 11 percent. He estimates the marketability discount for such a firm to be 14 percent. The discount for the key person, one of the founders who may leave the firm upon Alfred's control of the firm, is 16 percent. What price should he be willing to pay for these shares? (Round final answer to two decimal places.) A) $15.24 per share B) $18.10 per share C) $14.05 per share D) $20.70 per share Answer: A Explanation: Value per share = Share value × (1 + Control premium) × (1 - Marketability discount) × (1 - Key person discount) = $19 × (1 + 11%) × (1 - 14%) × (1 - 16%) = $19 × (1.11) × (0.86) × (0.84) = $15.24 Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 82) What difficulties are associated with valuing real assets compared to financial assets? Answer: The valuation of real assets is less straightforward than the valuation of financial assets for several reasons. First, in many cases, cash flows for financial assets are well documented in a legal contract. If they are not, we are at least able to make some reasonable assumptions about what they are. For real assets, no such information exists. Specialists within the firm; usually from the finance, marketing, and production groups; prepare estimates of future cash flows for the capital project. Second, many financial securities are traded in public markets, and these markets are reasonably efficient. Thus, market data on rates of return are accessible. For real assets, no such markets exist. As a result, we must look at investors' opportunity cost, the rate of return they give up when they invest in real assets rather than financial assets. We must estimate required rates of return on real assets from market data on financial assets, which can be difficult to do. Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

83) Explain how valuations can differ between public and private companies and between young and mature companies as well as the importance of marketability, control, and key person considerations in valuation. Answer: Valuations differ between public and private companies for a number of reasons. Two reasons are the quality of the financial statements and the marketability of the securities being valued can differ considerably. Marketability is important because it affects the price that investors are willing to pay for a security. The less marketable a security is, the lower the price investors will be willing to pay. Young, rapidly growing companies tend to be more difficult to value than mature companies because there is less reliable historical information on young companies and the future of young companies tends to be less certain. Control is an important consideration in business valuation because having control of a business provides an investor with more flexibility with regard to how he or she will manage the business. Investors value this flexibility and will, therefore, pay more for a controlling interest in a company. If the cash flows that a business is expected to generate depend heavily on certain employees, those employees are key people. When valuing a business, an analyst must account for the possibility that the key people will unexpectedly leave the company and the associated impact on the company's future cash flows. Diff: 2 Learning Objective: LO 4 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 84) What are some things to watch out for when doing multiples analysis? Answer: While doing a multiples analysis, one needs to be aware of certain issues. • When using multiples of publicly held firms to value one that is not, one should be aware of the presence of a marketability discount that can be sizable. • Identifying one or more comparable firms is not an easy task. • When using the multiple of a comparable firm, one needs to be aware of differences in the capital structures of the firms being compared. • You are estimating a fair market value, not the investment value. • It is important to make sure that the numerator and the denominator of the ratio you are using are consistent with each other. • The data used to compute the multiple for the comparable company should include the stock price as of the valuation date and accounting data from the same period for which you have accounting data for the company of interest. Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 35

85) Why does the value of a business change over time? Answer: The value of a business changes over time because of: • changes in general economic conditions, industry conditions, and managers' decisions all affect the value of the cash flows that a business is expected to generate in the future. • actions by competitors also affect the value of a business. • the investment, operating, and financing decisions made by managers also affect the value of a business. Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 19 Financial Planning and Managing Growth 1) Financial planning deals with establishing sales forecasts for a time horizon set by a firm's management. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2) In putting together a financial plan, management uses key information through their strategic plan, investment plan, financing plan, and their cash budget. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3) The investment plan of a firm addresses the issue of what capital assets management needs to obtain to achieve its goals. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4) The financing plan deals with how a firm is going to secure the funds needed to pay for the capital resources required. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

5) The financing plan documents a firm's long-term goals, the strategies that management will use to achieve the goals, and the capabilities that the firm needs to sustain its competitive position. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6) The strategic plan identifies major areas for investments in productive assets, and also identifies mergers, alliances, and divestitures to strengthen a firm's business portfolio. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7) The strategic plan of a firm addresses the issue of what capital resources the management needs to achieve its goals. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8) Capital expenditures can be one-time investments or routine investments that allow a firm to continue its operations. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

9) Once capital investments are made, they are almost impossible to be reversed. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10) In the financing plan of a firm, management states that the firm will seek to raise funds externally even if sufficient internally generated funds are available to fund projects. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11) The financial plan focuses only on strategic planning and investment planning. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12) The financial plan includes the cash budget, which identifies the time line for cash inflows and outflows included in divisional business plans. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13) Financial planning helps management establish financial and operating goals for a firm and to communicate those goals throughout the firm. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3

14) Financial planning models are not considered an integral part of financial planning. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15) Financial models provide management with the ability to prepare projected financial statements. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16) Since sales are often correlated with the regional or national economy, economic forecasts are incorporated into the financial planning model. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17) Financial statements and sales forecasts are considered major inputs in financial planning models. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18) Investment and financing policy decisions are not considered inputs in financial planning models. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4

19) The outputs of the financial planning model are a series of pro forma financial statements and financial ratios based on these statements. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 20) Pro forma financial statements that result from financial planning models are always perfectly balanced. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Budget Preparation AICPA: Industry/Sector Perspective 21) Projected or pro forma statements can be used to analyze the investment alternatives, but are not used to estimate the amounts of external funding needed. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Budget Preparation AICPA: Industry/Sector Perspective 22) Sales are often correlated with the regional or national economy, so it is not necessary to incorporate economic forecasts into the model. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

23) The percent of sales model is a complex financial planning model. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 24) In the percent of sales model, all income statement and balance sheet accounts vary directly with sales. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 25) The capital intensity ratio measures the dollar amount of sales per dollar invested in assets. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 26) Fixed assets vary directly with sales when firms are operating at less than full capacity. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 27) Firms that are not highly capital intensive tend to be riskier than similar firms that use more fixed assets. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

28) Lumpy assets are added as large discrete units and initially may not be used to full capacity. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 29) When a firm maintains a constant dividend policy, the firm's growth rate has no bearing on the external financing needed. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 30) Holding the growth rate constant, the higher a firm's dividend payout ratio, the larger the amount of external debt or equity financing needed. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 31) The sustainable growth rate is the rate of growth that a firm can sustain without issuing additional debt. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 32) The sustainable growth rate is the rate of growth that a firm can sustain without issuing additional equity while maintaining the same capital structure. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 7

33) The higher a firm's dividend payout ratio, the higher the firm's internal growth rate. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 34) Increasing a firm's plowback ratio, will result in increasing its sustainable growth rate. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 35) The lower a firm's ROE, the lower is the firm's sustainable growth rate. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 36) Which of the following components is NOT in a financial plan? A) The strategic plan B) The investment plan C) The financing plan D) Competitor's budgets Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

37) Which of the following questions is NOT addressed in a financial plan? A) Where is the company headed? B) What capital resources does the management need to get there? C) How is the firm going to pay for the resources needed? D) How is an auditing firm is to be selected? Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38) Which of the following questions is NOT addressed in a firm's financial plan? A) What is the growth rate for the firm's main competitor? B) Where is the firm headed? C) What capital resources does the management need to get there? D) How is the firm going to pay for the resources needed? Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39) The strategic plan identifies: A) the sales and marketing budget. B) the business plans for operating units. C) the capital budget. D) major areas of investment in productive assets. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

40) The strategic plan does NOT identify: A) major areas of investment in productive assets. B) future mergers, alliances, and divestitures. C) working capital strategies. D) the lines of business a firm will compete. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41) Which of the following is true of capital expenditures? A) They are part of a firm's strategic plan. B) Once a capital investment is made, it is generally easy to reverse it. C) Capital expenditures are exclusively for one-time investments. D) Capital expenditures can be one-time investments or routine investments that allow a firm to continue its operations. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42) The financing plan of a firm will indicate: A) the dollar amount of funds that must be raised externally and the sources of funds available to the firm, the desired capital structure for the firm, and the firm's dividend policy. B) the dollar amount of funds that must be raised externally and the sources of funds available to the firm, the desired capital structure for the firm, and the firm's working capital policy. C) the dollar amount of funds that must be raised externally and the sources of funds available to the firm, the firm's dividend policy, and the firm's working capital policy. D) the firm's dividend policy, the desired capital structure for the firm, and the firm's working capital policy. Answer: A Diff: 2 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

43) Which of the following is NOT a part of a financing plan? A) The dollar amount of funds that must be raised externally and the sources of funds available to a firm. B) The desired capital structure for a firm. C) A firm's dividend policy. D) Internal control policies. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44) A financial plan includes: A) the strategic plan, financing plan, and options plan. B) the strategic plan, investment plan, and financing plan. C) the financing plan, investment plan, and options plan. D) the strategic plan, investment plan, and options plan. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45) The financial planning model focuses on: A) the inventory accounting method decision and the accounts payables decision. B) the current assets decision and the current liabilities decision. C) the investment decision and the financing decision. D) the equity decision and the debt decision. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

46) Financial planning models: A) help management make investment decisions, but cannot determine external funding needs. B) help management make financing decisions, but not investment decisions. C) are not based on pro forma analysis. D) forecast future financial statements to aid in making investment and financing decisions. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47) The sales forecasts used in financial planning models: A) follow one specific technique. B) must be generated outside the firm due to conflicts of interest. C) utilize microeconomic productivity variables from firms in other industries as inputs. D) utilize macroeconomic variables as inputs. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48) Which of the following statements is NOT true? A) Sales forecasts models are typically very basic and use no complicated analysis. B) Sales forecasts are generated within a firm. C) Sales forecasts utilize economic variables as input. D) Sales forecasts are mainly used internally. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

49) The inputs used in building financial planning models include: A) financial statements, sales forecasts, and a firm's investment and financial policy decisions. B) pro forma statements, sales forecasts, and macroeconomic variables. C) pro forma statements, sales forecasts, and financing decisions. D) financial statements, macroeconomic variables, and financing decisions. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50) Which of the following is NOT an input in financial planning models? A) Financial statements B) Pro forma financial statements C) Investment decisions D) Financing decisions Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51) Which of the following statements is NOT true about financial planning models? A) Financial statements serve as the first major input and become the baseline to compare the projected financial statements. B) Economic forecasts and their impact on the firm's sales are also included in financial planning models. C) Investment and financing decisions are not considered as inputs in financial planning models. D) Changes in a firm's balance sheet and income statement items as a result of the growth in sales are also used in these models. Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

52) Planning models that are more sophisticated than the percent of sales method have: A) all variable costs change independently of sales. B) current asset accounts vary directly with sales, however, current liability accounts vary independent of sales. C) fixed assets always vary directly with sales. D) working capital accounts vary directly with sales. Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53) Which of the following statements is NOT true about more sophisticated financial planning model? A) Only fixed costs change directly with sales. B) Working capital accounts like inventory, accounts receivables, and accounts payables vary directly with sales. C) Fixed assets do not always vary directly with sales. D) Variable costs change directly with sales. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54) As sales increase, a firm needs to ________ proportionately to support the ________. A) increase the level of fixed assets; increase the level of inventory B) increase the level of inventory; higher sales level C) increase the level of inventory; increase the level of fixed assets D) increase the level of fixed assets; higher sales level. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

55) Which of the following statements is NOT true for a firm that operates below full capacity? A) Fixed assets can vary directly with sales. B) Fixed assets will not vary directly with sales. C) Fixed assets per unit can be incrementally changed. D) Fixed assets will vary inversely with sales. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 56) Which of the following statements is NOT true? A) The ratio of total assets to sales is called the capital intensity ratio. B) The ratio of sales to total equity is called the capital intensity ratio. C) The higher the capital intensity ratio, the more capital a firm needs to generate sales. D) Firms that have high capital intensive ratios are riskier than similar firms that use less fixed assets. Answer: B Diff: 2 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 57) A firm paid out $163,961.60 as dividends on net income of $298,112. What is the firm's retention ratio? A) 55% B) 45% C) 50% D) 40% Answer: B Explanation: Dividends = $163,961.60 Net income = $298,112. Dividends payout ratio =

= 55%

Retention ratio = (1 - Dividend payout ratio) = (1 - 0.55) = 45% Diff: 3 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

58) Drekker, Inc. has revenues of $312,766, costs of goods sold of $220,222, interest payment of $31,477, and a tax rate of 34 percent. It paid dividends of $34,125 to shareholders. Find the firm's dividend payout ratio and retention ratio. (Round your percentage answers to nearest whole number.) A) 85%, 15% B) 45%, 55% C) 55%, 45% D) 15%, 85% Answer: A Explanation: Revenues $312,766.00 Costs of Goods Sold 220,222.00 EBIT $92,544.00 Interest 31,477.00 EBT $61,067.00 Taxes (34%) 20,762.78 Net income $40,304.22 Dividends paid = $34,125 Dividend payout ratio =

= 85%

Retention ratio = (1 - Dividend payout ratio) = (1 - 0.85) = 15% Diff: 3 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

59) Comacho Traders has total assets of $513,480 and sales of $723,062. What is the firm's capital intensity ratio? (Round to two decimal places.) A) 1.41 B) 0.71 C) 1.23 D) 0.50 Answer: B Explanation: Total assets = $513,480 Sales = $723,062 Capital intensity ratio = =

= 71.01%

= 0.71 Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 60) Michael Holdings, Inc. has total assets of $1,480,072 and sales of $2,236,625. What is the firm's capital intensity ratio? (Round to two decimal places.) A) 66.17% B) 53.73% C) 151.14% D) 124.12% Answer: A Explanation: Total assets = $1,480,072 Sales = $2,236,625 Capital intensity ratio = =

= 66.17%

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

61) Dennis Compton, Inc. has total assets of $5,335,901 and a capital intensity of 53.9%. What is the firm's sales? (Round to nearest whole dollar.) A) $5,335,901 B) $2,828,028 C) $9,899,631 D) $6,945,641 Answer: C Explanation: Total assets = $5,335,901 Capital intensity ratio = 53.9% Capital intensity ratio = 0.539 = Net Sales =

= $9,889,631

Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 62) Which of the following statements about using more sophisticated planning models is NOT true? A) Current liabilities are likely to vary directly with sales. B) Long-term liabilities and equity accounts change as a direct result of managerial decisions. C) Retained earnings will vary directly as sales changes. D) Current assets are likely to vary directly with sales. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

63) Which of the following statements about using more sophisticated planning models is true? A) Current liabilities change as a direct result of managerial decisions with long-term debt. B) Long-term liabilities and equity accounts are likely to vary directly with sales. C) Retained earnings will vary directly with sales. D) Fixed assets will not always vary directly with sales. Answer: D Diff: 2 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64) Which of the following is not a weakness of financial planning models? A) Determining interest expense accurately. B) Determining cash accurately. C) Determining inventory needs accurately. D) Ability to use macroeconomic information. Answer: D Diff: 2 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 65) Which of the following statements about accounting for changes in fixed assets is NOT true? A) When a firm is not operating at full capacity, sales may be increased without adding any new fixed assets. B) Since it requires time to get new assets operational, they are added in small discrete quantities. C) Fixed assets are added in large discrete units called lumpy assets. D) Adding new fixed assets may increase sales. Answer: B Diff: 2 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

66) Which of the following statements about accounting for changes in fixed assets is NOT true? A) When a firm is not operating at full capacity, sales may be decreased without adding any new fixed assets. B) Since it requires time to get new assets operational, they are added as the firm nears full capacity. C) Fixed assets are added in large discrete units called lumpy assets. D) Adding new fixed assets may increase sales. Answer: B Diff: 2 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 67) Which of the following statements is true about the capital budgeting process? A) Management identifies a list of potential projects that are consistent with the business strategy and ranks them according to the value they would create for all stakeholders. B) Rapid growth is considered to be an undesirable outcome from capital budgeting decisions. C) The budget should grow based on cost of the desired projects even if the budget is initially too small. D) Management identifies a list of potential projects that are consistent with the business strategy and ranks them according to the value they would create for the shareholders. Answer: D Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68) Which of the following statements is NOT true about the capital budgeting process? A) Management identifies a list of potential projects that are consistent with the business strategy and ranks them according to the value they would create for the shareholders. B) Rapid growth is considered a desirable achievement in capital budgeting decisions. C) Once the list is made, no management review can change it. D) The capital budgeting process usually involves an outflow of large amount of cash. Answer: C Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

69) External funding needed (EFN) is defined as: A) the additional debt or equity a firm needs to issue so that it can purchase additional assets to support an increase in sales. B) the additional funds raised by a firm to pay off existing short-term debt. C) the additional funds raised by a firm to pay off existing long-term debt. D) the additional equity a firm needs to pay off debt. Answer: A Diff: 2 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 70) Which of the following statements is NOT true? A) The internal growth rate (IGR) is defined as the maximum growth rate that a firm can achieve without external funding. B) The higher the retained earnings generated by a firm, the higher the growth without using external funding. C) Given the same level of retained earnings, a firm that has the higher amount of total assets has a higher growth possibility without using external funding. D) Having a low debt-to-equity ratio may allow firms to achieve higher growth rates without seeking external funding. Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 71) Firms that achieve higher growth rates without requiring external financing: A) have a low plowback ratio. B) have a low ROE. C) are highly leveraged. D) have a low dividend payout ratio that allows more earnings to go back into the firm. Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

72) Firms that achieve higher growth rates without seeking external financing: A) have a low plowback ratio. B) have less equity and/or are able to generate high net income leading to a high ROE. C) are highly leveraged. D) are more risky. Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 73) The sustainable growth rate (SGR): A) is determined from market forces external to the firm. B) is the rate of growth that a firm can sustain by selling additional shares of equity. C) is unrelated to the firm's current level of equity. D) is a function of the plowback ratio and the ROE. Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 74) Which of the following statements about the sustainable growth rate (SGR) is NOT true? A) The SGR is a function of the plowback ratio and the ROE. B) The SGR determines the rate of growth that a firm can sustain without selling additional shares of equity. C) The SGR helps management to determine whether they can avoid issuing new debt. D) The SGR is calculated by multiplying the plowback ratio with the ROE. Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

75) Which of the following statements about the sustainable growth rate (SGR) is true? A) The lower a firm's ROE, the higher the SGR. B) The higher the plowback ratio, the lower the proportion of net income retained in the firm. C) The higher the plowback ratio, the higher the SGR. D) The lower the ROE and plowback ratio, the higher the SGR. Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 76) Hilton Corp. has revenues of $1,214,800, costs of goods sold of $816,355, and pays a tax rate of 32 percent. If the firm pays out 50 percent of its earnings as dividends every year, what is the amount of retained earnings? A) $135,471.30 B) $270,942.60 C) $413,032.00 D) $450,613.00 Answer: A Explanation: Revenue = $1,214,800 CGS = $816,355; Tax rate = 32% Payout ratio = 50% Net income = ($1,214,800 - $816,355)(1 - 0.32) = $270,942.60 Retained earnings = $270,942.60 (1 - 0.50) = $135,471.30 Diff: 3 Learning Objective: LO 3, 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

77) Tangent Inc. has revenues of $4,375,233, costs of goods sold of $2,467,321, and pays a tax rate of 34 percent. If the firm pays out 60 percent of its earnings as dividends every year, what is the amount of retained earnings? (Round final answer to two decimal places.) A) $171,254.18 B) $755,533.15 C) $503,688.77 D) $632,476.98. Answer: C Explanation: Revenue = $4,375,233 CGS = $2,467,321 Tax rate = 34% Payout ratio = 60% Net income = ($4,375,233 - $2,467,321)(1 - 0.34) = $1,259,221.92 Retained earnings = $1,259,221.92 (1 - 0.60) = $503,688.77 Diff: 3 Learning Objective: LO 3, 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

78) Tradewinds Corp. has revenues of $9,651,220, costs of goods sold of $6,080,412, interest payment of $511,233, and a tax rate of 34 percent. It paid dividends of $1,384,125 to shareholders. Find the firm's dividend payout ratio and retention ratio. (Round the percentage answer to nearest whole number.) A) 66%, 34% B) 25%, 75% C) 69%, 31% D) 34%, 66% Answer: C Explanation: Revenues $9,651,220.00 Costs 6,080,412.00 EBIT $3,570,808.00 Interest 511,233.00 EBT $3,059,575.00 Taxes (34%) 1,040,255.50 Net income $2,019,319.50 Dividends paid = $1,384,125 Dividend payout ration =

= 68.5% = 69%

Retention ratio = (1 - Dividend payout ratio) = (1 - 0.69) = 31% Diff: 3 Learning Objective: LO 3, 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

79) Swan Supply Company has net income of $1,212,335 on assets of $12,522,788 and retains 70 percent of its income every year. What is the company's internal growth rate? (Round your final answer to one decimal place.) A) 7.6% B) 6.8% C) 8.6% D) 9.3% Answer: B Explanation: Net income = $1,212,335 Total assets = $12,522,788 Plowback ratio = 70% Internal growth rate (IGR) = Plowback ratio × ROE × Equity ratio = Plowback ratio ×

= Plowback ratio × = 0.70 × = 6.8% Diff: 3 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

80) Mercantile Co. has net income of $3,413,500 on assets of $16,109,445 and retains 55 percent of its income every year. What is the company's internal growth rate? (Round your final answer to two decimal places.) A) 21.21% B) 8.62% C) 11.65% D) 9.43% Answer: C Explanation: Net income = $3,413,500 Total assets = $16,109,445 Plowback ratio = 55% Internal growth rate (IGR) = Plowback ratio × ROE × Equity ratio = Plowback ratio ×

= Plowback ratio × = 0.55 × = 11.65% Diff: 3 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

81) Mandolin Bottlers Co. has net income of $4,272,335 and retains 65 percent of its income every year. If the company's internal growth rate is 8.6 percent, what are total assets? (Round your answer to the nearest dollar.) A) $32,290,904 B) $238,824 C) $30,388,235 D) $29,682,421. Answer: A Explanation: Net income = $4,272,335 Total assets = ? Plowback ratio = 65% IGR = 8.6% Internal growth rate (IGR) = Plowback ratio × ROE × Equity ratio = Plowback ratio ×

= Plowback ratio × 0.086 = 0.65 × Total assets = 0.65 ×

= $32,290,904

Diff: 3 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

82) Meredith Inc. has a return on equity of 21.5 percent, an equity ratio of 55 percent, and a dividend payout ratio of 70 percent. What is the company's internal growth rate? (Round to two decimal places.) A) 8.32% B) 3.55% C) 6.43% D) 4.84% Answer: B Explanation: ROE = 21.5% Equity ratio = 55% Dividend payout ratio = 70% Plowback ratio = 30% IGR = Plowback ratio × ROE × Equity ratio = 0.30 × 0.215 × 0.55 = 3.55% Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 83) Sterling Resorts Co. has total assets worth $13,442,975. It is expecting to grow its revenue at a rate of 25 percent next year. For next year, it expects a net income of $3,475,321 and will pay out 45 percent as dividends. What is the external financing required by the firm to meet its growth expectations? A) $1,796,849.30 B) $1,449,317.20 C) No external funding is needed. D) $1,558,329.44 Answer: B Explanation: Total assets = $13,442,975 Expected net income = $ 3,475,321 Addition to retained earnings = $3,475,321 × (1 - 0.45) = $1,911,426.55 EFN = (Initial assets × Growth rate) - Addition to retained earnings = ($13,442,975 × 0.25) - $1,911,426.55 = ($3,360,743.75 - $1,911,426.55) = $1,449,317.20 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

84) Nederland Finance Company has total assets worth $9,751,223. It is expecting to grow its revenue at a rate of 20 percent next year and will have a net income of $2,213,564 next year. The firm pays out 65 percent of its net income as dividends. What is the external financing required by this firm to meet its growth expectations? A) $1,175,497.20 B) $511,428.00 C) No external funding is needed. D) $745,321.98. Answer: A Explanation: Total assets = $9,751,223 Net income = $2,213,564 Addition to retained earnings = $2,213,564 × (1 - 0.65) = $774,747.40 EFN = (Initial assets × Growth rate) - Additional earnings = ($9,751,223 × 0.20) - $774,747.40 = ($1,950,244.60 - $774,747.40) = $1,175,497.20 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

85) Triumph Company has total assets worth $6,413,228. Next year it expects a net income of $3,145,778 and will pay out 70 percent as dividends. If the firm wants to limit its external financing to $1 million, what is the growth rate it can support? (Round your final answer to one decimal place.) A) 32.9% B) 6.4% C) 30.3% D) 26.5% Answer: C Explanation: Total assets = $6,413,228 Net income = $3,145,778 EFN = $1,000,000 Addition to retained earnings = $3,145,778 × (1 - 0.70) = $943,733.40 EFN = (Initial assets × Growth rate) - Additional earnings $1,000,000 = ($6,413,228 × growth rate) - $943,733.40 $1,000,000 + $943,733.40 = $6,413,228 × growth rate Growth rate =

= 30.3%

Diff: 3 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

86) Jockey Company has total assets worth $4,417,665. At year-end, it will have net income of $2,771,342 and pay out 60 percent as dividends. If the firm wants no external financing, what is the growth rate it can support? (Round your final answer to one decimal place) A) 32.9% B) 25.1% C) 30.3% D) 27.3% Answer: B Explanation: Total assets = $4,417,665 Net income = $2,771,342 EFN = $0 Addition to retained earnings = $2,771,342 × (1 - 0.60) = $1,108,536.80 EFN = (Initial assets × Growth rate) - Additional earnings $0 = ($4,417,665 × growth rate) - $1,108,536.80 $1,108,536.80 = $4,417,665 × Growth rate Growth rate =

= 25.1%

Diff: 3 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 87) If Newell Corp. has a ROE of 18.6 percent and a dividend payout ratio of 60 percent, what is its sustainable growth rate? A) 7.44% B) 2.15% C) 0.47% D) 8.2% Answer: A Explanation: ROE = 18.6% Payout Ratio = 60% Plowback ratio = (1 - Payout ratio) = (1 - 0.60) = 40% SGR = Plowback ratio × ROE = 0.40 × 0.186 = 7.44% Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

88) If Merton Corp. has a ROE of 23.4 percent, what is the plowback ratio required to achieve a sustainable growth rate of 7 percent? (Round to nearest whole number.) A) 34% B) 30% C) 24% D) 28% Answer: B Explanation: ROE = 23.4% Plowback ratio =? Sustainable growth rate = 7% SGR = Plowback ratio × ROE 0.07 = Plowback ratio × 23.4 Plowback ratio =

= 29.9% = 30%

Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

89) Sterling Inc. currently has sales of $4,512,644 and net income of $736,253. It has a debt ratio of 47 percent and a dividend payout ratio of 65 percent. The company has total assets of $3,812,832. What is the company's sustainable growth rate? (In your interim computations, round your ROE percentage to one decimal place.) A) 12.74% B) 23.72% C) 18.96% D) 20.10% Answer: A Explanation: Sales = $4,512,644 Net income = $736,253 Debt ratio = 47% Dividend payout ratio = 65% Total assets = $3,812,832 Plowback ratio = (1 - 0.65) = 35% Equity ratio = (1 - 0.47) = 53% Equity = 0.53 × $3,812,832 = $2,020,800.96 ROE =

= 36.4%

SGR = Plowback ratio × ROE = 0.35 × 0.364 = 12.74% Diff: 3 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

90) Courtney Bike, Co. has a net profit margin of 7.8 percent, a debt ratio of 45 percent, total assets of $2,112,370, and sales of $4,276,990. If the company has a dividend payout ratio of 60 percent, what is the company's sustainable growth rate? (Round final answer to one decimal place.) A) 17.2% B) 15.6% C) 11.5% D) 18.9% Answer: C Explanation: Net profit margin = 7.8% Debt ratio = 45% Total assets = $2,112,370 Sales = $4,276,990 Dividend payout ratio = 60% Plowback ratio = (1 - 0.60) = 40% Net PM = Net income = Sales × Net PM = $4,276,990 × 0.078 = $333,605.22 Equity ratio = 1 - Debt ratio = (1 - 0.45) = 55% Equity = 0.55 × $2,112,370 = $1,161,803.50 SGR = =

× Plowback ratio × 0.40

= 11.49% Diff: 3 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

91) Explain how the strategic plan, investment plan, and financing plan integrate to help management do financial planning. Answer: Financial planning involves planning over a three to five year horizon. It calls for the integration of three basic plans—the strategic plan, the investment plan, and the financing plan. The strategic plan documents a firm's long-term goals, the strategies that management will use to achieve the goals, and the capabilities the firm needs to sustain its competitive position. The planning is done by the firm's top management with the financial manager providing key input, and it has to be approved by the board of directors. The strategic plan identifies the line of business in which the firm will compete, major areas of investment in real assets, and capital expenditures among other things. Next, the investment plan, which includes the capital budget, describes the firm's outlay for plant and equipment. Management will identify a list of potential projects that are consistent with the business strategy and rank them according to value they would create for the shareholders. Senior management then will review the list before revising it in order to comply with the firm's budget constraints. Based on the list prepared in the capital budget, management now needs to decide how to fund the projects. The firm will try and use a blend of internally generated funds and externally raised funds to finance the capital expenditures. Depending on the level of internally generated funds available to the firm, the firm will seek to raise funds in the form of either debt or equity. Diff: 2 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 92) Discuss the implications of the internal growth rate. Answer: The internal growth rate (IGR) is the maximum growth rate a firm can sustain without having to raise additional capital from external sources. Firms that are small and growing typically have limited access to outside financing. Such firms have a high enough retention ratio to fund growth, generate a high level of net income for every dollar of equity, and use low amounts of leverage or debt financing. Once a firm reaches a certain size and growth rate, it may be unable to totally fund their growth with retained earnings alone and may have to enter the capital markets to raise funds. Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

93) Explain the sustainable growth rate and discuss what it means to a firm's management. Answer: The sustainable growth rate (SGR) is the maximum growth rate at which a firm can grow without needing any external equity financing and holding the level of debt constant. Growing a firm at the sustainable growth rate allows management to avoid costly equity issues, thus reducing the dilution of earnings. Whenever a firm grows faster than the SGR, the firm is going to need external financing and may have to resort to debt financing, which increases the company's risk. Diff: 2 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Industry/Sector Perspective

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 20 Options and Corporate Finance 1) A put option with a strike price of $20 is expiring today. The stock is currently selling at $25. Based on this information, the put option should not be exercised. Answer: TRUE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 2) A stock is selling for $50 today. A call option on the stock with a strike price of $50 is set to expire next month. If the price of the stock goes down tomorrow, we would expect the price of the call option to go down as well. Answer: TRUE Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3) A call option can sometimes be priced higher than the underlying asset. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 4) Neither a call nor a put option can have a negative price. Answer: TRUE Diff: 2 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

5) The current price of an asset is $75. A put option on the asset with a strike price of $100 expires one year from now. It is possible, without arbitrage, for this put option to be priced at $24 today. Answer: FALSE Explanation: If the strike price is $100 and current price is $75, then it can be exercised for a profit of $25 immediately. Thus, the intrinsic value is $25. It cannot have a trading value lower than $25. Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6) If the risk-free rate of interest increases, all else being equal, we would expect the value of a call option to increase. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 7) In the binomial pricing model, an option is priced using a replicating portfolio that typically consists of a risk-free bond and the asset underlying the option. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 8) In the binomial pricing model, it is important that we know the probability that the underlying asset will increase in value. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

9) When using the binomial pricing model to price an option, the volatility of the underlying asset's value is represented by the difference between the two possible future values of the underlying asset. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 10) Consider a call option on a stock with a strike price of $60. If the stock price at expiration is $50, then the payoff from the call option is $10. Answer: FALSE Explanation: Call option will not be exercised as the stock price is lower than the strike price. Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 11) Consider a put option on a stock with a strike price of $60. If the stock price at expiration is $50, then the payoff from the put option is $10. Answer: TRUE Explanation: Put option will be exercised as the stock price is lower than the strike price. Payoff = $60 - $50 Payoff = $10 Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 12) Suppose you have sold a put option on a stock with a strike price of $25 and the current price of the stock is $25. If the stock price at expiration is $30, your payoff will be -$5. Answer: FALSE Explanation: The value of the put option to the owner is $0 when the value of underlying asset is greater than or equal to the strike price. Since the stock price at expiration is $30 which is greater than the strike price of $25. The payoff value would be equal to $0. Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 3

13) A portfolio consisting of one put option and one call option, both with the same exercise price, is an investment strategy for investors who do not know whether an asset's value is likely to go up or down but think that the volatility of the asset will increase. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 14) If a firm adds financial options to its debt securities, it will increase the interest expense to the firm. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 15) If a project has a positive NPV, then the real options that are relevant to the project are not important to the estimation of the value of the project. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 16) The option to defer investment can be characterized as the flexibility to wait and learn more information about a project before committing resources to that project. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

17) The option to terminate a project is similar to a put option. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 18) It is possible that some projects with a negative NPV should be pursued after taking into account the value of real options inherent in that project Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 19) A company is negotiating for the option to develop a platinum mine. Under the terms of the option contract, the company would be able to purchase the development rights to the mine one year from now for an exercise price specified today. If, during the negotiations over the option contract, the volatility of the price of platinum increases, the company should expect to pay a higher price for the development option. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 20) The option to abandon a project can decrease the project's value. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

21) Ecofren Thermostats Co. sells equipment to residential and commercial customers. It is considering whether or not to develop a new line of smart thermostats. The discounted cash flows from smart thermostat sales are not likely to cover the development costs. However, the company has decided to pursue the project anyway. If the commercial technology is successful, it might be applied to a new line of very profitable residential thermostats. This is an example of the option to make follow-on investments. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 22) Consider a firm with a single loan. There are no interest payments during the life of the loan, but the principal and interest are all due in two years. It is uncertain whether the cash flow the company will produce will be enough to pay off its debts. The payoff to stockholders in this company resembles that of the owner of a call option. Answer: TRUE Diff: 2 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 23) Consider a company that is likely to go bankrupt in the next year. The bondholders may encourage the company to pursue risky negative-NPV projects in hope that the firm will avoid financial distress. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 24) Consider a company that is likely to go bankrupt in the next year. Stockholders may wish to pursue negative-NPV projects, even if there is no additional value to the project from real options. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 6

25) By designing executive compensation plans with performance bonuses, stock-based compensation, and stock options, corporate boards are attempting to make the payoff function for managers similar to the payoff function for stockholders. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 26) Managers may use less debt than shareholders' expectation due to the increased financial distress. This is an example of agency costs of equity. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 27) Financial options can be used to hedge risks such as interest rates and foreign exchange rates. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 28) Suppose the current spot price of wheat is $25 a bushel. A wheat farmer expects to produce 1,000 bushels at the end of the season, and she wants to ensure that she gets at least $19 a bushel. If a put option on 1,000 bushels of wheat with a strike price of $20 and an expiration date at the end of the season is selling for $1,000, the farmer can purchase the put option to guarantee she gets $19 a bushel. Answer: TRUE Explanation: Put option will guarantee $20,000 ($20 × 1,000 bushels) minus the put option premium of $1,000. She will get $19,000 for 1,000 bushels or $19 per bushel. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

29) Suppose the current spot price of corn is $20 a bushel. A corn farmer expects to produce 2,000 bushels at the end of the season, and she wants to ensure that she gets at least $18 per bushel. Call options on 1,000 bushels of corn with a strike price of $15 and are selling for $3,000 at the expiration date. By selling call options on her corn crop, the farmer can guarantee that she gets at least $18 per bushel. Answer: FALSE Explanation: It only guarantees that she gets $15 a bushel. Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 30) Hedging is the use of financial instruments such as options, forwards, futures, and swaps to reduce the financial risks faced by a firm. Answer: TRUE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 31) Harmostrax Co. has a defined-benefit pension plan for its employees. To fund the plan, the company makes periodic contributions to a stock investment fund. If the stock market declines significantly, the company would have to make additional contributions to make up for lost value. The company could hedge its risk of a market downturn by periodically purchasing put options on the stock market. Answer: TRUE Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

32) A small soybean farmer wants to hedge the price risk of his next crop, but he is financially constrained. He cannot raise capital by either borrowing money or selling his current assets. Instead, he sells call options on his soybean crop with a strike price of $14 per bushel at a premium of $0.50 a bushel. Using the proceeds from selling the call options, he buys put options on his soybean crop with a strike price of $11.00 per bushel at a premium of $0.35 per bushel. Assume the risk-free interest rate is 0 percent. By taking these derivative positions, the farmer has guaranteed that he will earn somewhere between $14.15 and $11.15 per bushel. Answer: TRUE Explanation: Call option premium earned = $0.50 Put option premium paid = $0.35 Net premium earned = $0.15 If price of crop at expiration falls below $11, the farmer would exercise put option. If price of crop at expiration exceeds $14, the farmer is obligated to sell the crop at $14. Range = (Minimum price + Net premium earned) to (Maximum price + Net premium earned) Range = ($11 + $0.15) to ($14 + $0.15) Range = $11.15 to $14.15 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 33) An investor (a buyer) purchases a call option from a seller. On the expiration date of a call option, the buyer has the: A) obligation to buy the underlying asset and the seller has the obligation to sell it. B) right to buy the underlying asset and the seller has the obligation to sell it. C) obligation to sell the underlying asset and the seller has the right to buy it. D) right to sell the underlying asset and the seller has the right to buy it. Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

34) An investor (a buyer) purchases a put option from a seller. On the expiration date of a put option, the buyer has the: A) obligation to sell the underlying asset and the seller has the right to buy it. B) obligation to sell the underlying asset and the seller has the obligation to buy it. C) right to sell the underlying asset and the seller has the obligation to buy it. D) right to buy the underlying asset and the seller has the right to sell it. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 35) Which of the following statements is true of a call option? A) The value of a call option can never be positive. B) The value of a call option can be more than the value of the underlying asset. C) The value of a call option can never be worth less than the current value of the asset minus present value of the strike price. D) The value of a call option can be worth more than the strike price. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 36) Which of the following statements is true of a put option? A) The value of a put option can be negative. B) The value of a put option can be worth more than the underlying asset. C) The value of a put option can be less than the present value of the strike price minus the current value of the underlying asset. D) The value of a put option increases when the stock price increases. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

37) Suppose you own a call option on a stock with a strike price of $20 that expires today. The price of the underlying stock is $15. If you exercise the option and immediately sell the stock, then you will: A) earn $5. B) lose $5. C) lose $15. D) earn $15. Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 38) Suppose you own a put option on a stock with a strike price of $35 that expires today. The price of the underlying stock is $25. If you purchase the stock and exercise the put option, then you will: A) earn $10. B) lose $10. C) earn $25. D) lose $25. Answer: A Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 39) Consider an option that gives the owner the right to buy the underlying stock for $20 only on the third Friday of May, next year. This option can best be described as: A) an American call option. B) a European put option. C) an American put option. D) a European call option. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

40) Consider an American and a European call option on a dividend-paying stock, with otherwise identical features (same strike price, etc.). Which of the following statements is true? A) The American call option will never be worth less than the European call option. B) The European call option will never be worth less than the American call option. C) Both European call and American call option should always have the same value. D) The American option can be exercised only on a specific date which is the expiration date. Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 41) The option payoff function describes the relationship: A) between the value of an option and the value of a firm. B) between the value of an option and the price of the underlying asset. C) between the call premium and the value of an option. D) between the call premium and the price of underlying asset. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 42) Which of the following changes, everything else held constant, will increase the value of a call option? A) The value of the underlying asset becomes more volatile B) The price of the underlying asset goes down C) The option is nearing its expiration date D) A higher strike price Answer: A Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

43) Which of the following changes, everything else held constant, will increase the value of a put option? A) An increase in the risk-free interest rate B) Lower volatility of the price of the underlying asset C) A higher strike price D) The option is nearing its expiration date Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 44) What happens to the value of call and put options if the volatility of the price of underlying asset decreases? A) Put options will be worth more, call options will be worth less. B) Put options will be worth less, call options will be worth more. C) Both call and put options will be worth more. D) Both call and put options will be worth less. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 45) If the price of the underlying asset increases, what happens to the value of call and put options? A) Put options will be worth more, but call options will be worth less. B) Put options will be worth less, but call options will be worth more. C) Both call and put options will be worth more. D) Both call and put options will be worth less. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

46) What happens to the value of call and put options, as the expiration date gets closer, holding other things constant? A) Call option will be worth more, but put options will be worth less. B) Call option will be worth less, but put options will be worth more. C) Both call and put options will be worth more. D) Both call and put options will be worth less. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 47) What happens to the value of call and put options, with everything else held constant, if the risk-free interest rate increases? A) Call options will be worth more, but put options will be worth less. B) Call options will be worth less, but put options will be worth more. C) Both call and put options will be worth less. D) Both call and put options will be worth more. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 48) The management at PhoneUn considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to be easily converted to manufacture other types of large machinery. If its new line of phones is poorly received, its plant could be easily sold to another manufacturing company. In this example, the price at which they expect to sell the plant if things go poorly resembles: A) the premium of a put option on the plant. B) the premium of a call option on the plant. C) the strike price of a put option on the plant. D) the strike price of a call option on the plant. Answer: C Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

49) Frost1 Motors is very likely to enter financial distress. Without a dramatic change of events over the next couple of years, the company will be unable to pay its lenders, who will then gain control of the company's assets. A group of stockholders has pressured the company's management to begin manufacturing and selling one of the company's concept cars in the hope that it will be a big hit. Concept cars are prototypes that are developed to test new ideas and to show off at auto shows. Although elements of concept cars are often incorporated into product lines, rushing a concept car into production is very risky. The best estimates about the concept car make it appear to be a negative-NPV project. This is a good example of: A) the dividend payout problem. B) the underinvestment problem. C) the asset substitution problem. D) the agency cost of equity. Answer: C Diff: 2 Learning Objective: LO 4 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 50) Which of the following would be a reason to bundle options with stock in an IPO? A) To increase the supply of outstanding shares in order to attract more investors B) To promote the dilution of common stockholders' control on assets C) To reduce the number of common shares that must be sold at the IPO price in order to raise the amount of money that the firm needs D) To bring down the earnings per share of common stockholders Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

51) When a company issues convertible bonds with a $1,000 par value that can be converted to 20 shares of common stock, each bond includes: A) a put option with an exercise price of $200 per share. B) a call option with an exercise price of $50 per share. C) a put option with an exercise price of $20 per share. D) a call option with an exercise price of $20 per share. Answer: B Explanation: The bond includes call option Exercise price = Par value of convertible bonds/Number of shares offered for conversion Exercise price = $1,000/20 shares = $50 per share. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 52) Consider a CEO who holds neither stock nor stock options in the company she runs. Her payoff function regarding the firm's performance is most likely to resemble the payoff function of: A) stockholders. B) lenders. C) owners of a call option on the firm. D) holders of a risk-free bond with coupon payments equal to her salary. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 53) When the value of the firm is above the face value of the debt: A) the stockholders repay the debt and the equity is worth less than $0. B) the stockholders repay the debt and the equity is worth the difference between the firm value and the face value of the debt. C) the stockholders default and the lenders receive the value of the firm. D) the stockholders default and the equity is worth $0. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

54) Which of the following is a valid reason for managers selecting negative-NPV projects? A) The NPV analysis includes a valuable real option to expand the project if things go well. B) If a firm has debt, managers may create value for shareholders by taking on some risky negative NPV projects. C) Managers' payoff functions represent the payoffs of lenders. By taking negative NPV projects, the managers can create value for lenders. D) Projects having negative NPV can have high internal rate of return. Answer: B Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 55) As the manager of a sporting goods company, you are presented with a new golf project. An inventor has recently patented the design for a new golf club that makes playing golf much easier. Your company has made contact with the inventor, who is willing to sell the exclusive rights to the technology, but if you do not act fast he will sell the rights to a rival company. You are not certain whether the new golf club will become popular, but your analysts have completed a basic NPV analysis. Given the available information, the project has a positive NPV. However, you know there are several real options associated with the project, including the option to abandon the project and the option to make follow-on investments. Which of the following statements regarding the project is correct? A) Based on the NPV analysis, you should accept the project. The value of the project may be worth more than the NPV analysis but not less. B) Based on the NPV analysis, you should accept the project. The NPV analysis contains all the information about the value of the project. C) Based on the NPV analysis, you should reject the project. Without additional information about the value of the real options, there is no way to make a decision. D) Based on the NPV analysis, you should reject the project. The NPV analysis contains all the information about the value of the project. Answer: A Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

56) Arctic Inc. has built a highly interactive operating system for mobile and other electronic gadgets. The development cost to the company was high but the system was inexpensive to sustain and market. The NPV of this project was negative. However, in the coming years the company plans to launch mobile phones, portable audio and video devices. The decision of launching the operating system for mobile and other devices is an example of: A) option to defer investment. B) option to abandon a project. C) option to change operations. D) option to make follow-on investments. Answer: D Diff: 2 Learning Objective: LO 3 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 57) The employment contracts for professional athletes often contain options for either the player or the team. Consider one recent contract in Major League Baseball. The player's salary was guaranteed for the first couple of years. However, after several years, the team had the option to cancel the contract if the player became injured. If we think of each player as a project for the team, this option feature of the contract is best described as: A) the option to defer investment. B) the option to make follow-on investments. C) the option to change operations. D) the option to abandon projects. Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

58) Adosonic Reality is considering the construction of a new development of condominiums in downtown Austin, Texas. The site for the new development is currently occupied by an office building owned by the city. The project's profitability will depend largely on the population increase in Austin over the next several years. Rather than buying the site, Adosonic Reality has entered into an agreement with the city to pay $200,000 for the right to purchase the site for $10 million two years from now. The real option embedded in this contract is best described as: A) the option to defer investment. B) the option to make follow-on investments. C) the option to change operations. D) the option to abandon projects. Answer: A Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 59) Consider a new firm that is working on the first generation of long-awaited consumer jet packs. The project will take a tremendous amount of R&D expenditure. Even if the development is successful, manufacturing the first generation of jet packs is likely to be so expensive that only a selected few consumers will be able to afford them. The projected sales of the first generation of jet packs almost certainly will not cover the development and manufacturing costs—the project has a negative NPV. Which of these reasons would validate the firm's decision to pursue the jet pack project? A) If development is unsuccessful, it can abandon the project before spending money on manufacturing. B) If the project is successful, it may lead to a very profitable second project—a cheaper jet pack that will be a positive-NPV project. C) Because it is a high-tech firm, the cash flows generated by a project are not important in valuing the company. D) If development is successful, it allows managers to reach wide range of consumers. Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

60) A local city government has awarded a contract to sequentially build five new elementary schools over the next 10 years. The price for each school has been spelled out in the contract, but at the beginning of each year the city can cancel the order for the remaining schools. The city government is concerned that if the population of the town does not grow as expected it may not need all of the schools. What type of financial option does the option to cancel the order resemble? A) Owning a call option on the value of the new schools B) Owning a put option on the value of the new schools C) Selling a call option on the value of the new schools D) Selling a put option on the value of the new schools Answer: A Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 61) Purchasing a house is a somewhat complicated process. Typically, if the buyer's offer is accepted by the seller, the transaction will not be completed or "closed" for several weeks. During this time the buyer may gather more information about the house or research other houses in the area. Some home purchase contracts include an option fee. The buyer may pay the seller a few hundred dollars for the right to walk away from the contract prior to closing for any reason. This option fee can be best described as: A) the option to defer investment. B) the option to make follow-on investments. C) the option to change operations. D) the option to abandon project. Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

62) The management at Sevenglobe Motors considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to easily be converted to manufacture other types of large machinery. If their new line of cars is poorly received, their plant should be easy to sell to another manufacturing company. In this example, the extra cost of building the plant in such a way that it can easily be converted for other uses resembles: A) the premium of a put option on the plant. B) the premium of a call option on the plant. C) the strike price of a put option on the plant. D) the strike price of a call option on the plant. Answer: A Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 63) Anonxy Foods has made the decision to invest in a new line of organic microwave dinners. The new line of dinners is a negative-NPV project; paying its suppliers to convert to organic practices will be expensive. However, the company will be in a good position to expand into more profitable lines of food if consumer demand for organic foods grows more than expected. The negative value of the organic dinner project most closely resembles: A) the premium of a put option on future organic projects. B) the premium of a call option on future organic projects. C) the strike price of a put option on future organic projects. D) the strike price of a call option on future organic projects. Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

64) Bifive Homes, Inc., is a developer of planned residential communities. It has entered into an option contract with a land owner outside Austin, Texas. It will pay the land owner $100,000 for the option to buy the land in two years at a price of $20 million. During that time Bifive Homes will evaluate population and real estate trends in Austin. Its plan is to buy the land if real estate prices in Austin increase enough that developing the land would be worth more than the $20 million price. The $20 million purchase price resembles: A) the premium price of a put option on the land. B) the premium price of a call option on the land. C) the strike price of a put option on the land. D) the strike price of a call option on the land. Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 65) The claim stockholders have on a company's cash flow with outstanding debt can best be described as: A) a call option on the firm's assets. B) a put option on the firm's assets. C) an interest-free bond with the same value as the firm's assets. D) a put option on the firm's liabilities. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

66) Which of the following statements is an example of an agency cost of debt? A) ABC Co. shareholders pressure management to invest in very risky projects in hopes that one of the investments might pay off. The company is highly leveraged, so shareholders have little to lose. B) ABC Co. has little debt with very few investment opportunities. The board of directors decides not to pay out a large special dividend. Lenders are fully paid for the principal value of the debt. C) ABC Co. is financially sound. The company has a negative-NPV investment opportunity. Investors refuse to invest the additional funds to pursue the negative NPV project. D) Investors are unsure of the value for ABC Co.. The market assumes that ABC Co.'s managers are issuing equity to pay down debt because the company's stock is overvalued. As a result, the company's stock price falls when the equity issue is announced. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 67) The claim lenders' hold on cash flows in a company with outstanding risky debt is often described as: A) holding a call option on the firm's assets. B) holding a put option on the firm's assets. C) selling a put option on the firm's assets and holding a risk-free bond. D) selling a call option on the firm's asset and holding a risk-free bond. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 68) Adding stock options and bonuses to the compensation of a manager is intended to more closely align the interests of the manager with those of: A) stockholders. B) lenders. C) employees. D) public. Answer: A Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 23

69) What is the payoff for the buyer of a call option with a strike price of $50 if the underlying stock price at expiration is $85? A) $35 B) $50 C) $45 D) $140 Answer: A Explanation: (Call) Payoff = Stock price - Strike price = $85 - $50 = $35 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 70) What is the payoff for the buyer of a call option with a strike price of $35 if the underlying stock price at expiration is $30? A) $10 B) $20 C) $5 D) $0 Answer: D Explanation: The payoff for the buyer of a call option is zero as the value of the underlying asset, $30, is below the exercise price of $35. Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 71) What is the payoff for the buyer of a put option with a strike price of $63 if the underlying stock price at expiration is $43? A) $126 B) $43 C) $20 D) $63 Answer: C Explanation: Payoff for the owner of a put option = Strike price - Stock price = $63 - $43 = $20 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

72) You own a put option on Phosfranc Inc. stock with a strike price of $50. The current stock price is $50. Which of the following would benefit you? A) The stock price goes up. B) The stock price goes down. C) The stock price stays the same. D) The stock price has low volatility. Answer: B Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 73) You have sold a call option on Ausia Co. stock with a strike price of $50. You do not intend to make any other transactions before the options expiration date. The current stock price is $30. Which of the following statements best describes your hopes for the stock? A) You want the stock price to fall below $30. B) You want the stock price to rise above $50. C) You are indifferent, as long as the stock price stays under $50. D) You are indifferent to changes in the stock price. Answer: C Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 74) What is the payoff for the owner of a put option with a strike price of $22 if the price of the underlying stock at expiration is $19? A) $1 B) $3 C) $20 D) $22 Answer: B Explanation: Payoff for the owner of a put option = Strike price - Stock price = $22 - $19 = $3 Diff: 2 Learning Objective: LO 1 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

75) Consider a call option with a strike price of $20, which expires in one year. The risk-free rate of interest is 5 percent. The underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option? (Round intermediate computations to two decimal places.) A) $0 B) $8 C) $15 D) $1 Answer: C Explanation: Without arbitrage, the value of the option must fall between $10.95 and $30. Out of the given choices, only $15 is a possible price for the option.

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

76) Consider a call option with a strike price of $10, which expires in one year. The risk-free rate of interest is 10 percent. The current underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option? (Round intermediate computations to two decimal places.) A) $0 B) $19.50 C) $21.00 D) $19.00 Answer: C Explanation: Without arbitrage, the value of the option must fall between $20.91 and $30. Out of the given choices, only $21 is a possible price for the option.

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

77) Consider a put option with a strike price of $40, which expires in one year. The risk-free rate of interest is 8 percent. The current underlying stock price is $20. Without arbitrage, which of the following is a possible price for the put option? (Round intermediate computations to two decimal places.) A) $0.50 B) $16.20 C) $25.00 D) $10.20 Answer: C Explanation: Without arbitrage, the value of the put option must fall between $17.04 and $37.04 Out of the given choices, only $25 is a possible price for the option.

Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

78) Pitchgent, Inc., stock is currently trading at $22 per share. There are two types of options available on the stock. Call options with a strike price of $16, which expire next month, are currently trading at $7.00. Put options with a strike price of $16 which expire next month are currently trading at $1.10. Larry invests $132 in common stock. Keaty invests $132 in the call options. Marek invests $132 in the put options. At the end of one month, the price of Pitchgent, Inc., is $25. Who made the most money from their investment? A) Larry B) Keaty C) Marek D) Larry and Keaty tied Answer: B Explanation: Larry holds ($132)/($22) per share = 6 shares of stock. His gain is (6 shares) × ($25 per share) - $132 = $18 Keaty holds ($132)/($7 per call option) = 18.857 call options. The final price of the stock is above the $16 strike price, so her options are in the money. Her gain is ($25 - $16) × (18.857 call options) - $132 = $37.714 Marek holds ($132)/($1.1 per put option) = 120 put options. The final price of the stock is above the $16 strike price, so his options are out of the money. He received no payoff. His loss is $132. Keaty made the most money. Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

79) Tunerecord Unit Co. stock is currently trading at $24. There are two types of options available on the stock. Call options with a strike price of $24, which expire next year, are currently trading at $9.60. Put options with a strike price of $24, which expire next year, are currently trading for $2.40. Berniss invests $144 in common stock. Jewel invests $144 in the call options. Reynardo invests $144 in the put options. At the end of one year, the price of Tunerecord Unit stock is $21.60. Who made the least losses from their investment? A) Berniss B) Jewel C) Reynardo D) Berniss and Jewel tied Answer: C Explanation: Berniss holds ($144)/($24) per share = 6 shares of stock. The stock went down, so Berniss lost money. His loss is (6 shares) × ($21.6 per share) - $144 = -$14.4. Jewel holds ($144)/($9.6 per call option) = 15 call options. The final price of the stock is below the $21.6 strike price, so her options are out of the money. There is no payoff from her call options. Her loss is -$144. Reynardo holds ($144)/($2.4 per put option) = 60 put options. The final price of the stock is below the $24 strike price, so his options are in the money. His gain is ($24 - $21.6) × (60) $144 = 0. Reynardo broke even, the others lost money. Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

80) Assume that the stock of Alitor Craft, Inc. is currently trading for $19 and will either rise to $21 or fall to $15 in one year. The risk-free rate for one year is 12 percent. What is the value of a call option with a strike price of $16? (Do not round intermediate computations, but round final answer to two decimal places.) A) $4.67 B) $2.33 C) $1.04 D) $6.83 Answer: A Explanation: The payoff from the call option is $5 if the stock price rises and $0 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $5 = ($21 × x) + (1.12 × y) $0 = ($15 × x) + (1.12 × y) The first equation can be written in terms of x as follows: x= Now, substituting into the second equation gives us: $0 = $15 ×

+ 1.12y

1.12y = -$12.5 y = -$11.16071 Finally, substituting this value back into the first equation gives us the value of x: $5 = ($21 × x) + (1.12 × -$11.16071) x = 0.83333 The value of the option is the value of the replicating portfolio: (0.83333 × $19) + (1 × (-$11.16)) = $4.67 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

81) Assume that the stock of Tencheck, Inc., is currently trading for $45 and will either rise to $57 or fall to $19 in one year. The risk-free rate for one year is 9 percent. What is the value of a call option with a strike price of $47? (Do not round intermediate computations, but round final answer to two decimal places.) A) $3.40 B) $6.84 C) $8.84 D) $7.25 Answer: D Explanation: The payoff from the call option is $10 if the stock price rises and $0 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $10 = ($57 × x) + (1.09 × y) $0 = ($19 × x) + (1.09 × y) The first equation can be written in terms of x as follows: x=

Now, substituting into the second equation gives us: $0 = $19 ×

+ 1.09y

1.09 y = -$5 y = -$4.58716 Finally, substituting this value back into the first equation gives us the value of x: $10 = ($57 × x) + (1.09 × -$4.58716) x = 0.263158 The value of the option is the value of the replicating portfolio: (0.263158 × $45) + (1 × (-$4.58716)) = $7.25 Diff: 1 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

82) XYZ, Inc. stock is currently trading for $47 and will either rise to $49 or fall to $44 in one year. The risk-free rate for one year is 6 percent. You own a call option with a strike price of $32, which expires in one year. What is the value of your call option? (Do not round intermediate computations, but round final answer to two decimal places.) A) $0 B) $5.27 C) $10.05 D) $16.81 Answer: D Explanation: The payoff from the call option is $17 if the stock price rises and $12 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $17 = $49x + 1.06y $12 = $44x + 1.06y x= Now, substituting into the second equation gives us: $12 = $44 ×

+ 1.06y

1.06y = -$32.00 y = -$30.1887 Finally, substituting this value back into the first equation gives us the value of x: $17 = $49x + 1.06 × (-$30.1887) x=1 The value of the option is the value of the replicating portfolio: (1 × $47) + (1 × (-$30.1887)) = $16.81 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

83) Assume that the stock of XYZ, Inc., is currently trading for $18 and will either rise to $24 or fall to $13 in one year. The risk-free rate for one year is 11 percent. What is the value of a call option with a strike price of $26? A) $0 B) $5.23 C) $7.72 D) $2.00 Answer: A Explanation: The payoff from the call option is $0 either the stock price rises or falls. This option will never pay off as exercise price is higher than up and down stock prices, so it has a value of $0. Diff: 3 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 84) The standard deviation of the return on a stock is 25% per year. What is the standard deviation of stock return over two years? (Round your intermediate answer to three decimal places.) A) 30.35% B) 35.35% C) 12.25% D) 25.00% Answer: B Explanation: σ 2 years = σ × (n)1/2 = 25 × (2 years)1/2 = 25 × 1.414 = 35.35% Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Quantitative Methods AICPA: Global and Industry Perspectives

85) Phocuscorp's stock is currently worth $60. The replicating portfolio consists of one-half share and $24.50 risk-free loan. What is the value of call option?. A) $5.50 B) $4.50 C) $5.00 D) $6.00 Answer: A Explanation: Value of the call option today = C = ($60 × x) + (1 × y) = ($60 × 0.5) + (1 × -$24.50) = $5.50 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 86) Assume that the stock of Unmix, Inc., is currently trading for $22 and will either rise to $31 or fall to $18 in one year. Assume the risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $25? (Round the final answer to two decimal places.) A) $0 B) $1.85 C) $3.00 D) $4.85 Answer: D Explanation: The payoff from the put option is $0 if the stock price rises and $7 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($31 × x) + (1.00 × y) $7 = ($18 × x) + (1.00 × y) x = -0.538 shares of stock y = $16.69 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.538 × $22) + ($16.69) = $4.85 Diff: 3 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

87) Assume that the stock of AllSiete, Inc., is currently trading for $44 and will either rise to $50 or fall to $29 in one year. The risk-free rate for one year is 4 percent. What is the value of a put option with a strike price of $40? (Round the final answer to two decimal places.) A) $0 B) $2.13 C) $3.14 D) $5.54 Answer: B Explanation: The payoff from the put option is $0 if the stock price rises and $11 if the stock price falls ($40 - $29). From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($50 × x) + (1.04 × y) $11 = ($29 × x) + (1.04 × y) x = -0.5238 shares of stock y = $25.18 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.5238 × $44) + ($25.18) = $2.13 Diff: 3 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 88) Assume that the stock of Phoneeffect, Inc., is currently trading for $16 and will either rise to $23.50 or fall to $9 in one year. The risk-free rate for one year is 3 percent. What is the value of a put option with a strike price of $18 that expires in one year? (Round intermediate computations to three decimal places, but round final answer to two decimal places.) A) $0 B) $2.75 C) $4.23 D) $5.73 Answer: C Explanation: The payoff from the put option is $0 if the stock price rises and $9 if the stock price falls ($18 - $9). From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($23.50 × x) + (1.03 × y) $9 = ($9 × x) + (1.03 × y) x = -0.621 shares of stock y = $14.17 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.621 × $16) + ($14.17) = $4.23 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 36

89) Assume that the stock of TuneSeis, Inc. is currently trading for $29 and will either rise to $32 or fall to $5 in one year. The risk-free rate for one year is 2 percent. What is the value of a put option with a strike price of $30? (Round intermediate computations to three decimal places, but round final answer to two decimal places.) A) $0 B) $0.41 C) $1.78 D) $2.20 Answer: D Explanation: The payoff from the put option is $0 if the stock price rises and $25 if the stock price falls ($30 - $5). From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($32 × x) + (1.02 × y) $25 = ($5 × x) + (1.02 × y) x = -0.926 shares of stock y = $29.05 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.926 × $29) + ($29.05) = $2.20 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

90) Assume that the stock of Mixtoss, Inc., is currently trading for $18 and will either rise to $30 or fall to $12 in one year. Assume the risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $15? (Do not round intermediate computations.) A) $0 B) $2 C) $5 D) $6 Answer: B Explanation: The payoff from the put option is $0 if the stock price rises and $3 if the stock price falls ($15 - $12). From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $3 = ($12 × x) + (1.00 × y) x = -0.167 shares of stock y = $5 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.167 × $18) + ($5) = $2 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 91) If the value of the underlying asset is well above the exercise price of a put option, then: A) it is likely that the option will be exercised by the buyer. B) the exercise price remains constant irrespective of the change in the value of the underlying asset. C) the value of the option is directly proportional to the value of the underlying asset. D) the seller of the option will most likely make a profit. Answer: D Diff: 2 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

92) Assume that the stock of Statrec, Inc., is currently trading for $2.60 and will either rise to $10 or fall to $0 in one year. The risk-free rate for one year is 1 percent. What is the value of a put option with a strike price of $5? (Round all computations to two decimal places.) A) $0 B) $2.35 C) $3.65 D) $3.80 Answer: C Explanation: The payoff from the put option is $0 if the stock price rises and $5 if the stock price falls ($5 - $0). From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($10 × x) + (1.01 × y) $5 = ($0 × x) + (1.01 × y) x = -0.5 shares of stock y = $4.95 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.5 × $2.6) + ($4.95) = $3.65 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

93) You own a share of common stock in Vibrapower, Inc., which is currently trading for $18 and will either rise to $30 or fall to $12 in one year. Assume the risk-free rate for one year is 0 percent. You also own an American put option on the stock with a strike price of $20, which expires in one year. What is the value of the put option, and what would be the net payoff from exercising the option now? (Round intermediate computations to three decimal places, but round final answer to two decimal places.) A) Option value: $3.33, Net payoff $2 B) Option value: $3.33, Net payoff $6 C) Option value: $5.34, Net payoff $2 D) Option value: $5.34, Net payoff $6 Answer: C Explanation: First, we can calculate the value of the put option with the binomial model. The payoff from the put option is $0 if the stock price rises and $8 ($20 - $12) if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $8 = ($12 × x) + (1.00 × y) x = -0.444 shares of stock y = $13.33 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.444 × $18) + ($13.33) = $5.34 The payoff from exercising the put option now is the option strike price minus the current stock price: $20 - $18 = $2 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

94) You are fortunate enough to own a put option with a strike price of $40 on the stock of Osmerc, Inc. The current stock price is $3. When the option expires, you expect the stock price to be either $2 or $5. Assume the risk-free rate of interest is zero. What is the value of your put option? A) $0 B) $35 C) $37 D) $46 Answer: C Explanation: The payoff from the put option is $35 if the stock price rises ($40 - $5) and $38 ($40 - $2) if the stock price falls. When the put option pays off in either state, the value of the option is strike price minus the current stock price. $40 - $3 = $37 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 95) Assume that the stock of EffeUn, Inc. is currently trading for $16 and will either rise to $18 or fall to $12 in one year. The risk-free rate for one year is 1 percent. What is the value of a put option with a strike price of $10? A) $0 B) $2.00 C) $2.33 D) $5.00 Answer: A Explanation: The payoff from the put option is $0 if the stock price either rises or falls. Either way the put option has no payoff. The value of this put option is $0. Diff: 3 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

96) Assume that the stock of ABC, Inc., is currently trading for $21 and will either rise to $30 or fall to $18 in one year. Assume the risk-free rate for one year is 0 percent. You own a portfolio that consists of one call option and one put option. Both options have a strike price of $25, and both expire in one year. What is the value of your portfolio? (Round intermediate computations to three decimal places, but round final answer to two decimal place.) A) $4.50 B) $25.01 C) $6.00 D) $6.51 Answer: D Explanation: To calculate the value of this portfolio, we can use the binomial pricing model to calculate that value of the call and the put. Then, we can add the values together. The payoff from the call option is $5 ($30 - $25) if the stock price rises and $0 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $5 = ($30 × x) + (1.00 × y) $0 = ($18 × x) + (1.00 × y) x = 0.417 shares of stock y = -$7.51 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.417 × $21) + (-7.51) = $1.25 The payoff from the put option is $0 if the stock price rises and $7 ($25 - $18) if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $7 = ($18 × x) + (1.00 × y) x = -0.583 shares of stock y = $17.5 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.583 × $21) + ($17.5) = $5.26 The total value of the portfolio is $1.25 + $5.26 = $6.51 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

97) Assume that the stock of DiezEight, Inc., is currently trading for $16 and will either rise to $50 or fall to $2 in one year. The risk-free rate for one year is 8 percent. You own a portfolio that consists of one call option and one put option. Both options have a strike price of $15, and both expire in one year. What is the value of your portfolio? (Round intermediate computations to three decimal places, but round final answer to two decimal places.) A) $0 B) $15.64 C) $21.40 D) $18.52 Answer: D Explanation: To calculate the value of this portfolio, we can use the binomial pricing model to calculate that value of the call and the put. Then, we can add the values together. The payoff from the call option is $35 ($50 − $15) if the stock price rises and $0 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $35 = ($50 × x) + (1.08 × y) $0 = ($2 × x) + (1.08 × y) x = 0.729 shares of stock y = -$1.35 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.729 × $16) + (-1.35) = $10.31 The payoff from the put option is $0 if the stock price rises and $13 ($15 - $2) if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($50 × x) + (1.08 × y) $13 = ($2 × x) + (1.08 × y) x = -0.271 shares of stock y = $12.55 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.271 × $16) + ($12.55) = $8.21 The total value of the portfolio is $10.31 + $8.21 = $18.52 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

98) Consider two call options written on different stocks. Both call options have a strike price of $15 and expire one year from today. The first option is written on HearFour, Inc., whose current stock price is $16. One year from now, shares of HearFour will either rise to $18 or fall to $14. The second option is written on EsoOne, Inc., whose current stock price is also $16. In one year, shares of EsoOne Inc. will either rise to $22 or fall to $0. The risk-free interest rate is 0 percent. Which call option is worth more? A) The call option on HearFour, is worth more. B) The call option on EsoOne is worth more. C) They are both worth the same amount. D) There is not enough information to make a comparison. Answer: B Explanation: First, we can price the HearFour call option. The payoff from the HearFour call option is $3 ($18 - $15) if the stock price rises and $0 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $3 = ($18 × x) + (1.00 × y) $0 = ($14 × x) + (1.00 × y) x = 0.75 shares of stock y = -$10.50 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.75 × $16) + (-10.50) = $1.50 Next, we can price the EsoOne call option. The payoff from the EsoOne call option is $7 ($22 $16) if the stock price rises and $0 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $7 = ($22 × x) + (1.00 × y) $0 = ($0 × x) + (1.00 × y) x = 0.318 shares of stock y = $0 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.318 × $16) + ($0) = $5.09 The EsoOne call option is worth more. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

99) Consider a call option and a put option both written on Neunlay, Inc. stock. Both options have a strike price of $20 and expire in one year. The stock of Neunlay, Inc., is currently selling for $20. In one month the stock will be at either $24 or $18. Assume the risk-free rate is 0 percent. Which is worth more, the put option or the call option? A) The put option is worth more. B) The call option is worth more. C) They are worth the same. D) There is not enough information. Answer: C Explanation: The payoff from the call option is $4 ($24 - $20) if the stock price rises and $0 if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $4 = ($24 × x) + (1.00 × y) $0 = ($18 × x) + (1.00 × y) x = 0.667 shares of stock y = -$12 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.667 × $20) + (-12) = $1.34 The payoff from the put option is $0 if the stock price rises and $2 ($20 - $18) if the stock price falls. From the binomial pricing model, we can create a replicating portfolio with the following two equations: $0 = ($24 × x) + (1.00 × y) $2 = ($18 × x) + (1.00 × y) x = -0.333 shares of stock y = $8 of risk-free bonds The value of the option is the value of the replicating portfolio: (-0.333 × $20) + ($8) = $1.34 The call and the put options are worth the same. Note that this is a special case where interest rates are zero. With a positive interest rate, the call will be worth more than the put. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 100) The value of call option can never be less than: A) $0. B) $1. C) the strike price. D) the value of the underlying asset. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 45

101) When we consider the value of a call option that has not expired, we must: A) compare the current value of the underlying asset with the present value of the cash flow from the underlying asset, discounted at the risk-free rate. B) compare the current value of the underlying asset with the present value of the exercise price, discounted at the risk-free rate. C) compare the current value of the underlying asset with the present value of the cash flow of the underlying asset, discounted at the nominal rate. D) compare the current value of the underlying asset with the present value of the exercise price, compounded at the nominal rate. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 102) Which of the following is true of a call option? A) The value of a call option must be less than or equal to $0. B) The value of a call option cannot be lower than the value of the underlying asset. C) The value of a call option prior to expiration will never be less than the value of the option if it were exercised immediately. D) A call option protects the seller from price volatility. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

103) Calculate the value of put option using put-call parity model with the given information. Value of the call option is $6.20, exercise price is $58, risk-free rate of interest is 5.5 percent, time before the option expires is one year and the current value of underlying assets is $52. Consider the value for e as 2.71828. A) $9.10 B) $12.20 C) $6.20 D) $8.92 Answer: A Explanation: The value of put option can be computed using the equation of put-call parity. P = C + Xe-rt - V P = $6.2 + $58 × (2.71828)-(0.055)(1) - $52 P = $9.10 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 104) Trerec Co. is a privately-owned oil drilling and refinery company with a significant amount of debt. Most of the company's cash flows come from the financially stable refinery unit of the business. With only the assets in place, the company is very likely to avoid financial distress at least for the next 12 months. The company is considering a new positive-NPV oil drilling project. Because of the nature of oil prices, the project is very risky. At any oil price above $115, the project would add value to the company. However, if oil prices were to fall below $95 the losses could push the entire business into financial distress. Assume the risk-free interest rate is 0 percent. Which of the following strategies would allow the firm to pursue the positive NPV project while hedging the oil price risk? A) The firm purchases call options with a strike price of $130 for each barrel of oil it expects to produce. Each option costs $6. B) The firm sells call options with a strike price of $130 on each barrel of oil it expects to produce. Each option costs $6. C) The firm purchases put options with a strike price of $130 on each barrel of oil it expects to produce. Each option costs $6. D) The firm sells put options with a strike price of $130 on each barrel of oil it expects to produce. Each option costs $6. Answer: C Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

105) Consider a corn farmer who expects to produce 55,000 bushels of corn at the end of this season. To hedge the risk associated with corn prices, the farmer purchases put options to cover his entire crop. The put options have a strike price of $8.50 per bushel and a premium of $0.40 per bushel. He also sells an equal amount of call options with a strike price of $8.50 per bushel and a premium of $0.53 a bushel. Which of the following statements is correct? A) From this transaction, the farmer can pocket $7,500 immediately. B) If corn prices go up substantially, the farmer will earn more money. C) The put options guarantee that the farmer will receive at least $7.63 per bushel at the end of the season. D) The farmer has guaranteed himself that he will sell his corn for $8.50 a bushel. Answer: D Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 106) Consider a lease agreement recently offered by a car dealership. The agreement gives the customer the right to use a new SUV for four years in exchange for payments of $650 per month. At the end of the lease, the customer can choose to purchase the SUV for $18,000. What sort of option does this resemble? A) A put option on the SUV with a strike price of $18,000 B) A call option on the SUV with a strike price of $18,000 C) A put option on the SUV with a strike price of $17,800 D) A call option on the SUV with a strike price of $17,800 Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

107) Neunlay Inc., is a manufacturer of residential air conditioning equipment. Air conditioning equipment requires a lot of copper. In six months the company will purchase its copper supply for the next two years. Management is very concerned about the volatility of copper prices. Assume the risk-free rate of interest is 0 percent. Which of the following transactions will ensure the company does not have to pay more than $6,100 per ton of copper six months from now? A) The company purchases a put option for the necessary amount of copper with a strike price of $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now. B) The company purchases a call option for the necessary amount of copper with a strike price of $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now. C) The company sells a put option for the necessary amount of copper with a strike price of $6,000 per ton, a premium of $100 per ton and an expiration date six months from now. D) The company sells a call option for the necessary amount of copper with a strike price of $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now. Answer: B Diff: 2 Learning Objective: LO 5 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives 108) Describe the difference between American call options and American put options. Include in your answer a description of the option premium, the option strike price, the expiration date, and the payoff function. Answer: The buyer of an American call option pays the seller a premium for the right to purchase the underlying asset at the strike price, before or on the expiration date. Because the buyer of the option has the right, but not the obligation, to purchase the asset, he will only exercise the option if the asset is worth more than the strike price. The payoff function for a call option is zero until the value of the underlying asset reaches the strike price. If the price of the underlying asset is above the strike price, the payoff function is equal to the difference between the asset price and the strike price. The buyer of an American put option pays the seller a premium for the right to sell the underlying asset at the strike price, before or on the expiration date. Because the buyer of the option has the right, but not the obligation, to sell the asset, he will only exercise the option if the asset is worth less than the strike price. The payoff function for a put option is zero if the value of the underlying asset is higher than the option's strike price. If the value of the underlying asset is lower than the strike price, the payoff of the put option is equal to the difference between the strike price and the underlying asset price. Diff: 2 Learning Objective: LO 1 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

109) Name the factors that affect the value of a call option and explain the direction of the effects. Answer: Five factors affect the value of a call option. The Strike Price of the Option–All else equal, the lower the strike price of the call option, the more valuable the option is. This is true because with a low strike price, the underlying asset price will not have to be as high for the option to be "in the money." The Price of the Underlying Asset–All else equal, the higher the price of the underlying asset, the more valuable a call option on the asset is. If the price of the underlying asset is higher, it is more likely to be above the strike price at the expiration date. The call owner will benefit from higher underlying asset values. The Volatility of the Underlying Asset–All else equal, the higher the volatility of the price of an asset, the more a call option is worth. With higher volatility, the price of the underlying asset has a higher chance of going down or up significantly before the expiration date. Because the call option will only be exercised if the underlying asset price is above the strike price, the benefits from the upside of volatility outweigh the negatives from the downside of volatility. Time until Expiration of the Option–All else equal, the longer the expiration date, the more it is worth. The effect of the time until expiration is similar to the effect of volatility. With more time until maturity, the price of the underlying asset is more likely to increase or decrease significantly. The Risk-Free Interest Rate–The value of a call option increases with the risk-free interest rate. The present value of the strike price decreases with the risk-free rate. Since a call option involves paying the strike price in the future, a higher risk-free rate increases the value of the option. Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

110) You are brought in to consult on a project for Sanpharm Corp., which is considering whether or not to build a new high-tech steel manufacturing facility. Give four examples of real options that you would consider when evaluating the project. Answer: Real options fall into four categories: options to defer investment, options to change operations, options to abandon projects, and options to make follow-on investments. Many examples of real options might be included in this steel project. The following list gives one example from each category of real option. The option to defer investment. The firm may consider postponing the project until it has more information about the costs and benefits of the project. For example, the company may learn that the plant will be less profitable than expected. Suppose that during the next year costly environmental regulations are enacted, or the price of steel goes down. The company should take these considerations into account when deciding if now is the best time to build the plant. The option to change operations. The company must consider whether it will have the flexibility to change the way the plant is operated. For example, if the demand for steel falls, it might be able shut down the plant temporarily to reduce costs. Alternatively, it might be able to produce other metals, such as bronze or brass, if it becomes more profitable to do so. The option to abandon the project. The company should consider what it might be able to do with the project if it fails or it becomes unprofitable to continue. It might decide to construct the facility in such a way that it can accommodate other manufactures in the event it has to liquidate the plant. The option to make follow-on investments. The firm should consider whether any follow-on investments may spring from this project. For example, it might consider whether it can expand the plant to increase production if demand for steel is high. It might also consider whether the new production process might be retrofitted to its existing plants, if the project is successful. Diff: 2 Learning Objective: LO 3 Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

111) What are agency costs in corporate finance, and how do they relate to options? Answer: Agency costs arise when the interests of stockholders, lenders, and managers are not perfectly aligned. These costs often arise because the payoff functions for these different claimholders look like different types of options. One broad category is the agency costs of debt. When the firm has debt, the payoff function of stockholders looks similar to a call option on the firm's assets. The face value of debt is similar to the strike price on a call option. Because of this option-like payoff function, the stockholders have an incentive to take actions that increase the value of the stockholder's claim, but may reduce the total value of the firm. Examples of agency problems from debt include the dividend payout problem, the asset substitution problem, and the underinvestment problem. Another broad category of agency costs is the agency costs of equity. This describes the difference between the interests of stockholders and managers. The payoff function for a salaryonly manager is similar to a portfolio consisting of a risk-free bond and a put option. If the company performs well, the manager is not likely to see much additional benefit. However, if the company enters the stage of financial distress, the manager is likely to be fired and lose much of his or her future wealth. This option-like payoff gives the managers an incentive to avoid risky projects that might increase the probability of financial distress, even if the project has a positive NPV. Turning down positive-NPV projects reduces the total value of the firm. Often the compensation for senior managers contains additional payoffs for good performance to more closely align their incentives with those of shareholders. Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Global and Industry Perspectives

Fundamentals of Corporate Finance, 5e (Parrino) Chapter 21 International Financial Management 1) Globalization refers to the removal of barriers to free trade and the closer integration of national economies. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 2) While the production of goods and services has become globalized, American consumers only purchase domestic goods. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 3) The production of goods and services has become highly globalized due to the emergence of large multinational companies. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 4) Integration of the financial system globally is a result of deregulation of foreign exchange markets, money and capital markets, and banking systems. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

5) A transnational corporation is a business that operates in more than one country but is managed from the perspective of a firm residing in a particular country. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 6) Royal Dutch Shell is a transnational corporation. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 7) Differences in legal systems and tax codes do not affect the way firms operate in foreign countries. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 8) Legal systems can vary on simple matters, such as opening a business, selecting a site location, and hiring employees. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 9) English is the world's social language. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 2

10) English is the language for international business, but not the world's social language. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 11) Cultural views shape business practices and people's attitudes toward business. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 12) Both China and the nations that formerly made up the Soviet Union are currently moving toward centrally planned economies. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 13) Country risk has no effect on a firm's cash flows, and firm value. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 14) Maximizing stockholders' wealth is a widely embraced goal for firms in all countries around the world. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

15) The European manager's goal is to earn as much wealth as possible for a firm while considering the overall welfare of both the stockholders and stakeholders. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 16) European firms focus on maximizing market share rather than shareholders' wealth. Answer: FALSE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 17) Japanese managers focus on maximizing market share rather than shareholders' wealth. Answer: TRUE Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 18) The foreign exchange market is an international market, connected electronically, where currencies are bought and sold in wholesale amounts. Answer: TRUE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 19) Tokyo is the largest foreign exchange trading center in the world. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives

20) When a U.S. bank in Chicago gives a quote of £0.5089/$, it is a direct quote. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 21) A direct quote exchange rate is the amount of foreign currency exchanged for one dollar. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 22) The bid quote is the rate at which the dealer will sell foreign currency. Answer: FALSE Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 23) The decision to accept positive NPV international projects increases the value of a firm, and it should be consistent with maximizing stockholders' wealth. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 24) Most companies find it easier to estimate the incremental cash flows for foreign projects than for domestic projects. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

25) To convert a project's future cash flows into another currency, we need to project or forecast the exchange rate. Answer: TRUE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 26) To convert a project's future cash flows into another currency, we need to use today's spot exchange rate. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 27) If a firm is located in a country with a relatively unstable political environment, management will require a lower rate of return on projects. Answer: FALSE Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 28) A Eurodollar is defined as a U.S. dollar deposited in a bank outside the United States. Answer: TRUE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 29) Eurocredits refer to long-term loans of a Eurocurrency made to multinational corporations and governments of poor credit quality. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 6

30) Eurodollars and other Eurocurrency bonds have characteristics that are identical to U.S. corporate bonds. Answer: FALSE Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 31) American banks were encouraged by the U.S. government to offer services overseas in order to act as engines of territorial and economic expansion. Answer: FALSE Diff: 1 Learning Objective: LO 5 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 32) Evidence of globalization includes: A) consumers in many countries only buy goods that are produced within their country even if a cheaper alternative is available from another country. B) goods and services being limited to within a given country. C) a highly fragmented financial system. D) goods and services are produced around the world. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives

33) Which of the following statements about multinational firms is NOT true? A) A multinational corporation is a business firm that operates in more than one country but is headquartered or based in its home country. B) Multinational corporations are owned by domestic stockholders only. C) Multinational corporations may purchase raw materials from one country, obtain financing from a capital market in another country, and produce finished goods with labor and capital equipment from a third country. D) Multinational corporations may be owned by foreign stockholders. Answer: B Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 34) Which of the following factors do not cause international business transactions to differ from domestic deals? A) Exchange rate risk, legal systems, and country risk B) Legal systems, cultural factors, and economic systems C) Time value of money, expected returns procedures, and size of market D) Economic systems, cultural factors, and country risk Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 35) Which of the following statements about the goal of a firm in different countries is true? A) Maximizing stockholder's value is not the accepted goal for firms in India. B) Firms in Germany focus on maximizing stakeholder wealth. C) The goal of a Japanese business manager is to decrease the wealth and growth of the keiretsu business group. D) Firms in Germany focus on maximizing corporate wealth. Answer: D Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives

36) Which of the following statements about the goal of a firm in different countries is true? A) Corporate wealth maximization is the accepted goal for firms in India. B) Firms in Australia focus on maximizing corporate wealth. C) The goal of a Japanese business manager is to increase the wealth and growth of the keiretsu business group. D) Private-sector firms in China focus on providing full employment in the economy. Answer: C Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 37) Economic benefits provided by the foreign exchange markets do NOT include: A) a mechanism to transfer purchasing power from individuals who deal in one currency to people who deal in a different currency. B) a way for corporations to pass the risk associated with foreign exchange price fluctuations to professional risk-takers. C) a channel for importers and exporters to acquire credit for international business transactions. D) an inability to transfer currency risk. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 38) In 2020, the three largest foreign exchange markets based on daily volume were: A) London, New York, and Hong Kong. B) New York, Tokyo, and Zurich. C) London, Tokyo, and Zurich. D) London, New York, and Paris. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives

39) The major participants in the foreign exchange markets are: A) multinational commercial banks, large investment banking firms, and domestic firms. B) multinational commercial banks, local banks, and domestic firms. C) multinational commercial banks, large investment banking firms, and currency boutiques. D) multinational commercial banks, local banks, and currency boutiques. Answer: C Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 40) Which of the following statements is true? A) Equilibrium occurs at the price at which the quantity of the currency demanded exceeds the quantity supplied. B) When pounds become more expensive relative to dollars, British products become less expensive for Americans to buy. C) From the British buyers' perspective, the lower the dollar price of pounds, the less pounds that have to be exchanged for dollars to buy foreign goods. D) When euros become less expensive relative to dollars, German products become less expensive for Americans to buy. Answer: D Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 41) If the foreign exchange rate is the price in foreign currency for a dollar, then the exchange rate quote is called: A) an American quote. B) an indirect quote. C) a direct quote. D) a cross quote. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

42) A European quote is the same as: A) an American quote. B) an indirect quote. C) a bidding quote. D) a cross quote. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 43) Which of the following is an indirect quote from an American perspective? A) £0.5125/$ B) $0.006900/¥ C) $1.5637/€ D) ¥115.23/€ Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 44) The bid quote represents the rate at which: A) the dealer will buy foreign currency from investors. B) the dealer will sell foreign currency to investors. C) the dealer will buy domestic currency from investors. D) the dealer will sell domestic currency to the exchange. Answer: A Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

45) The ask quote represents the rate at which: A) the dealer will buy foreign currency from investors. B) the dealer will sell foreign currency to investors. C) the dealer will buy domestic currency from the exchange. D) the dealer will sell domestic currency to investors. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 46) The difference between the forward rate and the spot rate is called the: A) cross exchange rate. B) forward premium or forward discount. C) indirect quote. D) direct quote. Answer: B Diff: 1 Learning Objective: LO 2 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 47) Venkat Ram purchased a pair of dress shoes in Italy for €131.25. If the spot exchange rate is $1.5621/€, what did the shoes cost in dollars? (Round your final answer to two decimal places.) A) $205.03 B) $84.02 C) €131.25 D) €84.02 Answer: A Explanation: Cost of shoes in Italy = €131.25 Spot rate = $1.5621/€ Dollar cost of shoes = €131.25 × $1.5621/€ = $205.03 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

48) Starling Corp. purchased some components from a Mexican manufacturer. They have to pay 110 million Mexican pesos (MP) for the goods today. The spot rate today is MP10.3540/$. What is the dollar cost of this product? (Round your final answer to the nearest dollar.) A) $110,000,000 B) $10,623,913 C) $11,110,235 D) $1,138,940,000 Answer: B Explanation: Cost of payables = MP 110,000,000 Spot rate = MP 10.3540/$ Dollar cost of payables = MP 110,000,000/(MP 10.3540/$) = $10,623,913.46 or $10,623,913 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 49) Tantrix, Inc. purchased its inventory from an Indian manufacturer at a cost of Rs.5,325,000. The dollar cost of this payable is $125,634.07 at today's spot rate. What is the today spot rate? A) $4.2385/Rs B) $42.3850/Rs C) Rs.42.3850/$ D) Rs.4.2385/$ Answer: C Explanation: Inventory cost to firm = Rs.5,325,000 Dollar cost of purchase = $125,634.07 Spot rate at which the foreign currency revenue was converted: = Rs42.3850/$

This is the same as $0.0236/Rs. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

50) Suppose a Tata Nano car is priced at Rs.100,000 in New Delhi and $3,129 in New York. In which place is the car more expensive if the spot rate is $0.0242/Rs.? A) In New Delhi B) In New York C) It is the same in both places. D) It cannot be determined. Answer: B Explanation: Cost of car in New York = $3,129 Cost of car in New Delhi = Rs.100,000 Spot rate = $0.0242/Rs. Dollar cost in New Delhi = Rs.100,000 × $0.0242/Rs. = $2,420 The cost of the car is higher in New York based on the spot rate. Diff: 2 Learning Objective: LO 2 Bloomcode: Analysis AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 51) If the spot rate is quoted as $0.009369/¥, what is the exchange rate in terms of yen per dollar? (Round your final answer to four decimal places.) A) ¥0.0094/$ B) ¥0.9369/$ C) ¥106.7350/$ D) ¥16.7350/$ Answer: C Explanation: Spot rate = ¥0.009369/$ Direct quote = 1/($0.009369/¥) = ¥106.7350/$ Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

52) Given that the spot rate is $1.5136/€ and the 90-day forward quote is $1.4974/€, we can say that: A) the U.S. dollar is at a forward premium against the euro. B) the U.S. dollar is at a forward discount against the euro. C) the euro is at a forward premium against the U.S. dollar. D) the dollar is at neither a premium nor a discount against the euro. Answer: A Explanation: Since the forward quote of $1.4974/€ implies that fewer dollars will be needed to purchase the euro compared to the spot rate of $1.5136/€, we can say that the U.S. dollar is at a forward premium against the euro. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 53) Given that the spot rate is ¥106.74/$ and the 180-day forward quote is ¥100.37/$, we can say that: A) the U.S. dollar is at a forward premium against the yen. B) the yen is at a forward premium against the U.S. dollar. C) the yen is at a forward discount against the U.S. dollar. D) the U.S. dollar is at neither a premium nor a discount against the yen. Answer: B Explanation: Since the forward quote of ¥100.37/$ implies that fewer yen will be needed to purchase a dollar compared to the spot rate of ¥106.74/$, we can say that the U.S. dollar is at a forward discount against the yen, or that the yen is at a forward premium against the U.S. dollar. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

54) Celio, Inc. sold equipment to a French firm and will receive €1,249,425 in 30 days. If the company entered a forward contract to sell the euros at the 30-day forward rate of $1.5512/€, what is revenue received in dollars? (Round your final answer to the nearest dollar.) A) $1,249,425 B) $805,457 C) $1,938,108 D) $1,312,224 Answer: C Explanation: Expected euro revenue = €1,249,425 30-day forward rate = $1.5512/€ Dollar revenue received = €1,249,425 × $1.5512/€ = $1,938,108 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 55) Baljit, Inc. purchased machinery from a Japanese firm and will have to pay ¥278.45 million in 90 days. The bank quotes a forward rate of ¥105.46/$ to buy the required yen. What is the cost to Baljit in U.S. dollars? (Round your final answer to the nearest dollar.) A) $2,640,338 B) $2,784,500 C) $2,936,534 D) $2,714,300 Answer: A Explanation: Cost of machinery = ¥278.45 million Forward rate = ¥105.46/$ Cost of equipment in dollars = ¥278,450,000/(¥105.46/$) = $2,640,337.57 or $2,640,338 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

56) John Travers is planning a holiday to Thailand but is concerned that the U.S. dollar will depreciate before he makes his trip. His travel agent has planned a trip for him for a total cost of 41,250 Thai baht. John plans to purchase the baht forward and is given a dollar estimate of $1,247.17 based on the 30-day forward quote. What is the THB/$ forward rate? A) THB41.2500/$ B) THB33.0749/$ C) $0.0302/THB D) $1.2471/THB Answer: B Explanation: Cost of trip = THB 41,250 Cost of trip based on forward rate = $1,247.17 30-day forward quote = THB 41,250/$1,247.17 = THB 33.0749/$ Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 57) A local bank has requested foreign exchange quotes for the Swedish krona (SK) from Citibank. Citibank quotes a bid rate of $0.1652/SK and an ask rate of $0.1667/SK. What is the percentage bid-ask spread? (Round your final percentage answer to one decimal place.) A) 1.2% B) 2.1% C) 0.9% D) 0.65% Answer: C Explanation: Bid - Ask spread =

= 0.008998 = 0.9% Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

58) A foreign exchange dealer is willing to buy the New Zealand dollar (NZ$) at $0.7621/NZ$ and will sell it at a rate of $0.7714/NZ$. What is the percentage bid-ask spread? (Round your final answer to two decimal places.) A) 0.26% B) 2.13% C) 0.96% D) 1.21% Answer: D Explanation: Bid - Ask spread =

= 0.012056 = 1.21% Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 59) Banco Herrero wants to make a bid-ask spread of 0.55 percent on its foreign exchange transactions. If the ask rate on the Mexican peso (MP) is MP10.4192/$, what does the bid rate have to be? (Round intermediate calculation to four decimal places.) A) MP10.3619/$ B) MP10.4192/$ C) MP10.4249/$ D) MP10.2165/$ Answer: A Explanation: Bid - Ask spread = 0.0055 = 10.4192 - Bid rate = 0.0055 × 10.4192 = 0.0057 Bid rate = 10.4192 - 0.0572 = MP10.3619/$ The ask rate will have to be MP10.3619/$ to provide a 0.55 percent bid-ask spread. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

60) Bartman, Corp. observes that the Swiss franc (SF) is quoted at $0.6164/SF, while the Swedish krona (SK) is quoted at $0.1981/SK. What is the SK/SF cross rate? (Round your final answer to four decimal places.) A) SK0.3214/SF B) SK3.1116/SF C) SK0.4183/SF D) SK2.1467/SF Answer: B Explanation: To find the SK/SF cross rate, divide the Swiss franc quote by the Swedish krona quote. Cross rate = ($0.6164/SF)/($0.1981/SK) = SK3.1116/SF Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 61) Xecor Pharma just received revenues of A$2,372,300 in Australian dollars (A$). The only quotes management received are A$2.0651/£ and $1.8538/£. What is the U.S. dollar value of the company's revenues? (Do not round your intermediate calculation, but round your final answer to the nearest dollar.) A) $4,397,770 B) $4,899,037 C) $2,129,567 D) $9,081,834 Answer: C Explanation: Revenues received by Xecor Pharma = $2,372,300 To determine the A$/$ cross rate, you divide the A$ to £ quote by the $/£ quote. Cross rate = A$2.0651/£ ÷ $1.8538/£ = A$1.1139820/$ U.S. dollar value of its revenue = A$2,372,300/(A$1.1140/$) = $2,129,567 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

62) Trident Corp. recently purchased machinery parts worth 23.5 million Mexican pesos (MP). Management needs to know the U.S. dollar cost of the payables. It has access to two quotes for Canadian dollars (C$): C$1.0774/$ and C$0.0981/MP. What will it cost Trident to purchase 23.5 million Mexican pesos? (Do not round your intermediate calculation, and round your final answer to the nearest dollar.) A) $2,531,890 B) $2,305,350 C) $2,139,735 D) $1,987,325 Answer: C Explanation: Foreign currency payables = MP 23.5 million To find the $/MP quote, divide the C$/MP quote by the C$/$ quote. Cross rate = (C$0.0981/MP)/(C$1.0774/$) = $0.091052534/MP Dollar cost of payables = MP23,500,000 × $0.0910525/MP = $2,139,735 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 63) Dresdner Bank has offered the following exchange rate quotes on Indian rupees (Rs) Rs.83.7612/£ and $1.8654/£. What is the cross rate between the Indian rupees and the U.S. dollar? (Round your final answer to four decimal places.) A) Rs.44.9025/$ B) Rs.49.9375/$ C) Rs.51.2134/$ D) Rs.36,7122/$ Answer: A Explanation: To find the Rs./$ cross rate, divide the Rs/£ quote by the $/£ quote. Cross rate = (Rs.83.7612/£)/($1.8654/£) = Rs.44.9025/$ Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

64) The spot rate on the London market was £0.5434/$, while the 90-day forward rate was £0.5519/$. What is the annualized forward premium or discount on the U.S. dollar for the period? (Round your final answer to one decimal place.) A) 1.6% premium B) 6.3% premium C) 6.3% discount D) 1.6% discount Answer: B Explanation: Forward premium (discount) = =

× 100

× 100 = 6.26% or 6.30%

The British pound is at a forward discount of 6.3 percent against the U.S. dollar as it takes more pounds to buy a dollar at the forward rate. Or we can say that the U.S dollar is at a 90-day forward premium of 6.3 percent against the British pound. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 65) Bank of America quoted the 180-day forward rate on the Japanese yen at $0.009702/¥. The spot rate was quoted at $0.009466/¥. What is the forward premium or discount on the Japanese yen? (Round your final answer to the nearest percentage.) A) 7% premium B) 7% discount C) 5% premium D) 5% discount Answer: C Explanation: Forward premium (discount) = =

× 100 = 4.99% or 5.00%

The Japanese yen is at a 5 percent forward premium against the dollar. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

× 100

66) State Bank of India has offered a spot rate quote on Indian rupees (Rs.) of Rs. 42.47/$. The Indian rupee is quoted at a 30-day forward discount of 7.65 percent against the dollar. What is the 30-day forward quote? A) Rs.43.5622/$ B) Rs.41.5687/$ C) Rs.45.1226/$ D) Rs.42.7407/$ Answer: D Explanation: Spot rate = Rs.42.47/$ 30-day forward premium on the dollar = 7.65% Forward premium (discount) = 0.0765 =

F0 - Rs.42.47/$ = F0 - Rs. 0.270746/$ + Rs. 42.47/$ = Rs. 42.7407/$. The 30-day forward rate is Rs. 42.7407/$. Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

× 100

67) Tamcon Industries has purchased equipment from a Brazilian firm for a total cost of 1,272,500 Brazilian reals (BR). The firm has to pay in 30 days. Citicorp has given the firm a 30day forward quote of $0.6123/BR. Assume that on the day the payment is due, the spot rate is at $0.6317/BR. How much would Tamcon save by hedging with a forward contract? (Round your final answer to the nearest dollar.) A) $24,687 B) $803,838 C) $779,152 D) $31,278 Answer: A Explanation: Foreign currency payables = BR1,272,500 Spot rate on payment date = $0.6317/BR Dollar cost of payables = BR1,272,500 × $0.6317/BR = $803,838.25 30-day forward rate = $0.6123/BR Cost if hedged at forward rate = BR 1,272,500 × $0.6123/BR = $779,151.75 Cost savings = $803,838.25 - $779,151.75 = $24,686.50 or $24,687.00 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 68) Kapona Industries has purchased equipment from a Korean firm for a total cost of 11,500,000 Korean won. The firm has to pay in 90 days. J. P. Morgan has given the firm a 90day forward quote of $0.0009791/won. Assume that on the day the payment is due, the spot rate is at $0.001004/ won. How much would Kapona save by hedging with a forward contract? (Round your final answer to the nearest dollar.) A) $687 B) $338 C) $152 D) $286 Answer: D Explanation: Foreign currency payables = 11,500,000 Korean won Spot rate on payment date = $0.001004/won Dollar cost of payables = 11,500,000 won × $0.001004/won = $11,546 30-day forward rate = $0.0009791/won Cost if hedged at forward rate = 11,500,000 won × $0.0009791/won = $11,259.65 Cost savings = $11,546.00 - $11,259.65 = $286.35 or $286.00 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

69) Carrington Industries sold equipment to a Mexican firm. Payment of 41,275,000 pesos will be due in 30 days. Carrington has the option of selling the pesos at a 30-day forward rate of $0.09739/peso. If it waits 30 days to sell the pesos, the expected spot rate is $0.09596/peso. How much additional dollar revenue will Carrington gain by selling forward the pesos? (Round your final answer to the nearest dollar.) A) $24,687 B) $83,838 C) $59,023 D) $31,278 Answer: C Explanation: Foreign currency receivables = MP 41,275,000 Spot rate on payment date = $0.09596/peso Dollar revenues from receivables = MP 41,275,000 × $0.09596/peso = $3,960,749 30-day forward rate = $0.09739/peso Revenues if hedged at forward rate = MP 41,275,000 × $0.09739/peso = $ 4,019,772.25 Additional revenues received = $4,019,772.25 - $3,960,749 = $59,023.25 or $59,023 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 70) Palermo, Corp. sold equipment to a French firm. Payment of €4,275,000 will be due in 90 days. Palermo has the option of selling the euros at a 90-day forward rate of $1.5922/€. If it waits 90 days to sell the euros, the expected spot rate is $1.5645/€. How much dollar revenue will Palermo lose by not selling the euros forward? (Round your final answer to the nearest dollar.) A) $124,687 B) $118,418 C) $159,023 D) $131,278 Answer: B Explanation: Foreign currency receivables = €4,275,000 Spot rate on payment date = $1.5645/€ Dollar revenues from receivables = €4,275,000 × $1.5645/€ = $6,688,237.50 90-day forward rate = $1.5922/€ Revenues if hedged at forward rate = €4,275,000 × $1.5922/€ = $ 6,806,655 Additional revenues lost by not hedging = $6,688,237.50 − $ 6,806,655 = $118,417.50 or $118,418.00 Diff: 2 Learning Objective: LO 2 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

71) When performing capital budgeting analysis on international projects, managers: A) find it less difficult to estimate the incremental cash flows for foreign projects relative to domestic projects. B) have to deal with foreign exchange rate risk on international and domestic capital investments. C) must incorporate a country risk premium even when evaluating domestic business activities. D) must incorporate a country risk premium when evaluating foreign business activities. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 72) The ways that a foreign government can increase the risk of a foreign project include: A) allowing for its currency to be more available globally. B) imposing laws related to labor, wages, and prices that are less restrictive than those applicable for domestic firms. C) readily allowing any remittance of funds from the subsidiary to the parent firm throughout the duration of a project. D) changing tax laws in a way that raises the overall tax of the firm. Answer: D Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 73) The ways that a foreign government can adversely affect the risk of a foreign project include all of the following EXCEPT: A) changing tax laws in a way that adversely impacts the firm. B) imposing laws related to labor, wages, and prices that are more restrictive than those applicable for domestic firms. C) removing tariffs and quotas on any imports. D) requiring that the subsidiary be headed by a local citizen or have a local firm as a major equity partner. Answer: C Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

74) Country risk should be incorporated into an international capital budgeting analysis by: A) adjusting the firm's discount rate for the additional risk. B) increasing cash flow estimates from the project. C) including the country risk premium to sunk costs. D) reducing the firm's discount rate. Answer: A Diff: 1 Learning Objective: LO 3 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 75) The Euromarkets are: A) vast, largely unregulated money and capital markets existing in Tokyo, Hong Kong, and Singapore. B) vast, regulated money and capital markets with major financial centers in the United Kingdom. C) vast, regulated money and capital markets with major financial centers in the euro zone. D) vast, largely unregulated money and capital markets with major financial centers in the euro zone. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives 76) The Eurocurrency market is the: A) medium-term portion of the Euromarket. B) short-term portion of the Euromarket. C) long-term portion of the Euromarket. D) medium-term and long-term portions of the Euromarket. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

77) Which of the following statements about Eurocredits is true? A) The international banking system gathers funds from businesses and governments in the Eurocurrency market and then allocates funds to all banks regardless of lending opportunities. B) Eurocredits are denominated in U.S. dollars only. C) Eurocredits are medium to long-term loans made to multinational corporations and governments of medium to high credit quality. D) Eurocredits can have a high degree of credit risk and are typically floating-rate loans structured as "rollovers." Answer: D Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 78) Long-term debt sold by a foreign firm to investors in a foreign country and denominated in that country's currency is called a: A) Eurobond. B) municipal bond. C) foreign bond. D) currency bond. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 79) Long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated are called: A) Samurai bonds. B) Eurobonds. C) foreign bonds. D) currency bonds. Answer: B Diff: 1 Learning Objective: LO 4 Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

80) Which of the following statements about Eurobonds is NOT true? A) Multinational firms can use Eurobonds to finance international or domestic projects. B) Eurobonds are bearer bonds. C) Eurobonds have to be registered. D) Eurobonds also pay interest annually. Answer: C Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 81) Zylex Corporation's German unit is looking to borrow €4.5 million from Deutsche Bank. Deutsche Bank quotes a rate of three-month LIBOR plus 0.5 percent for the 90-day loan. Currently, the three-month LIBOR is 4.175 percent. If the exchange rate on the payoff date is €0.8334/$, what is the dollar cost of the loan? (Round your final answer to two decimal places.) A) $63,107.45 B) $126,214.90 C) $39,143.76 D) $56,357.99 Answer: A Explanation: Amount Zylex plans to borrow = €4.5 million Term of loan = 90 days Interest cost = LIBOR + 0.5% = 4.175 % + 0.5% = 4.675% Interest cost in euros = €4,500,000 × 0.04675 × (90/360) = €52,593.75 Spot rate on payoff date = €0.8334/$ Dollar interest cost = €52,593.75/(€0.8334/$) = $63,107.45 Diff: 2 Learning Objective: LO 5 Bloomcode: Application AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives

82) What are the six factors that can cause international business transactions to differ from domestic deals? Answer: The six factors are foreign exchange risk, differences in legal systems and tax codes, the divergence of the language for communication purposes in business and socialization, cultural differences, differences in economic systems, and country risk. These six factors can cause international business transactions to differ from domestic deals. The uncertainty of future exchange rate movements, which is called foreign exchange rate risk, can affect the dollar value of foreign currency denominated transaction. Differences in legal systems and tax codes can also impact the way firms operate in foreign countries. There are two important levels of communication in international business deals: business communication and social communication. Although English is the official business language, it is not the world's social language. Cultural views also shape business practices and people's attitudes toward business. An economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed. Country risk refers to political uncertainty associated with a particular country and hence, its impact on a firm's cash flows. Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Analytic IMA: Global Business AICPA: Global and Industry Perspectives 83) How does the goal of a firm vary across countries? Answer: Stockholder wealth maximization is the accepted goal for firms in the United States, as well as in some other countries that share a similar heritage, such as the United Kingdom, Australia, India, and Canada. In Continental Europe, for example, countries such as France and Germany focus on maximizing corporate wealth. The European manager's goal is to earn as much wealth as possible for a firm while considering the overall welfare of all stakeholders. In Japan, companies form tightly knit, interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo. The goal of a Japanese business manager is to increase the wealth and growth of the keiretsu. As a result, he or she might focus on maximizing market share rather than stockholders' wealth. In China, which is making a transition from a command economy to a market-based economy, there are sharp differences between state-owned companies and emerging private-sector firms. The large state-owned companies have an overall goal that can best be described as maintaining full employment in the economy, while the new private-sector firms fully embrace the Western standard of stockholders' wealth maximization as an accepted goal Diff: 1 Learning Objective: LO 1 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives

84) Describe the global debt markets. Answer: The international debt markets can be classified into the Eurocurrency market, the Eurocredit market, and the long-term bond market. The Eurocurrency market is the short-term portion of the Euromarket. The most widely quoted Eurocurrency interest rate is the London Interbank Offer Rate, or LIBOR, which is the short-term interest rate that major banks in London charge one another. The international banking system gathers funds from businesses and governments in the Eurocurrency market and then allocates funds to banks that have the most profitable lending opportunities. These loans, which are short- to medium-term loans of a Eurocurrency to multinational corporations and governments of medium to high credit quality, are called Eurocredits. Eurocredits are denominated in all major Eurocurrencies, although the dollar is the overwhelming favorite. International bonds fall into two generic categories: foreign bonds and Eurobonds. Foreign bonds are long-term debt sold by a foreign firm to investors in another country and denominated in that country's currency. Foreign bonds sold in the United States are called Yankee bonds, and yendenominated bonds sold in Japanese financial markets by non-Japanese firms are called Samurai bonds. Firms sell foreign bonds when they need to finance projects in a particular foreign country. Eurobonds are long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated. Multinational firms can use Eurobonds to finance international or domestic projects. Eurodollar and other Eurocurrency bonds have a number of characteristics that differ from similar U.S corporate bonds. Eurobonds are bearer bonds and do not have to be registered. Eurobonds also pay interest annually. While historically almost all Eurocurrency bonds were sold without credit ratings, today, more than half of the Eurodollar bonds sold in Europe have credit ratings. Diff: 1 Learning Objective: LO 4 Bloomcode: Comprehension AACSB: Diversity IMA: Global Business AICPA: Global and Industry Perspectives