Fundamentals of Corporate Finance, 11th Edition Test Bank Brealey Myers Marcus by Ace Test Banks

Fundamentals of Corporate Finance, 11th Edition Test Bank Brealey Myers Marcus

richard@qwconsultancy.com

1|Pa ge

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) A portfolio manager who adds commodities to a portfolio of traditional investments is most likely seeking to: A) both increase expected returns and decrease portfolio variance. B) decrease portfolio variance only. C) increase expected returns only. 2) A Hong Kong hedge fund was valued at HK$400 million at the end of last year. At year's end

the value before fees was HK$480 million. The fund charges 2 and 20. Management fees are calculated on end- of-year values. Incentive fees are independent of management fees and calculated using no hurdle rate. The previous year the fund’s net return was 2.5%. The annualized return for the last two years is closest to: A) 8.1%. B) 13.6%. C) 7.9%. 3) A Canadian hedge fund has a value of C$100 million at the beginning of the year. The fund

charges a 2% management fee based on assets under management at the beginning of the year and a 20% incentive fee with a 10% hard hurdle rate. Incentive fees are calculated net of management fees. The value at the end of the year before fees is C$112 million. The net return to investors is closest to: A) 10%. B) 9%. C) 8%. 4) For a given set of underlying real estate properties, the type of real estate index that is most

likely to have the lowest standard deviation is a(n): A) REIT trading price index. B) appraisal index. C) repeat sales index. 5) An example of a relative value hedge fund strategy is: A) convertible arbitrage. B) merger arbitrage. C) market neutral.

Version 1

6) A hedge fund that charges an incentive fee on all profits, but only if the fund's rate of return

exceeds a stated benchmark, is said to have a: A) hard hurdle rate. B) high water mark. C) soft hurdle rate. 7) A hedge fund has a 2-and-20 fee structure, based on beginning-of-period assets, with a soft

hurdle rate of 5%. Incentive fees are calculated before management fees. An endowment invests $60.0 million in the hedge fund. The value of the endowment's investment, before fees, decreases to $56.2 million after one year and increases to $58.0 million the next year. In the second year the endowment will be charged management and incentive fees closest to: A) $1.10 million. B) $1.70 million. C) $1.15 million. 8) Relatively infrequent valuations of private equity portfolio companies most likely cause: A) correlations of fund returns with equity returns to be biased downward. B) standard deviations of fund returns to be biased upward. C) average fund returns to be biased upward. 9) Adjusted funds from operations (AFFO) is best described as an estimate of a real estate

investment trust's: A) free cash flow. B) net operating income. C) operating cash flow. 10) To exit an investment in a portfolio company through a trade sale, a private equity firm sells: A) the portfolio company to one of the portfolio company’s competitors. B) shares of a portfolio company to the public. C) the portfolio company to another private equity firm. 11) If a commodity futures market is in backwardation: A) the futures price is of the commodity is higher than the spot price. B) a long futures position will have a negative roll yield. C) the commodity has a high convenience yield.

Version 1

Answer Key Test name: Alternative Investments 1) B

Unlike most alternative investments, expected returns on commodities are typically less than expected returns on traditional investments. However, because their returns typically have a low correlation with returns on traditional investments, adding commodities to a portfolio of traditional investments can decrease portfolio variance. 2) C

Management fee is HK$480 million × 0.02 = HK$9.6 million. Incentive fee is (HK$480 million − HK$400 million) × 0.20 = HK$16.0 million. Total fee is HK$9.6 million + HK$16.0 million = HK$25.6 million. Net of fee: HK$480.0 − HK$25.6 = HK$454.4 million Net return: (HK$454.4 / HK$400.00) − 1 = 13.6% Two year annualized return is(1.136 × 1.025)1/2 − 1 = 7.9% (Study Session 17, Module 50.2, LOS 50.d) 3) A

Management Fee: C$100.0 × 2.0% = C$2.0 million Gross value at end of year (given) = C$112.0 million Incentive fee = [(C$112.0 − C$100.0 − C$2.0 − (C$100.0 × 10.0%)] × 20% = C$0 Total fee = C$2.0 million Net of fee: C$112.0 − C$2.0 = C$110.0 million Net return = (C$110.0 / C$100.0) − 1 =10.0% (Study Session 17, Module 50.2, LOS 50.d) 4) B

Version 1

Appraisal index returns are based on estimates of property values. Because estimating values tends to introduce smoothing into returns data, appraisal index returns are likely to have lower standard deviations than index returns based on repeat sales or trading prices of REIT shares. (Study Session 17, Module 50.1, LOS 50.e) 5) A

Relative value strategies include convertible arbitrage fixed income, asset-backed fixed income, general fixed income, volatility, and multi-strategy. Market neutral is an equity hedge strategy. Merger arbitrage is an event driven strategy. 6) C

With a soft hurdle rate, a hedge fund charges an incentive fee on all profits, but only if the fund's rate of return exceeds a stated benchmark. With a hard hurdle rate, a hedge fund charges an incentive fee only on the portion of returns that exceed a stated benchmark. With a high water mark, a fund's value must exceed its highest previous value before the fund may charge an incentive fee. 7) B

Year 1: Management fee = $60.0 million × 2% = $1.2 million. No incentive fee is charged because the fund decreased in value. Value after fees = $56.2 million − $1.2 million = $55.0 million. Year 2: Management fee = $55.0 million × 2% = $1.1 million. Year 2 return = $58.0 million / $55.0 million − 1 = 5.45% which is greater than the hurdle rate. With a soft hurdle rate and no high water mark provision, the entire gain is eligible for incentive fees: ($58.0 million − $55.0 million) × 20% = $0.6 million. Total fees in Year 2 = $1.1 million + $0.6 million = $1.7 million. 8) A

Infrequent valuation results in downward bias in both standard deviations and correlations. 9) A

AFFO equals funds from operations minus recurring capital expenditures and is analogous to free cash flow. 10) A

Version 1

A trade sale involves selling a portfolio company to a competitor or another strategic buyer. An IPO involves selling all or some shares of a portfolio company to the public. A secondary sale involves selling a portfolio company to another private equity firm or a group of investors. 11) C

Backwardation refers to a situation where the futures price is less than the spot price for a commodity. Because commodities have no monetary yield, only a convenience yield greater than the opportunity (interest) cost and storage costs of holding the commodity can lead to backwardation. When a futures market is in backwardation, the roll yield is positive because the futures price moves towards the spot price over the life of the contract.

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) The liability of sole proprietors is limited to the amount of their investment in the company. ⊚ true ⊚ false 2) General partners have limited personal liability for business debts in a limited partnership. ⊚ true ⊚ false 3) The separation of ownership and management is one distinctive feature of corporations. ⊚ true ⊚ false 4) A major disadvantage of partnerships is that they have double taxation of profits. ⊚ true ⊚ false 5) Financial assets have value because they are claims on the firm's real assets and the cash that

those assets will produce. ⊚ true ⊚ false 6) Capital budgeting decisions are used to determine how to raise the cash necessary for

investments. ⊚ true ⊚ false 7) A successful investment is one that increases the value of the firm. ⊚ true ⊚ false 8) Facebook's decision to spend $700 million to acquire Instagram is an investment decision. ⊚ true ⊚ false 9) Boards of directors are generally appointed by the firm's senior officers. ⊚ true ⊚ false

Version 1

10) Financial analysts are involved in monitoring the risk associated with investment projects and

financing decisions. ⊚ true ⊚ false 11) The primary goal of any company should be to maximize current period profits. ⊚ true ⊚ false 12) Maximizing profits is the same as maximizing the value of the firm. ⊚ true ⊚ false 13) The Dodd-Frank financial reform law in 2010 granted shareholders a binding vote on

executive compensation. ⊚ true ⊚ false 14) Sole proprietorships face the same agency problems as those associated with corporations. ⊚ true ⊚ false 15) Real assets can be intangible assets. ⊚ true ⊚ false 16) Making good investment and financing decisions is the chief task of the financial manager. ⊚ true ⊚ false 17) If a project's value is less than its required investment, then the project is financially

attractive. ⊚ true ⊚ false 18) GlaxoSmithKline's spending of $3.6 billion on research and development of new drugs is a

capital budgeting decision but not a financing decision. ⊚ true ⊚ false

Version 1

19) Deltas's issuance of a $1.0 billion bond is a financing decision. ⊚ true ⊚ false 20) An IOU ("I owe you") from your brother-in-law is a financial asset. ⊚ true ⊚ false 21) The separation of ownership and management is one distinctive feature of both corporations

and sole proprietors. ⊚ true ⊚ false 22) Shareholders welcome higher short-term profits even when they damage long-term profits. ⊚ true ⊚ false 23) A well-designed compensation package can help a firm achieve its goal of maximizing

market value. ⊚ true ⊚ false 24) While control of large public companies in the United States is exercised through the board

of directors and pressure from the stock market; in many other countries the stock market is less important and control shifts to major stockholders, typically banks and other companies. ⊚ true ⊚ false 25) Corporate investors are responsible for deciding whether to reinvest in the firm’s operations

or take the profits as a distribution. ⊚ true ⊚ false 26) Established firms can create value by developing long-term relationships and maintaining a

good reputation. ⊚ true ⊚ false

Version 1

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 27) Which one of these is a disadvantage of the corporate form of business? A) Access to capital B) Unlimited personal liability for owners C) Limited firm life D) Legal requirements 28) Which one of the following gives a corporation its permanence? A) Multiple owners B) Limited liability C) Corporation taxation D) Separation of ownership and control 29) In a partnership form of organization, income tax liability, if any, is incurred by: A) the partnership itself. B) the partners individually. C) both the partnership and the partners. D) neither the partnership nor the partners. 30) Which one of the following would correctly differentiate general partners from limited

partners in a limited partnership? A) General partners have more job experience. B) General partners have an ownership interest. C) General partners are subject to double taxation. D) General partners have unlimited personal liability. 31) Which form of organization provides limited liability for the firm but yet allows the

professionals working within that firm to be sued personally? A) Limited liability partnership B) Limited liability company C) Sole proprietorship D) Professional corporation 32) Which of the following organizations is least likely to use a professional corporation (PC)

structure? A) Accountants B) Doctors C) Lawyers D) Manufacturers

Version 1

33) Which of the following is least likely to be discussed in the articles of incorporation? A) How the firm is to be financed B) The purpose of the business C) The price range of the shares of stock D) How the board of directors is to be structured 34) When a corporation fails, the maximum that can be lost by an individual shareholder is: A) the amount of their initial investment. B) the amount of their share of the profits. C) their proportionate share required to pay the corporation's debts. D) the amount of their personal wealth. 35) Which of the following is a disadvantage to incorporating a business? A) Easier access to financial markets B) Limited liability C) Becoming a permanent legal entity D) Profits taxed at the corporate level and the shareholder level 36) Unlimited liability is faced by the owners of: A) corporations. B) partnerships and corporations. C) sole proprietorships and general partnerships. D) all forms of business organization. 37) Which one of these statements correctly applies to a limited partnership? A) All partners share the daily management duties. B) All partners enjoy limited personal liability. C) General partners have unlimited personal liability. D) Taxes are imposed at both the firm and the personal level on profits earned. 38) In the case of a limited liability partnership, _____________ has/have limited liability. A) only some of partners B) only the managing partner C) all of the partners D) none of the partners

Version 1

39) A board of directors is elected as a representative of the corporation's: A) top management. B) stakeholders. C) shareholders. D) customers. 40) The legal "life" of a corporation is: A) coincidental with that of its CEO. B) equal to the life of its board of directors. C) permanent, as long as shareholders don't change. D) permanent, regardless of current ownership. 41) In which type of organizational structure is the agency problem least likely to exist? A) Limited liability corporation B) Partnership C) Professional corporation D) Sole proprietorship 42) When the management of a business is conducted by individuals other than the sole owners,

the business is most likely to be a: A) corporation. B) sole proprietorship. C) partnership. D) general partner. 43) "Double taxation" refers to: A) all partners paying equal taxes on profits. B) corporations paying taxes on both dividends and retained earnings. C) paying taxes on profits at the corporate level and dividends at the personal level. D) the fact that marginal tax rates are doubled for corporations. 44) A corporation is considered to be closely held when: A) only a few shareholders exist. B) the market value of the shares is stable. C) it operates in a small geographic area. D) management also serves as the board of directors.

Version 1

45) Which of the following is NOT a requirement of the Sarbanes-Oxley Act of 2002? A) The compensation committee must be appointed by an outside director B) The CEO and CFO must sign off personally on corporate accounting results C) The board of directors must meet in executive session D) More board of directors members are independent 46) Corporations are referred to as public companies when their: A) shareholders have no tax liability. B) shares are held by the federal or state government. C) stock is publicly traded. D) products or services are available to the public. 47) A common problem for closely held corporations is: A) the lack of access to substantial amounts of capital. B) the restriction that shareholders receive only one vote each. C) the separation of ownership and management. D) an abundance of agency problems. 48) Corporate managers are expected to make corporate decisions that are in the best interest of: A) top corporate management. B) the corporation's board of directors. C) the corporation's shareholders. D) all corporate employees. 49) Which one of the following is a financial asset? A) A corporate bond B) A machine C) A patent D) A factory 50) Which of the following statements best distinguishes the difference between real and

financial assets? A) Real assets have less value than financial assets. B) Real assets are tangible; financial assets are not. C) Financial assets represent claims to income that are generated by real assets. D) Financial assets appreciate in value; real assets depreciate in value.

Version 1

51) Which one of the following is a real asset? A) A patent B) A personal IOU C) A checking account balance D) A share of stock 52) Which one of these is not considered to be a security? A) Shares of GE stock B) A bond traded in the financial market C) A mortgage loan issued and held by a bank D) A convertible bond issued to the public 53) Corporations that issue financial securities such as stock or debt obligations to the public do

so primarily to: A) increase sales. B) become profitable. C) increase their access to funds. D) avoid double taxation of their profits. 54) Which one of the following would be considered a capital budgeting decision? A) Planning to issue common stock rather than issuing preferred stock B) Deciding to expand into a new line of products, at a cost of $5 million C) Repurchasing shares of common stock D) Issuing debt in the form of long-term bonds 55) Which one of these is a capital budgeting decision? A) Deciding between issuing stock or debt securities B) Deciding whether or not the firm should go public C) Deciding if the firm should repurchase some of its outstanding shares D) Deciding whether to buy a new machine or repair the old machine 56) The best criterion for success in a capital budgeting decision would be to: A) minimize the cost of the investment. B) maximize the number of capital budgeting projects. C) maximize the value added to the firm. D) finance all capital budgeting projects with debt.

Version 1

57) The overall goal of capital budgeting projects should be to: A) decrease the firm's reliance on debt. B) increase the firm's sales. C) increase the firm's outstanding shares of stock. D) increase the wealth of the firm's shareholders. 58) An example of a firm's financing decision would be: A) acquiring a competitive firm. B) determining how much to pay for a specific asset. C) issuing 10-year versus 20-year bonds. D) deciding whether or not to increase the price of its products. 59) Which of the following is a capital budgeting decision? A) Should the firm borrow money from a bank or sell bonds? B) Should the firm shut down an unprofitable factory? C) Should the firm buy or lease a new machine that it is committed to acquiring? D) Should the firm issue preferred stock or common stock? 60) Which of these duties are responsibilities of the corporate treasurer? A) Financial statements and taxes B) Cash management and tax reporting C) Cash management and banking relationships D) Raising capital and financial statements 61) The term "capital structure" refers to: A) the mix of long-term debt and equity financing. B) the length of time needed to repay debt. C) whether or not the firm invests in capital budgeting projects. D) the types of assets a firm acquires. 62) Firms can alter their capital structure by: A) not accepting any new capital budgeting projects. B) investing in intangible assets. C) issuing stock to repay debt. D) becoming a limited liability company.

Version 1

63) Which one of these statements is correct? A) Financial managers have a fiduciary duty to stockholders. B) Financial managers are concerned only with funds that flow to investors. C) The chief financial officer generally reports directly to the corporate treasurer. D) The corporate controller is primarily responsible for overseeing a firm's cash

functions. 64) A firm decides to pay for a small investment project through a $1 million increase in short-

term bank loans. This is best described as an example of a(n): A) financing decision. B) investment decision. C) capital budgeting decision. D) capital expenditure decision. 65) Which of the following is NOT a claim on the assets of a company? A) Bond B) Patent C) Promissory note D) Loan 66) The short-term decisions of financial managers are comprised of: A) capital structure decisions only. B) investment decisions only. C) financing decisions only. D) both investment and financing decisions. 67) A block holder is commonly defined as an investor who: A) owns 5% or more of a firm's outstanding shares. B) invests in more than one firm within the same industry. C) is another corporation. D) is also one of the firm's managers or directors. 68) Which of the firm's financial managers is most likely to be involved with obtaining financing

for the firm? A) Treasurer B) Controller C) Chief operating officer D) Board of directors

Version 1

69) In a large corporation, preparation of the firm’s financial statements would most likely be

conducted by the: A) treasurer. B) controller. C) chief financial officer. D) financial manager. 70) In a firm having both a treasurer and a controller, which of the following would most likely

be handled by the controller? A) Internal auditing B) Credit management C) Banking relationships D) Insurance 71) Which one of the following statements more accurately describes the controller than the

treasurer? A) Reports directly to the chief executive officer B) Monitors capital expenditures to make sure that they are not misappropriated C) Responsible for investing the firm's spare cash D) Responsible for arranging any issue of common stock 72) A chief financial officer would typically: A) report to the treasurer, but supervise the controller. B) report to the controller, but supervise the treasurer. C) report to both the treasurer and controller. D) supervise both the treasurer and controller. 73) Which one of these determines the minimum acceptable rate of return on a capital

investment? A) The alternative investment opportunities available to investors B) The profit margin of the existing firm C) The rate of return on the firm's outstanding shares D) The rate of return on risk-free debt securities 74) A financial analyst in a corporation may be involved with all of the following EXCEPT: A) analyzing a new investment project. B) monitoring risk. C) managing investment of the company's cash. D) purchasing the firm's plant and equipment.

Version 1

75) Investment banks like Morgan Stanley or Goldman Sachs: A) collect deposits and relend the cash to corporations and individuals. B) help companies sell their securities to investors. C) design and sell insurance policies for businesses. D) lend to corporations and investors in commercial real estate. 76) The primary goal of corporate management should be to: A) maximize the number of shareholders. B) maximize the firm's profits. C) minimize the firm's costs. D) maximize the shareholders' wealth. 77) A corporate board of directors should provide support for the top management team: A) under all circumstances. B) in all decisions related to cash dividends. C) only when the board approves of management's actions. D) under no circumstances; it is an adversarial system. 78) Which of the following appears to be the most appropriate goal for corporate management? A) Maximizing market value of the company's shares B) Maximizing the company's market share C) Maximizing the current profits of the company D) Minimizing the company's liabilities 79) A firm with spare cash: A) should always reinvest it in new equipment. B) should pay it out to shareholders unless the firm can earn a higher rate of return on

the cash than the shareholders can earn by investing in the capital market. C) should invest it in the safest projects available. D) should always invest it in U.S. equities since these securities have a higher rate of return than Treasury bills. 80) Financial managers should only accept investment projects that: A) increase the current profits of the firm. B) can increase the firm's market share. C) earn a higher rate of return than the firm currently earns on its existing projects. D) earn a higher rate of return than shareholders can get by investing on their own.

Version 1

81) Agency problems can least be controlled by: A) establishing good internal controls and procedures. B) designing compensation packages that align manager's goals with those of the

shareholders. C) good systems of corporate governance. D) electing senior managers to the board of directors. 82) Which one of these best defines the objective of a well-functioning financial market? A) Establishing accurate security prices B) Creating higher security prices C) is not in the best interests of shareholders. D) Increasing shareholder value by any means possible 83) Ethical decision making by management has a payoff for shareholders in terms of: A) improved capital structure. B) enhanced firm reputation value. C) increased managerial benefits. D) higher current dividend payments. 84) Ethical decision making in business: A) reduces the firm's profits. B) requires adherence to implied rules as well as written rules. C) is not in the best interests of shareholders. D) is less important than good capital budgeting decisions. 85) A corporate director: A) is selected by and can be removed by management. B) can be voted out of power by the shareholders. C) has a lifetime appointment to the board. D) is selected by a vote of all corporate stakeholders. 86) Sole proprietorships resolve the issue of agency problems primarily by: A) avoiding excessive expense accounts. B) discharging those who violate the rules. C) allowing owners to share the cost of their actions with others. D) forcing owners to bear the full cost of their actions.

Version 1

87) Which one of the following can best be characterized as an agency problem? A) Differing opinions among directors as to the merits of paying a higher dividend B) Differing incentives between managers and owners C) Persistently late delivery times by a major supplier D) Geological problems in the company’s new gold mine 88) Which of the following is least likely to represent an agency problem? A) Lavish spending on expense accounts B) Plush remodelling of the executive suite C) Excessive avoidance of taxes D) Executive incentive compensation plans 89) When managers' compensation plans are tied in a meaningful manner to the value of the

firm, agency problems: A) can be reduced. B) will be created. C) are shifted to other stakeholders. D) are eliminated entirely from the firm. 90) A firm's reputation: A) has no value. B) is an important firm asset. C) is irrelevant to shareholders. D) can be easily restored once damaged. 91) Which of the following groups is least likely to be considered a stakeholder of the firm? A) Government B) Customers C) Competitors D) Employees 92) A manager's compensation plan that offers financial incentives for increases in quarterly

profitability may create agency problems in that: A) the managers are not motivated by personal gain. B) the board of directors may claim the credit. C) short-term, not long-term profits become the focus. D) investors desire stable profits.

Version 1

93) One continuing problem with managerial incentive compensation plans is that: A) the plans increase agency problems. B) managers prefer guaranteed salaries. C) their effectiveness is difficult to evaluate. D) the plans do not reward shareholders. 94) Which one of the following forms of compensation is most apt to align the interests of

managers and shareholders? A) A fixed salary B) A salary that is linked to current company profits C) A salary that is paid partly in the form of the company's shares D) A salary that is linked to the company's market share 95) Which of the following is a real asset? A) A patent B) A share of stock issued by Bank of New York C) An IOU ("I owe you") from your brother-in-law D) A mortgage loan taken out to help pay for a new home 96) Which one of these statements is correct? A) A dollar received next year has the same value as a dollar received today. B) Risky cash flows are more valuable than certain cash flows. C) Smart investment decisions create more value than smart financing decisions. D) Corporate governance is irrelevant. 97) Short selling involves selling a security: A) you do not own. B) that you have owned for less than one year. C) at a price below current market value. D) for less than you originally paid to purchase it.

Version 1

Answer Key Test name: Ch01 1) FALSE 2) FALSE 3) TRUE 4) FALSE 5) TRUE 6) FALSE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) FALSE 12) FALSE 13) FALSE 14) FALSE 15) TRUE 16) TRUE 17) FALSE 18) TRUE 19) TRUE 20) TRUE 21) FALSE 22) FALSE 23) TRUE 24) TRUE 25) FALSE 26) TRUE 27) D 28) D 29) B 30) D 31) D 32) D 33) C 34) A 35) D 36) C 37) C

Version 1

38) C 39) C 40) D 41) D 42) A 43) C 44) A 45) A 46) C 47) A 48) C 49) A 50) C 51) A 52) C 53) C 54) B 55) D 56) C 57) D 58) C 59) B 60) C 61) A 62) C 63) A 64) A 65) B 66) D 67) A 68) A 69) B 70) A 71) B 72) D 73) A 74) D 75) B 76) D 77) C

Version 1

78) A 79) B 80) D 81) D 82) A 83) B 84) B 85) B 86) D 87) B 88) D 89) A 90) B 91) C 92) C 93) C 94) C 95) A 96) C 97) A

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) An asset's liquidity is determined by how readily the asset can be converted to an appropriate amount of cash. ⊚ true ⊚ false 2) The principal reason for excluding many intangible assets from the balance sheet is that they

are difficult to value. ⊚ true ⊚ false 3) Based on generally accepted accounting principles, assets are recorded on the balance sheet

at their current market value. ⊚ true ⊚ false 4) Assets can be either tangible or intangible. ⊚ true ⊚ false 5) There is generally a bigger difference between the book value and the market value of fixed

assets as compared to cash. ⊚ true ⊚ false 6) All items in the common-size balance sheet are expressed as a percentage of total assets. ⊚ true ⊚ false 7) The income statement resembles a snapshot of the firm at a specific time. ⊚ true ⊚ false 8) If the market value of assets is high, then the market value of liabilities must be high also. ⊚ true ⊚ false

Version 1

9) One reason for the difference between profits and cash is that the cost of capital equipment is

spread over the forecast life. ⊚ true ⊚ false 10) Accrual accounting aims to provide a fairer measure of the firm's profitability. ⊚ true ⊚ false 11) If net income is positive, then cash flow from operations must be positive for that period. ⊚ true ⊚ false 12) Dividends paid are treated as a financing activity on the statement of cash flows. ⊚ true ⊚ false 13) An increase in the accounts receivable balance increases the cash flow of a firm. ⊚ true ⊚ false 14) The payment of interest expense is considered a financing activity in the statement of cash

flows. ⊚ true ⊚ false 15) Accounting practices are currently standardized across all countries. ⊚ true ⊚ false 16) Businesses that aggressively exploit any means possible to increase current earnings may

cross over into fraudulent account practices. ⊚ true ⊚ false 17) A company may deduct the interest paid to debtholders and the dividends paid to

shareholders when calculating its taxable income. ⊚ true ⊚ false

Version 1

18) Both the dividends and interest payments that companies make to individuals are subject to

personal tax. ⊚ true ⊚ false 19) The balance sheet presents a snapshot of the firm's assets and liabilities at one particular

moment. ⊚ true ⊚ false 20) Book values are "forward-looking" measures of value. ⊚ true ⊚ false 21) The difference between the market values of assets and liabilities is the market value of the

shareholders' equity claim. ⊚ true ⊚ false 22) To calculate free cash flow, you must deduct capital expenditures from the cash flow from

operations. ⊚ true ⊚ false 23) Depreciation charge is a cash payment. ⊚ true ⊚ false 24) An expenditure on new capital equipment is a cash payment. ⊚ true ⊚ false 25) The statement of cash flows shows the firm's cash inflows and outflows from operations as

well as from its investments and financing activities. ⊚ true ⊚ false 26) An increase in inventories uses cash, reducing the firm's net cash balance. ⊚ true ⊚ false

Version 1

27) IFRS uses a more “principles based” approach to financial reporting than does GAAP. ⊚ true ⊚ false 28) A reduction in accounts receivable uses cash, reducing the firm's net cash balance. ⊚ true ⊚ false 29) The purchase of new equipment is a use of cash, and it reduces the firm's net cash balance. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 30) Calculate the EBIT for a firm with $5.8 million total revenues, $5.3 million cost of goods sold, $500,000 depreciation expense, and $129,000 interest expense. A) $500,000 B) $371,000 C) $0 D) −$129,000 31) Assume a firm generates $2,140 in sales and has a $514 increase in accounts receivable

during an accounting period. Based solely on this information, cash flow will increase by: A) $2,654. B) $2,140. C) $1,626. D) $514. 32) Johnson's Nursery has net income of $43,700, depreciation expense of $2,040, interest

expense of $924, taxes of $1,660, additions to net working capital of $2,360, and capital expenditures of $12,300. What is the amount of the free cash flow? A) $31,080 B) $35,324 C) $32,004 D) $29,228

Version 1

33) Assume a firm increases its revenue by $115 while increasing its cost of goods sold by $95.

How much additional tax will the firm owe if its marginal tax rate is 21%? A) $4.20 B) $8.55 C) $14.80 D) $26.05 34) Assume a single taxpayer is taxed at 10% on the first $9,875 of taxable income, 12% on the

next $30,250 of income, and at 22% for the following $45,400 of income. What is the average tax rate for that individual if his taxable income is $82,025? A) 16.87% B) 16.46% C) 19.79% D) 14.46% 35) Assume a single taxpayer is taxed at 10% on the first $9,875 of taxable income, 12% on the

next $30,250 of income, and at 22% for the following $45,400 of income. What is the tax liability for a single individual with $53,250 of taxable income, which includes $2,250 of dividends? A) $7,505.00 B) $9,378.50 C) $7,945.00 D) $8,631.25 36) Professor Diehard discovered an effective antibiotic and patented the drug. He believes that

he could sell the patent for $20 million. He then formed a corporation and invested $740,000 in setting up a production plant. There are 2 million shares of stock outstanding. If the professor's belief is correct, what would be the price per share and the book value per share? A) $10.37; $0.37 B) $10.00; $0.37 C) $9.63; $0.74 D) $9.63; $0.37

Version 1

37) You have gathered this information on a firm: $510,000 sales, $11,000 cash dividends,

$305,000 cost of goods sold, $22,000 administrative expense, $22,000 depreciation expense, $44,000 interest expense, $11,000 purchase of productive equipment, no changes in working capital, and a tax rate of 21%. What is the free cash flow? A) $92,430 B) $140,630 C) $147,430 D) $157,430 38) What is the overall change in cash resulting from: $370 increase in inventories, $178 increase

in accounts payable, $148 decrease in accounts receivable, $88 decrease in other current assets, $178 decrease in other current liabilities? A) −$134 B) −$268 C) $222 D) $134 39) What is the change in cash for a firm with the following: $12,800 cash flow from operations,

$1,600 cash used for new investment, a reduction in the level of debt of $2,560, $1,280 in cash dividends, and $340 in depreciation expense? A) $7,700 B) $11,840 C) $11,500 D) $7,360 40) In general, what is changing as you read down the left-hand side of a balance sheet? A) The assets are becoming more fully depreciated. B) The assets are increasing in value. C) The assets are increasing in maturity. D) The assets are becoming less liquid. 41) A balance sheet portrays the value of a firm's assets and liabilities: A) over an annual period. B) over any stated period of time. C) at any stated point in time. D) only at the end of the calendar year.

Version 1

42) Which of the following items should not be included in a listing of current assets? A) Marketable securities B) Accounts payable C) Accounts receivable D) Inventories 43) Which of the following assets is likely to be considered the most liquid? A) Marketable securities B) Net fixed assets C) Accounts payable D) Inventories 44) If the value of a firm's net fixed assets equals the value of the accumulated depreciation, from

an accounting context the fixed assets are: A) new. B) fully depreciated. C) one-half depreciated. D) equal in value to the firm's current assets. 45) If the balance sheet of a firm indicates that total assets exceed current liabilities plus

shareholders' equity, then the firm has: A) no retained earnings. B) long-term debt. C) no accumulated depreciation. D) current assets. 46) Which one of the following is an intangible asset? A) Goodwill B) Retained earnings C) Deferred income taxes D) Treasury stock 47) If Company X were to purchase Company Y’s assets for a price above their book value, how

would the overpayment be classified? A) Intangible asset B) Long-term investment C) Marketable security D) Prepaid expense

Version 1

48) Suppose Dee's just acquired the assets of Flo's Flowers. The book value of Flo's Flowers

assets was $68,000 but Dee's paid a total of $75,000. The additional $7,000 paid by Dee's will be recorded on Dee's balance sheet as: A) accounts payable. B) goodwill. C) other current assets. D) property, plant, and equipment. 49) What happens to a firm's net worth as it uses cash to repay accounts payable? A) Net worth increases B) Net worth decreases C) Net worth remains constant D) Net worth decreases temporarily, until cash is replenished 50) If a payment of principal is due in 13 months on a long-term liability, that payment will now

appear on the balance sheet as: A) a current liability. B) long-term debt. C) cash. D) interest expense. 51) Net working capital is a measure of a company's: A) goodwill. B) short-term liabilities. C) estimated cash reservoir. D) shareholders' equity. 52) Net working capital is calculated by taking the difference between: A) total assets and total liabilities. B) inventory and accounts payable. C) current assets and current liabilities. D) cash and accounts payable. 53) Which of the following statements about net working capital (NWC) is correct? A) NWC is positive for all firms. B) As NWC decreases, potential liquidity increases. C) NWC excludes inventory, which is deemed illiquid. D) NWC is negative if current liabilities exceed current assets.

Version 1

54) The existence of goodwill on a corporate balance sheet indicates that the corporation has: A) been profitable in the past. B) depreciated its tangible assets. C) intangible assets from past acquisitions. D) retained earnings resulting from past income. 55) A balance sheet may be considered backward-looking from the perspective that it: A) works backward, starting with net income. B) records historic, not current values. C) cannot forecast the future. D) records costs over many previous periods. 56) According to GAAP, assets and liabilities are typically recorded on the balance sheet at: A) historical cost plus depreciation. B) market value. C) salvage value. D) historical cost less depreciation. 57) Which of the following statements about depreciation is correct? A) Each year the accountant adds an amount for depreciation when calculating the

company’s profit. B) The annual depreciation charge measures the cash that the company has spent on maintaining and renewing its plant and equipment. C) To calculate the cash produced by the business, it is necessary to deduct the depreciation charge from accounting profits. D) To calculate the cash produced by the business, it is necessary to add the depreciation charge back to accounting profits. 58) Depreciation expense is used to: A) allocate costs to all departments of the firm. B) determine when an asset is fully paid off. C) allocate historical cost over the life of an asset. D) equate the historical cost and market values of an asset. 59) If a firm has not had a significant change in its financial health, which balance sheet item is

most likely to have a book value very close to its market value over the course of time? A) Shareholder’s equity B) Real estate C) Finished goods inventory D) Bonds

Version 1

60) When subtracting an asset's accumulated depreciation from its historic cost, the resulting

value is termed the: A) book value of the asset. B) market value of the asset. C) depreciation expense. D) current asset value. 61) ABC Corporation's balance sheet shows its long-term debt to be $20 million. The debt was

issued with a 10% interest rate, and the current interest rate is 7%. Based on this information alone, the market value of this debt is most likely: A) less than $20 million. B) more than $20 million. C) equal to $20 million. D) unknown without knowing the maturity of the debt. 62) Which of the following statements about depreciation is correct? A) Depreciation is subtracted from cost of goods sold to calculate net income. B) When depreciation expense is incurred, cash balances are reduced. C) Depreciation expense does not affect net income. D) Depreciation reduces the book value of assets. 63) If market interest rates have increased since a company last borrowed long-term funds, the

market value of these long-term funds will likely be: A) greater than their book value. B) less than their book value. C) equal to their book value. D) unknown without knowing the maturity of the debt. 64) Which of the following values would most likely interest a shareholder? A) Book value of equity B) Market value of equity C) Retained earnings D) Net working capital 65) What happens to the market value of a firm's equity as the book value of the firm's equity

increases? A) It increases by the same amount. B) It decreases by the same amount. C) It remains constant. D) There is no set relationship to determine this outcome.

Version 1

66) Which of the following statements is true for a corporation with $1 million market value of

equity, $2 million market value of assets, and 1,000 shares of outstanding stock? A) Market value of liabilities exceeds book value of liabilities. B) Market value of liabilities equals $1 million. C) Book value per share equals $1,000. D) Market value per share equals $2,000. 67) Which of the following is more likely to be correct if market value of equity is less than book

value of equity? A) Investors anticipate excellent earning potential. B) Investors anticipate low earning potential. C) Assets have been fully depreciated. D) The company is bankrupt. 68) Market-value balance sheets differ from book-value balance sheets in that market values: A) are higher than book values. B) are lower than book values. C) reflect GAAP accounting. D) reflect investors' expectations. 69) If market values of equity exceed book values of equity, then: A) equity has been depreciated too rapidly. B) the firm uses accrual-based accounting. C) profit potential is expected to be attractive. D) the firm is holding too much cash. 70) Perhaps the best method for estimating the market value of shareholders' equity is to: A) review the firm's balance sheet. B) review the firm's income statement. C) multiply number of shares outstanding by the price of each share. D) add the retained earnings to the total liabilities. 71) In which of the following balance-sheet entries are you least likely to find a difference

between market value and book value? A) Cash B) Inventory C) Land D) Shareholders' equity

Version 1

72) Amy wants to know if inventory is increasing as a percentage of total assets. Which one of

these statements most easily provides the information she is seeking? A) Statement of cash flows B) Balance sheet C) Common-size balance sheet D) Income statement 73) Which one of the following expense categories is subtracted from total revenues to help

arrive at a firm's EBIT? A) Cash dividends B) Depreciation expense C) Interest expense D) Tax liability 74) Which one of the following does not reduce a firm's net income? A) Income taxes B) Interest expense C) Dividends D) Depreciation expense 75) Calculate the EBIT for a firm with $4 million total revenues, $3.5 million cost of goods sold,

$500,000 depreciation expense, and $120,000 interest expense. A) $500,000 B) $380,000 C) $0 D) −$120,000 76) The net income figure on an income statement is calculated before deducting the: A) interest expense. B) depreciation expense. C) cash dividends. D) tax liability. 77) An increase in depreciation expense will (other things equal): A) increase net income. B) decrease net income. C) increase taxable income. D) decrease the market value of assets.

Version 1

78) Current period depreciation expense is listed: A) on the balance sheet. B) in the investment section of the cash flow statement. C) on the income statement. D) on neither the balance sheet nor the income statement; it is a noncash expense. 79) Retained earnings result from: A) the sale of additional shares of stock to investors. B) income not paid to shareholders. C) an excess of assets over liabilities. D) market values that exceed book values. 80) The gathering of related revenues and expenses into the same period, regardless of when they

were incurred, is: A) cash-basis accounting. B) market-value accounting. C) book-value accounting. D) accrual accounting. 81) According to accrual accounting, when goods are not sold until the period after they were

produced, then the cost of goods sold will be: A) recognized when the goods are produced. B) recognized when the goods are sold. C) recognized when payment is received. D) split between the production and the sale periods. 82) Accrual accounting, which attempts to match sales revenues and the expenses associated

with the production of the goods, is conducted in an attempt to: A) reduce income-tax liability. B) reduce bias in reported profitability measures. C) speed up the receipt of accounts receivable. D) reduce the time necessary to depreciate assets. 83) Which of the firm's financial statements most clearly recognizes the payment for new

equipment? A) Balance sheet B) Income statement C) Statement of cash flows D) Common-size balance sheet

Version 1

84) If a firm pays taxes, which one of these will reduce net income but increase cash flow? A) Depreciation expense B) Income taxes C) Cash sales D) Interest expense 85) Which one of the following will reduce the cash flow during an accounting period? A) High depreciation expense B) Reduction of inventory levels C) Acquisition of equipment D) Increase in accounts payable 86) Assume a firm generates $2,000 in sales and has a $500 increase in accounts receivable

during an accounting period. Based solely on this information, cash flow will increase by: A) $2,500. B) $2,000. C) $1,500. D) $500. 87) In a statement of cash flows, which category includes depreciation expense as a line item? A) Cash provided by operations B) Cash flows from investments C) Cash provided by (used for) financing activities D) Current liabilities 88) Which of the following will occur in a statement of cash flows as a result of paying cash

dividends? A) Cash flows from operations will increase B) Cash flows from investments will decrease C) Cash flows from financing will decrease D) Cash balances will not be affected 89) Which of the following changes in working capital will result in an increase in cash flows? A) Increase in accounts payable B) Increase in inventories C) Increase in accounts receivable D) Decrease in other current liabilities

Version 1

90) Which of the following statements is more likely if cash and marketable securities increase

by $5,000 during a period in which cash provided by operations increases by $1,000 and cash used by investments decreases by $500? A) Cash provided by financing increases by $6,500. B) Cash used by financing decreases by $1,000. C) Debt increases by more than cash dividends paid. D) Debt is reduced by more than cash dividends paid. 91) If a firm's net income is positive and its noncash expenses are positive, which of the

following could account for a negative amount of cash provided by operations? A) Current assets decrease more than current liabilities decrease. B) Current assets increase more than current liabilities increase. C) Current assets decrease more than current liabilities increase. D) A large addition is made to plant and equipment. 92) What is the most likely conclusion for a firm whose statement of cash flows shows an

increase in cash balances and has negative cash flows from both operations and financing? A) The firm has low depreciation expense. B) The firm did not pay any dividends. C) The firm sold more equipment than it purchased. D) The firm has a low interest rate on its debt. 93) Johnson's Nursery has net income of $42,500, depreciation expense of $1,800, interest

expense of $900, taxes of $1,600, additions to net working capital of $2,300, and capital expenditures of $11,700. What is the amount of the free cash flow? A) $30,300 B) $34,400 C) $31,200 D) $28,700 94) According to the statement of cash flows, cash flows from financing could be positive if: A) the firm repaid more debt than it added. B) the firm added more debt than it repaid. C) interest rates were low on outstanding debt. D) the firm sold portions of its plant and equipment.

Version 1

95) Which of the following categories of a statement of cash flows is affected by the payment of

interest expense? A) Cash flows from operations B) Cash flows from noncash expenses C) Cash flows from investments D) Cash flows from financing 96) Which of the following could account for a firm that has a negative net income, yet has a

positive amount of cash provided by operations? A) The net loss was greater than the amount of depreciation expense. B) Inventory increased significantly more than accounts payable. C) Accounts receivable decreased by significantly more than accounts payable. D) The cash balance increased significantly. 97) If a firm's statement of cash flows shows that cash was used for investments, which of the

following would seem most likely? A) The inventory balance increased B) Common stock was repurchased C) New machines were acquired D) Cash dividends were paid 98) Interest expense appears in the operations section of the statement of cash flows because: A) firms cannot operate without incurring interest expense. B) its payment is not within managerial discretion. C) it is paid to finance a firm's inventory. D) none of the options; interest expense appears in the financing section of the statement

of cash flows. 99) Which one of these would not be paid from free cash flow? A) Cash dividends B) Repayment of principal on a long-term debt C) Repurchase of outstanding shares of common stock D) New equipment purchase

Version 1

100)

Which of the following statements correctly describes international accounting standards? A) The standards are becoming less similar over time. B) They are concerned only with assets and not liabilities. C) Compared with standards in the United States, international standards involve less detailed rules. D) Balance sheets differ, but income statements are similar in all countries.

101)

Which of these statements related to free cash flow is correct? A) Free cash flow must be fully distributed to the firm's debtors and shareholders. B) Free cash flow must be positive for a firm to acquire new fixed assets. C) All, or part, of free cash flow can be used to increase a firm's cash reserves. D) When capital expenditures are positive, free cash flow will exceed the cash flow from operations.

102)

What is the fundamental difference between IFRS and GAAP? A) GAAP relies more on general principles but ignores the spirit of those principles. B) GAAP relies more on specific rules and the spirit of the rules. C) GAAP relies more on specific rules but not the spirit of the rules. D) GAAP relies more on general principles as well as the spirit of those rules.

103)

What is the marginal corporate tax rate for large companies? A) 15% B) 21% C) 35% D) 39%

104)

Which of the following cannot be used to reduce taxable corporate income? A) Cash dividends B) Depreciation expense C) Interest expense D) Administrative expenses

105)

Assume a firm increases its revenue by $100 while increasing its cost of goods sold by $85. How much additional tax will the firm owe if its marginal tax rate is 21%? A) $3.15 B) $7.50 C) $13.75 D) $25.00

Version 1

106)

According to the U.S. tax code at the beginning of 2021, the highest marginal tax rate for personal taxpayers is: A) 25.0%. B) 28.5%. C) 35.0%. D) 37.0%.

107)

Which one of the following statements is correct for a corporation with a negative net income in both the present and the last fiscal year? A) This year's loss can be carried back, but last year's loss cannot be used. B) Neither of the losses can be used to reduce taxes. C) 80% of the loss can be carried forward. D) Both losses can be carried forward and backward, without limit.

108)

Assume a single taxpayer is taxed at 10% on the first $9,875 of taxable income, 12% on the next $30,250 of income, and at 22% for the following $45,400 of income. What is the average tax rate for that individual if his taxable income is $85,525? A) 17.08% B) 16.67% C) 22.00% D) 14.67%

109)

An individual's income for the year includes both dividend and interest payments. Which of these statements correctly applies to that individual's tax liability? A) Dividends are taxed; tax on interest payments is paid at the corporate level. B) Interest is taxed; tax on dividend payments is paid at the corporate level. C) Both dividend and interest payments are taxed at the personal level. D) All taxes on dividend and interest payments are paid at the corporate level.

110)

A major goal of the Sarbanes-Oxley Act is to: A) increase transparency in the financial reporting of a firm's activities. B) require firms to provide common-size balance sheets to shareholders. C) lower corporate tax rates. D) require U.S. firms to abide by international accounting standards.

Version 1

111)

Which one of the following is not a requirement imposed by the Sarbanes-Oxley Act? A) Accounting firms may not offer other services to companies they audit. B) Any one individual is prohibited from serving as the chairman of a firm's board of directors for more than 5 years. C) A board's audit committee must consist of directors who are independent of the firm's management. D) Management must certify that the financial statements present a fair view of the firm's financial position.

112)

Who pays taxes on earnings distributed as dividends? A) The issuing corporation B) The shareholder receiving the dividend C) Both the issuing corporation and the shareholder D) Neither the issuing corporation nor the shareholder

113)

Assume a single taxpayer is taxed at 10% on the first $9,875 of taxable income, 12% on the next $30,250 of income, and at 22% for the following $45,400 of income. What is the tax liability for a single individual with $52,000 of taxable income, which includes $2,000 of dividends? A) $7,230.00 B) $9,103.50 C) $7,670.00 D) $8,356.25

114)

Which of the following forms of income can individuals defer from taxation? A) Dividends B) Interest C) Realized capital gains D) Unrealized capital gains

115)

Which type of income is subject to "double taxation"? A) Dividends and wages B) Capital gains C) Dividends D) Wages

Version 1

116)

Professor Diehard discovered an effective antibiotic and patented the drug. He believes that he could sell the patent for $20 million. He then formed a corporation and invested $400,000 in setting up a production plant. There are 2 million shares of stock outstanding. If the professor's belief is correct, what would be the price per share and the book value per share? A) $10.20; $0.20 B) $10.00; $0.20 C) $9.80; $0.40 D) $9.80; $0.20

117)

You have gathered this information on a firm: $500,000 sales, $10,000 cash dividends, $300,000 cost of goods sold, $20,000 administrative expense, $20,000 depreciation expense, $40,000 interest expense, $10,000 purchase of productive equipment, no changes in working capital, and a tax rate of 21%. What is the free cash flow? A) $94,800 B) $138,000 C) $144,800 D) $154,800

118)

What is the overall change in cash resulting from: $300 increase in inventories, $150 increase in accounts payable, $120 decrease in accounts receivable, $60 decrease in other current assets, $150 decrease in other current liabilities? A) −$240 B) $180 C) $120 D) −$120

119)

What is the change in cash for a firm with the following: $10,000 cash flow from operations, $1,600 cash used for new investment, a reduction in the level of debt of $2,000, $1,000 in cash dividends, and $200 in depreciation expense? A) $5,600 B) $9,600 C) $9,400 D) $5,400

Version 1

120)

Which one of these will increase a firm's cash balance? A) An increase in inventory B) A decrease in accounts payable C) An issue of common stock D) Purchase of new equipment

Version 1

Answer Key Test name: Ch03 1) TRUE 2) TRUE 3) FALSE 4) TRUE 5) TRUE 6) TRUE 7) FALSE 8) FALSE 9) TRUE 10) TRUE 11) FALSE 12) TRUE 13) FALSE 14) FALSE 15) FALSE 16) TRUE 17) FALSE 18) TRUE 19) TRUE 20) FALSE 21) TRUE 22) TRUE 23) FALSE 24) TRUE 25) TRUE 26) TRUE 27) TRUE 28) FALSE 29) TRUE 30) C

EBIT = $5,800,000 − 5,300,000 − 500,000 = $0 31) C

Cash flow increase = $2,140 − 514 = $1,626 32) C

Version 1

Free cash flow = $43,700 + 924 + 2,040 − 2,360 − 12,300 = $32,004 33) A

Increase in taxes = 0.21 × ($115 − 95) = $4.20 34) A

35) A

Tax = (0.10 × $9,875) + (0.12 × $30,250) + (0.22 × ($53,250 − 9,875 − 30,250)) = $7,505.00 36) A

Book value equals the $740,000 Professor Diehard has contributed in tangible assets. Market value equals the value of his patent plus the value of the production plant, or $20.74 million. Price per share = $20.74 million ÷ 2 million shares = $10.37. Book value per share = $740,000 ÷ 2 million shares = $0.37. 37) C

Net income = ($510,000 − 305,000 − 22,000 − 22,000 − 44,000) × (1 − 21) = $92,430 Cash flow from operations = $92,430 + 44,000 + 22,000 = $158,430 Free cash flow = $158,430 − 11,000 = $147,430 38) A

Net change in cash = −$370 + 178 + 148 + 88 − 178 = −$134 39) D

Change in cash = $12,800 − 1,600 − 2,560 − 1,280 = $7,360 40) D 41) C 42) B 43) A 44) C 45) B 46) A 47) A 48) B 49) C 50) B

Version 1

51) C 52) C 53) D 54) C 55) B 56) D 57) D 58) C 59) D 60) A 61) B 62) D 63) B 64) B 65) D 66) B 67) B 68) D 69) C 70) C 71) A 72) C 73) B 74) C 75) C

EBIT = $4,000,000 − 3,500,000 − 500,000 = $0 76) C 77) B 78) C 79) B 80) D 81) B 82) B 83) C 84) A 85) C 86) C

Cash flow increase = $2,000 − 500 = $1,500

Version 1

87) A 88) C 89) A 90) C

Cash provided by financing increased. This could occur by increasing debt by a larger amount than the amount paid out in dividends. 91) B 92) C 93) C

Free cash flow = $42,500 + 900 + 1,800 − 2,300 − 11,700 = $31,200 94) B 95) A 96) C 97) C 98) B 99) D 100) 101) 102) 103) 104) 105)

C C C B A A Increase in taxes = 0.21 × ($100 − 85) = $3.15 106) 107) 108)

D C A

109) 110) 111) 112) 113)

C A B C A Tax = (0.10 × $9,875) + (0.12 × $30,250) + (0.22 × ($52,000 − 9,875 − 30,250)) = $7,230.00 114)

Version 1

115) 116)

C A Book value equals the $400,000 Professor Diehard has contributed in tangible assets. Market value equals the value of his patent plus the value of the production plant, or $20.4 million. Price per share = $20.4 million ÷ 2 million shares = $10.20. Book value per share = $400,000 ÷ 2 million shares = $0.20. 117)

C Net income = ($500,000 − 300,000 − 20,000 − 20,000 − 40,000) × (1 − 0.21) = $94,800 Cash flow from operations = $94,800 + 40,000 + 20,000 = $154,800 Free cash flow = $154,800 − 10,000 = $144,800 118)

D Net change in cash = −$300 + 150 + 120 + 60 − 150 = −$120 119)

D Change in cash = $10,000 − 1,600 − 2,000 − 1,000 = $5,400 120)

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) The income statement of a firm shows the value of its assets and liabilities over a specified period of time. ⊚ true ⊚ false 2) The higher the times interest earned ratio, the higher the interest expense. ⊚ true ⊚ false 3) The net working capital of a firm will decrease when unpaid bills from suppliers are later

paid with cash. ⊚ true ⊚ false 4) Net working capital is determined from the difference between current assets and current

liabilities. ⊚ true ⊚ false 5) Net working capital to total assets ratio and current ratio are both liquidity ratios. ⊚ true ⊚ false 6) The net working capital to total assets ratio is always a larger number than the current ratio. ⊚ true ⊚ false 7) The asset turnover ratio and inventory turnover ratio are both efficiency ratios. ⊚ true ⊚ false 8) The inventory turnover ratio times the average days in inventory equals 365. ⊚ true ⊚ false 9) Return on assets and return on equity are both profitability ratios. ⊚ true ⊚ false

Version 1

10) Return on assets is always a larger number than the return on equity. ⊚ true ⊚ false 11) The reduction in value over time of intangible assets is known as amortization. ⊚ true ⊚ false 12) Receivable turnover ratio and asset turnover ratio are both efficiency ratios. ⊚ true ⊚ false 13) Market value added is the difference between the market value of the firm's equity and its

book value. ⊚ true ⊚ false 14) Market value added is the same as economic value added. ⊚ true ⊚ false 15) The difference between the current and quick ratios is that inventory has been subtracted

from current assets. ⊚ true ⊚ false 16) A healthy current ratio and an unhealthy quick ratio may be caused by excess inventory. ⊚ true ⊚ false 17) Other things equal, an increase in average accounts receivable will increase a firm's return on

assets. ⊚ true ⊚ false 18) Residual income is another term for economic value added. ⊚ true ⊚ false

Version 1

19) EVA is the net profit of the firm adjusted for the cost of capital. ⊚ true ⊚ false 20) The market value added by a firm is reduced by an increase in retained earnings if the market

price does not change. ⊚ true ⊚ false 21) ROE is equal to ROC when the firm has no debt. ⊚ true ⊚ false 22) Since Hollywood movies generate most of their profit in the first few months following their

release, economic value added is a good way to measure their financial performance. ⊚ true ⊚ false 23) Increasing leverage will always act to increase a firm's ROE. ⊚ true ⊚ false 24) Bondholders exercising their right to convert bonds to equity will cause an increase in times

interest earned. ⊚ true ⊚ false MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 25) What are the annual sales for a firm with $406,000 in debt, a total debt ratio of 0.4, and an asset turnover of 3? A) $338,333 B) $1,218,000 C) $1,827,000 D) $3,045,000

Version 1

26) The board of directors is dissatisfied with last year's ROE of 17%. If the operating profit

margin and asset turnover ratio remain unchanged at 8% and 1.25, respectively, by how much must the leverage ratio (i.e., assets/equity) increase to achieve 22% ROE? A) 1.70% B) 5.75% C) 15.88% D) 29.41% 27) What must happen to asset turnover to leave ROE unchanged from its original 18% level if

the operating profit margin is reduced from 8% to 6% and the leverage ratio increases from 1.2 to 1.6? Asset turnover must: A) remain constant. B) increase from 1.65 to 2.52. C) decrease from 1.95 to 1.88. D) increase from 1.57 to 1.88. 28) What is the debt ratio for a firm with a debt-equity ratio of 0.57? A) 38.1% B) 36.3% C) 59.1% D) 72.7% 29) A firm has average daily expenses of $2.26 million and average accounts payable of $114.0

million. On average, how many days does it take the firm to pay its bills? A) 61.00 days B) 50.44 days C) 45.72 days D) 56.56 days 30) What is the inventory turnover ratio for ABC Corporation if cost of goods sold equals

$5,600, current ratio equals 3, quick ratio equals 1.5, and the firm has $1,980 in current assets? A) 2.83 times B) 4.22 times C) 5.66 times D) 8.48 times

Version 1

31) What is the book value per share for a firm with 2 million shares outstanding at a price of

$65, a market-to-book ratio of 0.75, and a dividend-payout ratio of 50%? A) $43.33 B) $48.75 C) $81.25 D) $86.67 32) What is the ROE for a firm with a times interest earned ratio of 2, a tax liability of $1

million, and interest expense of $1.53 million if equity equals $1.53 million? A) 26.14% B) 30.60% C) 34.64% D) 44.87% 33) XYZ Corporation has an operating profit margin of 9%, a debt burden of 0.9, and has

financed two-thirds of its assets through equity. What asset turnover ratio is necessary to achieve an ROE of 18%? A) 0.48 B) 0.85 C) 1.48 D) 2.67 34) A company has total assets of $1,260, current liabilities of $260, and total liabilities of $610.

If debt is the only long-term liability, what is the long-term debt ratio? A) 0.29 B) 0.35 C) 0.46 D) 0.41 35) TSI Incorporated has liquid assets of $1,280, enough to finance its operations for 70 days.

TSI's average daily expenditures from operations are: A) $5.47. B) $12.82. C) $18.29. D) $24.40.

Version 1

36) Calculate the average collection period for Dots Incorporated if its accounts receivables were

$640 at the beginning of a year in which the firm generated $3,100 of sales. A) 68 days B) 69 days C) 75 days D) 81 days 37) Balsco's balance sheet shows total assets of $278,000 and total liabilities of $127,000. The

firm has 59,000 shares of stock outstanding that sell for $11 a share. What is amount of market value added? A) $397,000 B) $498,000 C) $1,198,091 D) $143,712 38) What will be Gamma Incorporated's return on equity if total asset turnover is 0.79, operating

profit margin is 0.21, two-thirds of its assets are financed through equity, and debt burden is 0.54? A) 11.34% B) 13.44% C) 18.74% D) 44.81% 39) In the past year, TVG had revenues of $3.22 million, cost of goods sold of $2.61 million, and

depreciation expense of $233,264. The firm has a single issue of debt outstanding with a face value of $1.22 million, market value of $0.92 million, and a coupon rate of 8%. What is the firm's times interest earned ratio? A) 3.86 B) 3.09 C) 2.69 D) 3.49 40) Which of the following is the least effective measure of operating performance? A) ROC B) ROA C) ROE D) All of the options are equally ineffective measures of operating performance.

Version 1

41) Lease obligations are included in certain leverage ratios because leases: A) require the payment of interest. B) represent long-term fixed obligations. C) must be financed through a bank. D) are perpetual obligations. 42) A firm with no leases has a long-term debt ratio of 50%. This means that the book value of

equity: A) equals the book value of long-term debt. B) is less than the book value of long-term debt. C) is greater than the book value of long-term debt. D) is unknown in relation to the book value of long-term debt. 43) When a firm's long-term debt-equity ratio is 0.98, the firm: A) has too much long-term debt in relation to leases. B) has less long-term debt than equity. C) is nearing insolvency. D) has as much in long-term liabilities as in equity. 44) The market value added of a firm uses which of the following numbers in its calculation? A) Market capitalization B) Market return C) Market value of assets D) Market value of debt 45) If a firm's debt ratio is greater than 0.5, then: A) its current liabilities are quite high. B) its debt-equity ratio exceeds 1.0. C) it has too few total assets. D) it has more long-term debt than equity. 46) A times interest earned ratio of 5 indicates the firm: A) pays 5 times its earnings in interest expense. B) earns significantly more than its interest obligations. C) has interest expense equal to 5% of EBIT. D) has a low tax liability.

Version 1

47) If a firm's cash coverage ratio is greater than its times interest earned ratio, then the: A) firm's assets are not fully depreciated. B) firm has no lease obligations. C) firm has very little long-term debt. D) firm has a high degree of liquidity. 48) An asset's liquidity measures its: A) potential for generating a profit. B) cash requirements. C) ease and cost of being converted to cash. D) proportion of debt financing. 49) Which of the following actions could improve a firm's current ratio if it is now less than 1.0? A) Converting marketable securities to cash B) Paying accounts payable with cash C) Buying inventory on credit D) Selling inventory at cost 50) If a firm's quick ratio is equal to its current ratio: A) it has a low level of current liabilities. B) it has no inventory. C) it faces a potentially serious liquidity crisis. D) it is in a loss-making position. 51) A firm has $600,000 in current assets and $150,000 in current liabilities. Which of the

following is correct if it uses cash to pay off $50,000 in accounts payable? A) Current ratio will increase to 5.0 B) Net working capital will increase to $500,000 C) Current ratio will decrease D) Net working capital will not change 52) How would you interpret an inventory turnover ratio of 10.7? A) It takes 50 days on average to collect receivables. B) Inventory is converted into sales every 50 days. C) The firm has sufficient inventories to maintain sales for 34.1 days. D) Assets are converted into sales every 50 days.

Version 1

53) What are the annual sales for a firm with $400,000 in debt, a total debt ratio of 0.4, and an

asset turnover of 3? A) $333,333 B) $1,200,000 C) $1,800,000 D) $3,000,000 54) Which one of the following will cause a reduction in the NWC turnover ratio all else held

constant? A) A decrease in sales B) An increase in average payables C) An increase in average inventory D) An increase in the average cash balance 55) Which statement is likely true for a company with a cash ratio close to 1.95? A) Collection agencies are likely to call B) Lines of credit can be easily repaid C) Payroll may be difficult to meet D) Sufficient money exists for capital projects 56) The inventory turnover ratio compares: A) current assets to inventory. B) cost of goods sold to inventory. C) average receivables to inventory. D) average assets to inventory. 57) When Tri-C Corporation compares its ratios to industry averages, it has a higher current

ratio, an average quick ratio, and a lower inventory turnover. What might you assume about Tri-C? A) Its cash balance is relatively low. B) Its cost of goods sold is relatively low. C) Its current liabilities are relatively low. D) Its average inventory is relatively high. 58) Which one of the following statements is most likely correct for a firm with an average

collection period of 90 days? A) Its average daily sales are low. B) Its average daily sales are high. C) Its current ratio will be high. D) It is providing financing for approximately 25% of its annual sales.

Version 1

59) An all-equity firm reports a net profit margin of 10% on sales of $3 million. If the tax rate is

21%, what is the pretax profit? A) $103,082 B) $323,421 C) $379,747 D) $726,568 60) Which of the following will allow your firm to achieve its targeted 16% ROA with an asset

turnover of 2.5? A) A leverage ratio of 0.0667 B) A P/E ratio of 14 C) A return on equity of 25% D) An operating profit margin of 6.4% 61) What is the ROA of a firm with $150,000 in receivables, which represents 60 days' sales,

assets of $750,000, and an operating profit margin of 9%? A) 7.50% B) 9.00% C) 10.95% D) 16.70% 62) Last year's return on equity was 30%. This year the ROE has decreased to 20% even though

the firm's earnings equaled last year's earnings. The firm has no preferred stock. What caused the decrease? A) Equity decreased by 10%. B) Equity decreased by 50%. C) Equity increased by 10%. D) Equity increased by 50%. 63) Which one of these costs accounts for the difference between accounting income and

economic value added? A) Depreciation B) Cost of capital C) Taxes D) Dividends

Version 1

64) After-tax operating income for a leveraged firm is defined as: A) net income + after-tax interest. B) EBIT × (1 − tax rate). C) net income + depreciation. D) profit margin × sales. 65) Which one of these changes indicates an improvement in a firm's asset management

efficiency? A) An increase in the amount of assets per dollar of sales B) An increase in the inventory turnover rate C) A decrease in the receivables turnover rate D) An increase in the average days in inventory 66) What is the market price of a share of stock for a firm with 100,000 shares outstanding, a

book value of equity of $3,000,000, and a market-to-book ratio of 3? A) $10 B) $30 C) $90 D) $105 67) Which one of the following may be the best measure of company performance since it

accounts for the opportunity cost of capital? A) EVA B) Net income C) Increase in sales D) Current ratio 68) Which one of these statements is correct? A) Market value added measures the difference between the total market value and the

total book value of equity. B) Net income is also called economic value added. C) EVA measures the net profit of a firm after deducting the cost of the assets used in the production process. D) EVA considers the cost of long-term debt financing but excludes the cost of equity financing.

Version 1

69) The board of directors is dissatisfied with last year's ROE of 15%. If the operating profit

margin and asset turnover ratio remain unchanged at 8% and 1.25, respectively, by how much must the leverage ratio (i.e., assets/equity) increase to achieve 20% ROE? A) 1.50% B) 5.08% C) 16.67% D) 33.33% 70) What must happen to asset turnover to leave ROE unchanged from its original 16% level if

the operating profit margin is reduced from 8% to 6% and the leverage ratio increases from 1.2 to 1.6? Asset turnover must: A) remain constant. B) increase from 1.46 to 2.33. C) decrease from 1.74 to 1.67. D) increase from 1.38 to 1.67. 71) The use of debt in the firm's capital structure will increase ROE if the firm: A) has more debt than equity. B) pays less in taxes than in interest. C) earns a higher return than the rate paid on debt. D) has a times interest earned ratio greater than 1.0. 72) To calculate which of these measures do you need to know the cost of capital? A) ROC B) ROA C) ROE D) EVA 73) A corporation declares $25 million in net income, $1 million in preferred stock dividends,

and $7 million in common stock dividends. By how much will shareholders' equity increase on the balance sheet? A) $17 million B) $18 million C) $19 million D) $25 million

Version 1

74) If a firm starts the year with receivables of $80,000 and produces sales for the year of

$300,000, what is its average collection period? A) 3.75 days B) 97.33 days C) 52.67 days D) 77.90 days 75) A firm's after-tax operating income was $1,000,000 in 2020. It started the year with total

capital of $8,000,000 and raised an additional $1 million of capital during the year. The additional capital raised during 2020 only started to affect the operating income in 2021. Which value best represents the return on capital for 2020? A) 12.5% B) 11.8% C) 11.1% D) 10.0% 76) If ROC is less than a firm's cost of capital, which of the following must be true? A) The firm's EVA is positive. B) The firm's EVA is negative. C) The firm's ROE is equal to zero. D) The firm's ROE is negative. 77) When will ROE equal ROC? A) Whenever the firm has equal debt and equity financing B) Whenever the firm has no debt C) Whenever the value of the firm's assets exceeds the value of its equity D) ROE will never equal ROC 78) If the ratio of total liabilities to total assets is 0.5, long-term liabilities are $3,000, and equity

is $5,000, then: A) you know that current liabilities must be $2,000. B) you know that current assets must be $400. C) you know that retained earnings must be $800. D) you know that preferred stock must be $400. 79) What is the debt ratio for a firm with a debt-equity ratio of 0.5? A) 35.0% B) 33.3% C) 54.5% D) 66.7%

Version 1

80) Which one of the following will increase a firm's times interest earned ratio? A) An increase in debt B) A decrease in cost of goods sold C) An increase in interest expense D) A decrease in net income 81) Which one of the following would be most detrimental to a firm's current ratio if that ratio is

currently 2? A) Collecting payment on an accounts receivable B) Selling marketable securities at cost C) Paying off accounts payable with cash D) Purchasing inventory on credit 82) A retail store with zero net working capital has: A) no cash or marketable securities. B) insufficient inventory. C) no current debt. D) a quick ratio that is less than 1. 83) A deficiency of the standard measures of liquidity is that the measures: A) ignore a firm's reserve borrowing capacity. B) fail to include accounts receivable as an asset. C) give inventories equal weighting in the quick ratio. D) do not include the current portions of long-term debt. 84) A firm has average daily expenses of $2.13 million and average accounts payable of $112.7

million. On average, how many days does it take the firm to pay its bills? A) 63.47 days B) 52.91 days C) 48.19 days D) 59.03 days 85) If a company has a healthy current ratio but a significantly lower quick ratio, then you can

assume that: A) the cost of goods sold represents more than half of sales. B) current liabilities exceed current assets. C) the firm sells only on a cash basis. D) inventory represents a large portion of the firm's current assets.

Version 1

86) Last year's asset turnover ratio was 2.0. Sales have increased by 25% and total assets have

increased by 10% since that time. What is the current asset turnover ratio? A) 1.82 B) 2.05 C) 2.15 D) 2.27 87) What is the inventory turnover ratio for ABC Corporation if cost of goods sold equals

$5,000, current ratio equals 3, quick ratio equals 1.5, and the firm has $1,800 in current assets? A) 2.78 times B) 4.17 times C) 5.56 times D) 8.33 times 88) Assume BDS acquired its main supplier, ABC. As a result of the acquisition, BDS finds that

its profit margin increased but its ROA remained constant. A decrease in which one of these ratios is most apt to be the reason why the ROA did not increase with the increase in the profit margin? A) Leverage ratio B) Market-to-book ratio C) Asset turnover D) Debt burden 89) A firm's operating profit margin is 20% with an EBIT of $1.5 million and sales of $5 million.

If it has no debt, how much did the firm pay in taxes? A) $50,000 B) $300,000 C) $350,000 D) $500,000 90) What is primarily responsible for the potential distortion among the ROA of different firms

when net income is used in the numerator of ROA? A) Firms have different dividend payout ratios. B) Some firms use fully depreciated assets. C) Financial leverage varies among firms. D) Unprofitable firms will not have any tax liability.

Version 1

91) Which one of the following changes will provide an increase in a firm's ROE? A) A decrease in the profit margin B) An increase in the interest rate C) An increase in equity D) A decrease in the tax rate 92) An increase in which one of the following will have no effect on the cash coverage ratio? A) Depreciation B) Interest C) Sales D) Cost of goods sold 93) What is the book value per share for a firm with 2 million shares outstanding at a price of

$50, a market-to-book ratio of 0.75, and a dividend-payout ratio of 50%? A) $33.33 B) $37.50 C) $62.50 D) $66.67 94) What is the residual income for a firm that is entirely equity-financed with $1 million in

capital, $300,000 in net income, and a 20% cost of capital? A) $100,000 B) $140,000 C) $240,000 D) $500,000 95) By how much must a firm reduce its assets in order to improve ROA from 10% to 12% if the

firm's operating profit margin is 5% on sales of $4 million? Assume that the reduction in assets has no effect on sales or profit margin. A) $240,000 B) $333,333 C) $400,000 D) $516,167 96) What is the ROE for a firm with a times interest earned ratio of 2, a tax liability of $1

million, and interest expense of $1.5 million if equity equals $1.5 million? A) 26.67% B) 30.00% C) 33.33% D) 50.00%

Version 1

97) Which of the following choices would be guaranteed to increase a firm's ROE if the ROA is

currently 10% and the leverage ratio equals 1? A) Decrease the leverage ratio B) Increase the debt burden from its current level C) Decrease assets from the current level D) Decrease the debt burden from its current level 98) XYZ Corporation has an operating profit margin of 7%, a debt burden of 0.8, and has

financed two-thirds of its assets through equity. What asset turnover ratio is necessary to achieve an ROE of 18%? A) 1.26 B) 1.61 C) 2.14 D) 4.02 99) The use of financial leverage will be detrimental to a firm's ROE if the: A) firm currently has no long-term debt. B) firm's current ratio is greater than 1. C) interest expense exceeds the tax liability. D) interest rate on debt exceeds the firm's ROA. 100)

Efficiency ratios: A) include the quick ratio, asset turnover ratio, and return on equity. B) are used to measure how well the company uses its assets. C) are used to measure how liquid the company is. D) measure the profits generated by a firm's equity and assets.

101)

A total debt ratio of 0.35: A) indicates that the firm is financed with 35% long-term debt. B) would exist if a firm had liabilities of $700 and assets of $2,000. C) indicates that 35 cents of every dollar of capital is in the form of short-term debt. D) indicates that 35 cents of every dollar of capital is in the form of long-term debt.

102)

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

Version 1

103)

If the cash coverage ratio exceeds the times interest earned ratio, then the firm has: A) a positive cash flow. B) depreciable assets. C) no long-term debt. D) short-term debts.

104)

Instead of increasing its long-term debt by borrowing money from a bank to purchase new stereo equipment, Jay's Jams Incorporated decides to lease the equipment on a long-term basis. How will the long-term debt ratio differ if the lease option is selected over the bankdebt option? A) The ratio will be lower under the leasing option. B) The ratio will be higher under the leasing option. C) The ratio will be the same regardless of the financing method selected. D) The ratio effects are unknown without the amount of the lease obligation.

105)

Which of these assets is generally considered to be the most liquid? A) Buildings B) Land C) Finished goods inventory D) Accounts receivable

106)

High levels of liquidity may indicate: A) low levels of net working capital. B) low profit margins. C) high levels of economic value added. D) inefficient use of assets.

107)

The current ratio is a good proxy for a firm's: A) liquidity. B) efficiency. C) degree of leverage. D) profitability.

108)

If a company uses cash to pay off some of its accounts payables, what effect will this have on its liquidity ratios, given that the ratios exceeded 1 before the payoff? A) The quick ratio and current ratio will both increase. B) The quick ratio and current ratio will both decrease. C) The quick ratio will increase but the current ratio will remain unchanged. D) The current ratio will increase but the quick ratio will remain unchanged.

Version 1

109)

TSI Incorporated has liquid assets of $1,000, enough to finance its operations for 67 days. TSI's average daily expenditures from operations are: A) $6.70. B) $8.23. C) $14.93. D) $22.28.

110)

An asset turnover ratio of 1.75 can be interpreted as: A) $1.75 in sales are generated by every $1 of assets. B) $1.75 in additional assets are generated by every $1 of sales. C) $1.75 in assets are used to generate $1 of sales. D) $1 in sales are used to generate $1.75 in assets.

111)

Which of these indicates that a firm is efficient? A) A high average collection period B) A high days' sales in inventories C) A low asset turnover D) A high inventory turnover

112)

Calculate the average collection period for Dots Incorporated if its accounts receivables were $550 at the beginning of a year in which the firm generated $3,000 of sales. A) 60 days B) 61 days C) 67 days D) 73 days

113)

Which one of these ratios is commonly referred to as the acid-test ratio? A) Times interest earned ratio B) Quick ratio C) Cash coverage ratio D) Cash ratio

114)

Balsco's balance sheet shows total assets of $238,000 and total liabilities of $107,000. The firm has 55,000 shares of stock outstanding that sell for $11 a share. What is amount of market value added? A) $389,000 B) $474,000 C) $1,073,000 D) $123,712

Version 1

115)

What will be Gamma Incorporated's return on equity if total asset turnover is 0.85, operating profit margin is 0.15, two-thirds of its assets are financed through equity, and debt burden is 0.6? A) 9.56% B) 11.48% C) 16.96% D) 38.25%

116)

Which of the following is not a problem with EVA? A) EVA cannot be used to measure the profitability of a private company. B) EVA cannot be used to compare the effectiveness of managers with different amounts of assets under their control. C) EVA assumes that the book values of assets are equal to their current worth. D) EVA assumes that you know the cost of capital.

117)

In the past year, TVG had revenues of $3 million, cost of goods sold of $2.5 million, and depreciation expense of $200,000. The firm has a single issue of debt outstanding with a face value of $1 million, market value of $0.92 million, and a coupon rate of 8%. What is the firm's times interest earned ratio? A) 3.75 B) 2.98 C) 2.80 D) 3.40

Version 1

Answer Key Test name: Ch04 1) FALSE 2) FALSE 3) FALSE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) TRUE 9) TRUE 10) FALSE 11) TRUE 12) TRUE 13) TRUE 14) FALSE 15) TRUE 16) TRUE 17) FALSE 18) TRUE 19) TRUE 20) TRUE 21) TRUE 22) FALSE 23) FALSE 24) TRUE 25) D

Total debt ratio = Total debt ÷ Total assets, so: Assets = $406,000 ÷ .4 = $1,015,000 Asset turnover ratio = Sales ÷ Total assets, so: Sales = $1,015,000 × 3 = $3,045,000 26) D

Version 1

Last year: ROE = leverage ratio × asset turnover × operating profit margin 0.17 = leverage ratio × 1.25 × 0.08 Leverage ratio = 1.70 This year: ROE = leverage ratio × asset turnover × operating profit margin 0.20 = leverage ratio × 1.25 × 0.08 Leverage ratio = 2.20 Percentage increase = (2.20 − 1.70) ÷ 1.70 = 0.2941, or 29.41% 27) A

Original: ROE = leverage ratio × asset turnover × operating profit margin 0.18 = 1.2 × asset turnover × 0.08 Asset turnover = 1.88 New: 0.18 = 1.6 × asset turnover × 0.06 Asset turnover = 1.88 28) B

If debt ÷ equity = 0.57, then debt ÷ (debt + equity) = 0.57 ÷ 1.57 = 0.363, or 36.3% 29) B

$114.0 million ÷ $2.26 million = 50.44 days 30) C

Current ratio = current assets ÷ current liabilities 3 = $1,980 ÷ current liabilities Current liabilities = $660 Quick ratio = (current assets − inventory) ÷ current liabilities 1.5 = ($1,980 − inventory) ÷ $660 Inventory = $990 Inventory turnover = cost of goods sold ÷ inventory Inventory turnover = $5,600 ÷ $990 Inventory turnover = 5.66 times 31) D

Version 1

Market-to-book ratio = stock price ÷ book value per share 0.75 = $65 ÷ book value per share Book value per share = $86.67 32) C

Times interest earned = EBIT ÷ Interest 2 = EBIT ÷ $1,530,000 EBIT = $3,060,000 Net income = EBIT − interest − taxes Net income = $3,060,000 − 1,530,000 − 1,000,000 Net income = $530,000 ROE = net income ÷ equity ROE = $530,000 ÷ $1,530,000 ROE = 0.3464, or 34.64% 33) C

ROE = leverage ratio × asset turnover × operating profit margin × debt burden 0.18 = (3 ÷ 2) × asset turnover × 0.09 × 0.9 Asset turnover = 1.48 34) B

Equity = assets − liabilities Equity = $1,260 − 610 Equity = $650 Long-term debt ratio = long-term debt ÷ (long-term debt + equity) Long-term debt ratio = ($610 − 260) ÷ [($610 − 260) + $650] Long-term debt ratio = 0.35 35) C

Average daily expenditures = $1,280 ÷ 70 = $18.29 36) C

Average collection period = $640 ÷ ($3,100 ÷ 365) = 75 days 37) B

Market value added = (59,000 × $11) − ($278,000 − 127,000) = $498,000 38) B

Version 1

Leverage ratio = 1 ÷ 0.67 ROE = leverage ratio × asset turnover × operating profit margin × debt burden ROE = 1.5 × 0.79 × 0.21 × 0.54 ROE = 0.1344, or 13.44% 39) A

EBIT = revenues − COGS − depreciation EBIT = $3,220,000 − 2,610,000 − 233,264 EBIT = $376,736 Interest payments = 0.08 × $1,220,000 Interest payments = $97,600 Times interest earned = EBIT ÷ interest payments Times interest earned = $376,736 ÷ $97,600 Times interest earned = 3.86 40) C 41) B 42) A 43) B 44) A 45) B 46) B 47) A 48) C 49) C 50) B 51) D 52) C

Days' sales in inventory = 365 days ÷ 10.7 = 34.1 days 53) D

Total debt ratio = Total debt ÷ Total assets, so: Assets = $400,000 ÷ 0.4 = $1,000,000 Asset turnover ratio = Sales ÷ Total assets, so: Sales = $1,000,000 × 3 = $3,000,000 54) B 55) B 56) B 57) D

Version 1

58) D 59) C

Net profit margin = Net profit margin = (Pretax income − Taxes) ÷ Sales 0.10 = (1 − 0.21) × Pretax income ÷ $3,000,000 Pretax income = $379,747 60) D

ROA = Operating profit margin × Asset turnover 0.16 = Operating profit margin × 2.50 Operating profit margin = 0.064, or 6.4% 61) C

Sales = ($150,000 ÷ 60) × 365 = $912,500 ROA = Operating profit margin × Asset turnover = 0.09 × ($912,500 ÷ $750,000) = 0.1095, or 10.95% 62) D

NI = 0.3(Old equity) NI = 0.2(Old equity + New equity) 0.3(Old equity) = 0.2(Old equity + New equity) New equity = 0.5 Old equity 63) B 64) A 65) B 66) C

Market price per share = ($3,000,000 ÷ 100,000) × 3 = $90 67) A 68) A 69) D

Version 1

Last year: ROE = leverage ratio × asset turnover × operating profit margin 0.15 = leverage ratio × 1.25 × 0.08 Leverage ratio = 1.5 This year: ROE = leverage ratio × asset turnover × operating profit margin 0.20 = leverage ratio × 1.25 × 0.08 Leverage ratio = 2 Percentage increase = (2 − 1.5) ÷ 1.5 = 0.3333, or 33.33% 70) A

Original: ROE = leverage ratio × asset turnover × operating profit margin 0.16 = 1.2 × asset turnover × 0.08 Asset turnover = 1.67 New: 0.16 = 1.6 × asset turnover × 0.06 Asset turnover = 1.67 71) C 72) D 73) A

Shareholders' equity increase = $25 million − 1 million − 7 million = $17 million 74) B

Average collection period = $80,000 ÷ $300,000 × 365 = 97.33 days 75) A

ROC = $1,000,000 ÷ $8,000,000 = 0.125, or 12.5% 76) B 77) B 78) A

Total liabilities ÷ total assets = (long-term liabilities + current liabilities) ÷ (long-term liabilities + current liabilities + equity) 0.5 = ($3,000 + current liabilities) ÷ ($3,000 + current liabilities + $5,000) Current liabilities = $2,000 79) B

Version 1

If debt ÷ equity = 0.5, then debt ÷ (debt + equity) = 0.5 ÷ 1.5 = 0.333, or 33.3% 80) B 81) D 82) D 83) A 84) B

$112.7 million ÷ $2.13 million = 52.91 days 85) D 86) D

Asset turnover (last year) = sales ÷ total assets = 2 Asset turnover (this year) = 2 × 1.25 ÷ 1.1 = 2.27 87) C

Current ratio = current assets ÷ current liabilities 3 = $1,800 ÷ current liabilities Current liabilities = $600 Quick ratio = (current assets − inventory) ÷ current liabilities 1.5 = ($1,800 − inventory) ÷ $600 Inventory = $900 Inventory turnover = cost of goods sold ÷ inventory Inventory turnover = $5,000 ÷ $900 Inventory turnover = 5.56 times 88) C 89) D

Without any interest expense, the operating profit margin can be computed as: Operating profit margin = (EBIT − taxes) ÷ sales 0.20 = ($1,500,000 − taxes) ÷ $5,000,000 Taxes = $500,000 90) C 91) D 92) A 93) D

Market-to-book ratio = stock price ÷ book value per share 0.75 = $50 ÷ book value per share Book value per share = $66.67

Version 1

94) A

Residual income = net income − (cost of capital × total capitalization) Residual income = $300,000 − (0.20 × $1,000,000) Residual income = $100,000 95) B

ROA = (sales ÷ assets) × operating profit margin 0.10 = ($4,000,000 ÷ assets) × 0.05 Assets = $2,000,000 0.12 = ($4,000,000 ÷ assets) × 0.05 Assets = $1,666,667 Reduction in assets = $2,000,000 − 1,666,667 Reduction in assets = $333,333 96) C

Times interest earned = EBIT ÷ Interest 2 = EBIT ÷ $1,500,000 EBIT = $3,000,000 Net income = EBIT − interest − taxes Net income = $3,000,000 − 1,500,000 − 1,000,000 Net income = $500,000 ROE = net income ÷ equity ROE = $500,000 ÷ $1,500,000 ROE = 0.3333, or 33.33% 97) B 98) C

ROE = leverage ratio × asset turnover × operating profit margin × debt burden 0.18 = (3 ÷ 2) × asset turnover × 0.07 × 0.8 Asset turnover = 2.14 99) D 100) B 101) B

Total debt ratio = total debt ÷ assets = $700 ÷ $2,000 = 0.35 102)

Version 1

Equity = assets − liabilities Equity = $1,000 − 350 Equity = $650 Long-term debt ratio = long-term debt ÷ (long-term debt + equity) Long-term debt ratio = ($350 − 130) ÷ [($350 − 130) + $650] Long-term debt ratio = 0.25 103) 104) 105) 106) 107) 108) 109)

B C D D A A C Average daily expenditures = $1,000 ÷ 67 = $14.93 110) 111) 112)

A D C Average collection period = $550 ÷ ($3,000 ÷ 365) = 67 days 113) 114)

B B Market value added = (55,000 × $11) − ($238,000 − 107,000) = $474,000 115)

B Leverage ratio = 1 ÷ 0.67 ROE = leverage ratio × asset turnover × operating profit margin × debt burden ROE = 1.5 × 0.85 × 0.15 × 0.6 ROE = 0.1148, or 11.48% 116) 117)

A A

Version 1

EBIT = revenues − COGS − depreciation EBIT = $3,000,000 − 2,500,000 − 200,000 EBIT = $300,000 Interest payments = 0.08 × $1,000,000 Interest payments = $80,000 Times interest earned = EBIT ÷ interest payments Times interest earned = $300,000 ÷ $80,000 Times interest earned = 3.75

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) Compound interest pays interest for each time period on the original investment plus the accumulated interest. ⊚ true ⊚ false 2) When money is invested at compound interest, the growth rate is the interest rate. ⊚ true ⊚ false 3) For a given amount, the lower the discount rate, the less the present value. ⊚ true ⊚ false 4) Present values decline as the time to the cash flows increases. ⊚ true ⊚ false 5) The present value of an annuity due equals the present value of an ordinary annuity times the

discount rate. ⊚ true ⊚ false 6) A perpetuity is a special form of an annuity. ⊚ true ⊚ false 7) An annuity factor represents the future value of $1 that is deposited today. ⊚ true ⊚ false 8) With a fixed-rate mortgage, the proportion of each payment used to pay interest on the loan

declines over time. ⊚ true ⊚ false 9) Converting an annuity to an annuity due decreases the present value. ⊚ true ⊚ false

Version 1

10) It is important to discount both real and nominal cash flows at the real interest rate. ⊚ true ⊚ false 11) The term "constant dollars" refers to equal payments for amortizing a loan. ⊚ true ⊚ false 12) Nominal dollars refer to their purchasing power. ⊚ true ⊚ false 13) When inflation is positive, the nominal interest rate is larger than the real rate. ⊚ true ⊚ false 14) The effective annual interest rate cannot be less than the annual percentage rate. ⊚ true ⊚ false 15) The more frequent the compounding, the higher the future value, other things equal. ⊚ true ⊚ false 16) An annual percentage rate (APR) is determined by annualizing the rate using compound

interest. ⊚ true ⊚ false 17) A dollar tomorrow is worth more than a dollar today. ⊚ true ⊚ false 18) To calculate present value, we discount the future value by some interest rate r, the discount

rate. ⊚ true ⊚ false

Version 1

19) The discount factor is used to calculate the present value of $1 received in year t. ⊚ true ⊚ false 20) You should never compare cash flows occurring at different times without first discounting

them to a common date. ⊚ true ⊚ false 21) Present values can always be calculated by dividing the cash flow by a discount factor. ⊚ true ⊚ false 22) The five-year discount factor is less than the four-year discount factor. ⊚ true ⊚ false 23) As long as the interest rate is positive, the future value will always be larger than the present

value given any period of time. ⊚ true ⊚ false 24) An annuity due must have a present value at least as large as an equivalent ordinary annuity. ⊚ true ⊚ false 25) Any sequence of equally spaced, level cash flows is called an annuity. An annuity is also

known as a perpetuity. ⊚ true ⊚ false 26) Increasing the frequency in payments on a loan can decrease the annual percentage rate paid

on the loan. ⊚ true ⊚ false

Version 1

27) A mortgage loan is an example of an amortizing loan. "Amortizing" means that part of the

monthly payment is used to pay interest on the loan and part is used to reduce the amount of the loan. ⊚ true ⊚ false 28) When considering compounding, a semi-annual interest rate will need to be one half the

annual rate to achieve the same return. ⊚ true ⊚ false MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 29) What is the future value of $11,200 on deposit for 2 years at 8% simple interest? A) $12,096.00 B) $13,064.00 C) $12,992.00 D) $16,456.47 30) How much interest is earned in just the third year on a deposit of $970 that earns 8% interest

compounded annually? A) $77.60 B) $90.51 C) $117.09 D) $155.20 31) The salesperson offers, "Buy this new car for $36,000 cash or, with an appropriate down

payment, pay $760 per month for 48 months at 9% interest." Assuming that the salesperson does not offer a free lunch, calculate the "appropriate" down payment. A) $1,520.00 B) $5,459.57 C) $8,601.23 D) $13,680.00 32) A bond promises to pay $1,400 20 years from today. No interest will be paid on the bonds

during the 20 years. If the interest rate is 7%, what is the bond’s present value? A) $70.00 B) $361.79 C) $881.38 D) $1,400.00

Version 1

33) You're ready to make the last of four equal annual payments on a $1,300 loan with a 10%

interest rate. If the amount of the payment is $410.11, how much of that payment is accrued interest? A) $37.28 B) $41.01 C) $130.00 D) $410.11 34) How much do you need when you retire to provide a $2,780 monthly check that will last for

25 years? Assume that your savings can earn 0.5% a month. A) $404,984.06 B) $431,475.08 C) $447,876.54 D) $460,377.16 35) How much can be accumulated for retirement if $2,080 is put aside at the end of each of the

next 40 years? Assume that you can earn 9% a year on your savings. A) $90,688.00 B) $702,795.49 C) $766,047.08 D) $834,991.32 36) What APR is being earned on a deposit of $5,060 made 10 years ago today if the deposit is

worth $9,988.21 today? The deposit pays interest semiannually. A) 3.57% B) 6.78% C) 6.92% D) 7.14% 37) What is the effective annual interest rate on a 8.90% APR automobile loan that has monthly

payments? A) 8.90% B) 9.27% C) 9.70% D) 10.81%

Version 1

38) Eighteen years from now, 4 years of college are expected to cost $159,000. How much more

must be deposited into an account today to fund this expense if you can earn only 8% on your savings rather than the 11% you hope to earn? A) $12,943.85 B) $14,425.76 C) $14,846.80 D) $15,490.87 39) After reading the fine print in your credit card agreement, you find that the "low" interest rate

is actually an 17.76% APR, or 1.48% per month. What is the effective annual rate? A) 18.20% B) 19.28% C) 18.55% D) 19.13% 40) You are considering the purchase of a home that would require a mortgage of $164,000. How

much more in total interest will you pay if you select a 30-year mortgage at 6.35% rather than a 15-year mortgage at 5.6%? (Round the monthly payment amount to 2 decimal places.) A) $109,390.93 B) $100,436.73 C) $124,596.00 D) $127,904.79 41) Lester's just signed a contract that will provide the firm with annual cash inflows of $29,400,

$36,400, and $43,400 over the next three years with the first payment of $29,400 occurring one year from today. What is this contract worth today at a discount rate of 7.25%? A) $91,892.75 B) $93,042.68 C) $94,237.87 D) $95,024.10 42) Miller's Hardware plans on saving $43,200, $55,200, and $59,200 at the end of each year for

the next three years, respectively. How much will the firm have saved at the end of the three years if it can earn 4.5% on its savings? A) $164,059.48 B) $161,810.99 C) $171,442.16 D) $169,092.48

Version 1

43) $53,600 is borrowed, to be repaid in three equal annual payments with 10% interest.

Approximately how much principal is amortized with the first payment? A) $16,193.35 B) $2,155.30 C) $5,360.00 D) $21,553.35 44) What is the future value of $10,000 on deposit for 2 years at 6% simple interest? A) $10,600 B) $11,236 C) $11,200 D) $13,382 45) If the five-year discount factor is d, what is the present value of $1 received in five years’

time? A) 1 ÷ (1 + d)5raise to the power of 5 B) 1 ÷ d C) 5d D) d 46) How much interest is earned in just the third year on a $1,000 deposit that earns 7% interest

compounded annually? A) $70.00 B) $80.14 C) $105.62 D) $140.00 47) How much interest will be earned in the next year on an investment paying 12%

compounded annually if $100 was just credited to the account for interest? A) $88 B) $100 C) $112 D) $200 48) The concept of compound interest refers to: A) earning interest on the original investment. B) payment of interest on previously earned interest. C) investing for a multiyear period of time. D) determining the APR of the investment.

Version 1

49) If interest is compounded semi-annually rather than annually, then: A) future values and present values will both be higher. B) futures values and present values will both be lower. C) future values will be lower and present values will be higher. D) future values will be higher and present values will be lower. 50) Assume the total expense for your current year in college equals $20,000. How much would

your parents have needed to invest 21 years ago in an account paying 8% compounded annually to cover this amount? A) $952.46 B) $1,600.00 C) $1,728.08 D) $3,973.11 51) An investment offers to pay $100 a year forever starting at the end of year 6. If the interest

rate is 8%, what is the investment’s value today? A) $787.71 B) $850.73 C) $1,250 D) $1,586.87 52) An investment of $100 pays interest of 2.5% per quarter. What will be the value of this

investment at the end of 3 years? A) $107.69 B) $133.10 C) $134.49 D) $313.84 53) To achieve an annual return of 7.0%, an investment that is compounded semi-annually would

need to earn how much every six months? A) 3.44% B) 3.50% C) 3.64% D) 7.00%

Version 1

54) A car’s price is currently $20,000 and is expected to rise by 4% a year. If the interest rate is

6%, how much do you need to put aside today to buy the car one year from now? A) $18,182 B) $19,231 C) $19,623 D) $4,080 55) If the 5-year discount factor is 0.7008, what is the interest rate? A) 5.43% B) 7.37% C) 8.00% D) 9.50% 56) The bank offers a credit card with an initial promotional rate of 0.0%. After six months, the

rate adjusts to 21%. If no payments are required on an initial balance of $10,000, and the bank calculates payments based on a five-year repayment schedule, what will the monthly payment be after six months? A) $210.87 B) $245.25 C) $270.53 D) $302.22 57) Given the future value, which of the following will contribute to a lower present value? A) Higher discount rate B) Fewer time periods C) Less frequent discounting D) Lower discount factor 58) Cash flows occurring in different periods should not be compared unless: A) interest rates are expected to be stable. B) the flows occur no more than one year from each other. C) high rates of interest can be earned on the flows. D) the flows have been discounted to a common date. 59) What will be the approximate population of the United States, if its current population of 300

million grows at a compound rate of 2% annually for 25 years? A) 413 million B) 430 million C) 488 million D) 492 million

Version 1

60) If the future value of an annuity due is $25,000 and the future value of an ordinary annuity is

$24,000 (they are otherwise identical), what is the implied discount rate? A) 1.04% B) 4.17% C) 5.00% D) 8.19% 61) A furniture store is offering free credit on purchases over $1,000. You observe that a big-

screen television can be purchased for nothing down and $4,000 due in one year. The store next door offers an identical television for $3,650 but does not offer credit terms. Which rate below best describes the cost of the "free" credit? A) 8.75% B) 9.13% C) 9.59% D) 0.00% 62) How much must be invested today in order to generate a 5-year annuity of $1,000 per year,

with the first payment 1 year from today, at an interest rate of 12%? A) $3,604.78 B) $3,746.25 C) $4,037.35 D) $4,604.78 63) The salesperson offers, "Buy this new car for $25,000 cash or, with an appropriate down

payment, pay $500 per month for 48 months at 8% interest." Assuming that the salesperson does not offer a free lunch, calculate the "appropriate" down payment. A) $1,000.00 B) $4,519.04 C) $5,127.24 D) $8,000.00 64) What is the present value of the following payment stream, discounted at 8% annually:

$1,000 at the end of year 1, $2,000 at the end of year 2, and $3,000 at the end of year 3? A) $5,022.10 B) $5,144.03 C) $5,423.87 D) $5,520.00

Version 1

65) You invested $1,200 three years ago. During the three years, you earned annual rates of

return of 4.8%, 9.2%, and 11.6%. What is the value of this investment today? A) $1,498.08 B) $1,512.11 C) $1,532.60 D) $1,549.19 66) You will be receiving cash flows of: $1,000 today, $2,000 at end of year 1, $4,000 at end of

year 3, and $6,000 at end of year 5. What is the present value of these cash flows at an interest rate of 7%? A) $9,731.13 B) $10,412.27 C) $10,524.08 D) $11,524.91 67) Someone offers to buy your car for four equal annual payments beginning 2 years from

today. If you think that the present value of your car is $9,000 and the interest rate is 10%, what is the minimum annual payment that you would accept? A) $2,839.24 B) $3,435.48 C) $3,123.16 D) $2,250 68) How much more is a perpetuity of $1,000 worth than an annuity of the same amount for 20

years? Assume an interest rate of 10% and cash flows at the end of each period. A) $297.29 B) $1,486.44 C) $1,635.08 D) $2,000.00 69) A stream of equal cash payments lasting forever is termed: A) an annuity. B) an annuity due. C) an installment plan. D) a perpetuity.

Version 1

70) If the interest rate is 6%, which of these investments would you prefer? A) A single payment of $500 in year 3. B) A payment of $40 a year for 20 years starting in one year’s time. C) A perpetuity of $30 a year starting in one year’s time. D) A payment of $342.17 today. 71) The present value of a perpetuity can be determined by: A) multiplying the payment by the interest rate. B) dividing the interest rate by the payment. C) multiplying the payment by the number of payments to be made. D) dividing the payment by the interest rate. 72) You are borrowing $245,000 to purchase a home. The loan agreement requires a monthly

payment based upon a 4.5% quoted APR over 20 years. What is your monthly mortgage payment? (Round to two decimal places) A) $1,326.33 B) $1,549.99 C) $1,783.87 D) $1,803.65 73) A perpetuity of $5,000 per year beginning today offers a 15% return. What is its present

value? A) $33,333.33 B) $37,681.16 C) $38,333.33 D) $65,217.39 74) A bond promises to pay $1,000 20 years from today. No interest will be paid on the bonds

during the 20 years. If the interest rate is 7%, what is the bond’s present value? A) $50.00 B) $258.42 C) $629.56 D) $1,000.00

Version 1

75) Your car loan requires payments of $200 per month for the first year and payments of $400

per month during the second year. The APR is 12% and payments begin in one month. What is the present value of this 2-year loan? A) $6,246.34 B) $6,389.78 C) $6,428.57 D) $6,753.05 76) Which one of the following will increase the present value of an annuity, other things equal? A) Increasing the interest rate B) Decreasing the interest rate C) Decreasing the number of payments D) Decreasing the amount of the payment 77) What is the present value of a five-period annuity of $3,000 if the interest rate per period is

12% and the first payment is made today? A) $9,655.65 B) $10,814.33 C) $12,112.05 D) $13,200.00 78) The sum of $3,000 is deposited into an account paying 10% annually. If $1,206 is withdrawn

at the end of years 1 and 2, how much then remains in the account? A) $1,326.97 B) $1,206.34 C) $1,097.40 D) $587.32 79) Suppose you take out a 30-year mortgage for $100,000 with annual payments. The interest

rate on the mortgage is 8%. When you have paid off half the mortgage, so that the value of the remaining payments is reduced to $50,000, how many more payments need to be made? A) Approximately 15 payments B) Approximately 12 payments C) Approximately 8 payments D) Approximately 20 payments

Version 1

80) What is the present value of a four-year annuity of $100 per year that makes its first payment

2 years from today if the discount rate is 9%? A) $297.22 B) $323.97 C) $356.85 D) $272.68 81) If $120,000 is borrowed for a home mortgage, to be repaid at 9% interest over 30 years with

annual payments of $11,680.36, what is the total interest paid during the life of the loan? A) $918.25 B) $942.51 C) $227,598 D) $230,411 82) If $120,000 is borrowed for a home mortgage, to be repaid at 9% interest over 30 years with

annual payments of $11,680.36, how much interest (as opposed to return of capital) is paid in the last year of the loan? A) $0.00 B) $814.56 C) $458.54 D) $964.43 83) An amortizing loan is one in which: A) the principal remains unchanged with each payment. B) accrued interest is paid regularly. C) the maturity of the loan is variable. D) the principal balance is reduced with each payment. 84) You're ready to make the last of four equal annual payments on a $1,000 loan with a 10%

interest rate. If the amount of the payment is $315.47, how much of that payment is accrued interest? A) $28.68 B) $31.55 C) $100.00 D) $315.47

Version 1

85) What will be the monthly payment on a $75,000 30-year home mortgage at 1% interest per

month? A) $771.46 B) $775.90 C) $1,028.61 D) $1,034.53 86) Your real estate agent mentions that homes in your price range require a payment of $1,200

per month for 30 years at 0.75% interest per month. What is the size of the mortgage with these terms? A) $128,035.05 B) $147,940.29 C) $149,138.24 D) $393,120.03 87) Assume you are making $989 monthly payments on your amortized mortgage. The amount

of each payment that is applied to the principal balance: A) decreases with each succeeding payment. B) increases with each succeeding payment. C) is constant throughout the loan term. D) fluctuates monthly with changes in market interest rates. 88) How much must be saved at the end of each year for the next 10 years in order to accumulate

$50,000, if you can earn 9% annually? Assume you contribute the same amount to your savings every year. A) $3,291.00 B) $3,587.87 C) $4,500.33 D) $4,587.79 89) Your retirement account has a current balance of $50,000. You plan to add $6,000 a year to

the account for each of the next 30 years. Use a financial calculator or Excel to find what interest rate you need to earn in order to have $1,000,000 in the account at the end of the 30 years. A) 5.02% B) 7.24% C) 9.80% D) 10.07%

Version 1

90) How much do you need when you retire to provide a $2,500 monthly check that will last for

25 years? Assume that your savings can earn 0.5% a month. A) $361,526.14 B) $388,017.16 C) $402,766.67 D) $414,008.24 91) The present value of an annuity stream of $100 per year is $614 when valued at a 10% rate.

By approximately how much would the value change if these were annuities due? A) $10 B) $61.40 C) $10 × Number of years in annuity stream D) $6.14 × Number of years in annuity stream 92) Approximately how much must be saved for retirement in order to withdraw $100,000 per

year for the next 25 years if the balance earns 8% annually, and the first payment occurs one year from now? A) $1,067,477.62 B) $1,128,433.33 C) $1,487,320.09 D) $1,250,000.00 93) You have just retired with savings of $1.5 million. If you expect to live for 30 years and to

earn 8% a year on your savings, how much can you afford to spend each year? Assume that you spend the money at the start of each year. A) $112,148.50 B) $120,000.00 C) $123,371.44 D) $133,241.15 94) How much can be accumulated for retirement if $2,000 is put aside at the end of each of the

next 40 years? Assume that you can earn 9% a year on your savings. A) $87,200.00 B) $675,764.89 C) $736,583.73 D) $802,876.27

Version 1

95) If inflation in Wonderland was 3% per month in 2021, what was the annual rate of inflation? A) 36.00% B) 42.58% C) 40.09% D) 41.27% 96) Assume your uncle recorded his salary history during a 40-year career and found that it had

increased 10-fold. If inflation averaged 4% annually during the period, then over his career his purchasing power: A) remained on par with inflation. B) increased by nearly 1% annually. C) increased by nearly 2% annually. D) decreased. 97) Real interest rates: A) always exceed inflation rates. B) can decline to zero but no lower. C) can be negative, zero, or positive. D) traditionally exceed nominal rates. 98) On the day you retire you have $1,000,000 saved. You expect to live another 25 years during

which time you expect to earn 6.19% on your savings while inflation averages 2.5% annually. Assume you want to spend the same amount each year in real terms and die on the day you spend your last dime. What real amount will you be able to spend each year? A) $61,334.36 B) $79,644.58 C) $79,211.09 D) $61,931.78 99) What is the expected real rate of interest for an account that offers a 12% nominal rate of

return when the rate of inflation is 6% annually? A) 5.00% B) 5.66% C) 6.00% D) 9.46%

Version 1

100)

What happens over time to the real cost of purchasing a home if the mortgage payments are fixed in nominal terms and inflation is in existence? A) The real cost is constant. B) The real cost is increasing. C) The real cost is decreasing. D) The price index must be known to answer this question.

101)

What is the minimum nominal rate of return that you should accept if you require a 4% real rate of return and the rate of inflation is expected to average 3.5% during the investment period? A) 7.36% B) 7.50% C) 7.64% D) 8.01%

102)

What APR is being earned on a deposit of $5,000 made 10 years ago today if the deposit is worth $9,848.21 today? The deposit pays interest semiannually. A) 3.56% B) 6.76% C) 6.89% D) 7.12%

103)

An interest rate that has been annualized using compound interest is termed the: A) discount factor. B) annual percentage rate. C) discounted interest rate. D) effective annual interest rate.

104)

What is the effective annual rate of interest on a deposit that pays interest of 10% continuously compounded? A) 10.000% B) 10.517% C) 1.105% D) 9.531%

Version 1

105)

What is the relationship between an annually compounded rate and the annual percentage rate (APR) which is calculated for truth-in-lending laws for a loan requiring monthly payments? A) The APR is lower than the annually compounded rate. B) The APR is higher than the annually compounded rate. C) The APR equals the annually compounded rate. D) The answer depends on the interest rate.

106)

What is the APR on a loan that charges interest at the rate of 1.4% per month? A) 10.20% B) 14.00% C) 16.80% D) 18.16%

107)

If interest is paid m times per year, then the per-period interest rate equals the: A) effective annual rate divided by m. B) compound interest rate times m. C) effective annual rate. D) annual percentage rate (APR) divided by m.

108)

If the effective annual rate of interest is known to be 16.08% on a debt that has quarterly payments, what is the annual percentage rate? A) 4.02% B) 10.02% C) 14.50% D) 15.19%

109)

Would a depositor prefer an APR of 8% with monthly compounding or an APR of 8.5% with semiannual compounding? A) 8.0% with monthly compounding. B) 8.5% with semiannual compounding. C) The depositor would be indifferent. D) The time period must be known to select the preferred account.

110)

What is the annually compounded rate of interest on an account with an APR of 10% and monthly compounding? A) 10.00% B) 10.47% C) 10.52% D) 11.05%

Version 1

111)

What is the APR on a loan with an effective annual rate of 15.26% and weekly compounding of interest? A) 14.35% B) 14.49% C) 13.97% D) 14.22%

112)

What is the effective annual interest rate on a 9% APR automobile loan that has monthly payments? A) 9.00% B) 9.38% C) 9.81% D) 10.94%

113)

Other things being equal, the more frequent the compounding period, the: A) higher the annual percentage rate. B) lower the annual percentage rate. C) higher the effective annual interest rate. D) lower the effective annual interest rate.

114)

How much interest will be earned in an account into which $1,000 is deposited for one year with continuous compounding at a 13% rate? A) $130.00 B) $138.83 C) $169.00 D) $353.34

115)

What is the present value of $100 to be deposited today into an account paying 8%, compounded semiannually for 2 years? A) $85.48 B) $100.00 C) $116.00 D) $116.99

Version 1

116)

If a borrower promises to pay you $1,900 nine years from now in return for a loan of $1,000 today, what effective annual interest rate is being offered if interest is compounded annually? A) 5.26% B) 7.39% C) 9.00% D) 10.00%

117)

What is the present value of your trust fund if you have projected that it will provide you with $50,000 7 years from today and it earns 10% compounded annually? A) $25,000.00 B) $25,657.91 C) $28,223.70 D) $29,411.76

118)

What is the discount factor for $1 to be received in 5 years at a discount rate of 8%? A) 0.4693 B) 0.5500 C) 0.6000 D) 0.6806

119)

How much more would you be willing to pay today for an investment offering $10,000 in 4 years rather than in 5 years? Your discount rate is 8%. A) $544.47 B) $681.48 C) $740.74 D) $800.00

120)

"Give me $5,000 today and I'll return $10,000 to you in 5 years," offers the investment broker. What annual interest rate is being offered? A) 12.29% B) 13.67% C) 14.87% D) 12.84%

121)

The APR on a loan must be equal to the effective annual rate when: A) compounding occurs monthly. B) compounding occurs annually. C) the loan is for less than one year. D) the loan is for more than one year.

Version 1

122)

A car dealer offers payments of $522.59 per month for 48 months on a $25,000 car after making a $4,000 down payment. What is the loan's APR? A) 6% B) 9% C) 11% D) 12%

123)

A credit card account that charges interest at the rate of 1.25% per month would have an annually compounded rate of _________ and an APR of _________. A) 16.08%; 15.00% B) 14.55%; 16.08% C) 12.68%; 15.00% D) 15.00%; 14.55%

124)

Eighteen years from now, 4 years of college are expected to cost $150,000. How much more must be deposited into an account today to fund this expense if you can earn only 8% on your savings rather than the 11% you hope to earn? A) $12,211.18 B) $13,609.21 C) $14,006.41 D) $14,614.03

125)

Prizes are often not "worth" as much as claimed. What is the value of a prize of $5,000,000 that is to be received in 20 equal yearly payments, with the first payment beginning today? Assume an interest rate of 7%. A) $2,833,898.81 B) $2,911,015.68 C) $2,609,144.14 D) $2,738,304.13

126)

A loan officer states, "Thousands of dollars can be saved by switching to a 15-year mortgage from a 30-year mortgage." Calculate the difference in payments on a 30-year mortgage at an interest rate of .75% a month versus a 15-year mortgage with an interest rate of .7% a month. Both mortgages are for $100,000 and have monthly payments. What is the difference in total dollars that will be paid to the lender under each loan? (Round the monthly payment amounts to 2 decimal places.) A) $89,211 B) $98,406 C) $113,465 D) $124,300

Version 1

127)

Would you prefer a savings account that paid 7% interest compounded quarterly, 6.8% compounded monthly, 7.2% compounded weekly, or an account that paid 7.5% with annual compounding? A) 7% compounded quarterly B) 6.8% compounded monthly C) 7.2% compounded weekly D) 7.5% compounded annually

128)

After reading the fine print in your credit card agreement, you find that the "low" interest rate is actually an 18% APR, or 1.5% per month. What is the effective annual rate? A) 18.47% B) 19.56% C) 18.82% D) 19.41%

129)

You are considering the purchase of a home that would require a mortgage of $150,000. How much more in total interest will you pay if you select a 30-year mortgage at 5.65% rather than a 15-year mortgage at 4.9%? (Round the monthly payment amount to 2 decimal places.) A) $86,311.18 B) $78,487.92 C) $99,595.80 D) $102,486.68

130)

Lester's just signed a contract that will provide the firm with annual cash inflows of $28,000, $35,000, and $42,000 over the next three years with the first payment of $28,000 occurring one year from today. What is this contract worth today at a discount rate of 7.25%? A) $88,311.08 B) $89,423.91 C) $90,580.55 D) $91,341.41

131)

Miller's Hardware plans on saving $42,000, $54,000, and $58,000 at the end of each year for the next three years, respectively. How much will the firm have saved at the end of the three years if it can earn 4.5% on its savings? A) $160,295.05 B) $158,098.15 C) $167,508.33 D) $165,212.57

Version 1

132)

$50,000 is borrowed, to be repaid in three equal annual payments with 10% interest. Approximately how much principal is amortized with the first payment? A) $2,010.60 B) $5,000.00 C) $15,105.74 D) $20,105.74

Version 1

Answer Key Test name: Ch05 1) TRUE 2) TRUE 3) FALSE 4) TRUE 5) FALSE 6) TRUE 7) FALSE 8) TRUE 9) FALSE 10) FALSE 11) FALSE 12) FALSE 13) TRUE 14) TRUE 15) TRUE 16) FALSE 17) FALSE 18) TRUE 19) TRUE 20) TRUE 21) FALSE 22) TRUE 23) TRUE 24) TRUE 25) FALSE 26) FALSE 27) TRUE 28) FALSE 29) C

FV = $11,200 + 2 × 0.08 × $11,200 = $12,992.00 30) B

$970.00 × (1.08)2raise to the power of 2 = $1,131.41 after 2 years $1,131.41 × 0.08 = $90.51 31) B

Version 1

Down payment = $36,000 − 30,540.43 = $5,459.57 32) B

33) A

$410.11 − ($410.11 ÷ 1.10) = $37.28 34) B

= $431,475.08 35) B

FV = $2,080 {[(1 + 0.09)40 − 1] ÷ 0.09} FV = $702,795.49 36) C

FV = PV (1 + r)traise to the power of t $9,988.21 = $5,060 × [1 + (r ÷ 2)]10 × 2raise to the power of 10 × 2 r = 6.92% 37) B

EAR = [1 + (0.0890 ÷ 12)]12raise to the power of 12 − 1 = 0.0927, or 9.27% 38) D

Additional deposit = $159,000 ÷ 1.0818raise to the power of 18 − $159,000 ÷ 1.1118raise to the power of 18 Additional deposit = $15,490.87 39) B

EAR = 1.014812raise to the power of 12 − 1 = 0.1928, or 19.28% 40) C

Version 1

PMT = $1,020.47 PMT = $1,348.74 Total difference = ($1,020.47 × 12 × 30) − ($1,348.74 × 12 × 15) = $124,596.00 41) C

PV = $29,400 ÷ 1.0725 + $36,400 ÷ 1.07252raise to the power of 2 + $43,400 ÷ 1.07253raise to the power of 3 PV = $94,237.87 42) A

FV = ($43,200 × 1.0452raise to the power of 2 ) + ($55,200 × 1.045) + $59,200 FV = $164,059.48 43) A

Principal payment = $21,553.35 − ($53,600 × 0.1) Principal payment = $16,193.35 44) C

FV = $10,000 + 2 × 0.06 × $10,000 = $11,200 45) D 46) B

$1,000.00 × (1.07)2raise to the power of 2 = $1,144.90 after 2 years $1,144.90 × 0.07 = $80.14 47) C

The investment will again pay $100 plus interest on the previous interest: $100 × 1.12 = $112 48) B 49) D 50) D

PV = $20,000 ÷ (1.08)21raise to the power of 21 PV = $3,973.11 51) B

Version 1

It will be worth 100 ÷ 0.08 = $1,250 at the end of year 5, and therefore worth $1,250 ÷ 1.085raise to the power of 5 = $850.73 today. 52) C

FV = PV(1 + r)traise to the power of t = 100 × 1.02512raise to the power of 12 = $134.49 53) A

1.07 = (1 + r)2raise to the power of 2 R = 0.0344 or 3.44% 54) C

Future price of car = ($20,000 × 1.04) = $20,800 PV = $ 20,800 ÷ (1.06) = $19,623 55) B

FV = PV(1 + r)traise to the power of t 0.7008 = 1 ÷ (1 + r)5raise to the power of 5 r = 0.0737, or 7.37% 56) C

57) A 58) D 59) D

FV = PV(1 + r)traise to the power of t FV = 300 million × (1.02)25raise to the power of 25 FV = 492.2 million ≈ 492 million 60) B

$25,000 = $24,000 × (1 + r) r = 0.0417, or 4.17% 61) C

Version 1

FV = PV × (1 + r)traise to the power of t $4,000 = $3,650 × (1 + r) r = 0.0959, or 9.59% 62) A

= $3,604.78 63) B

Down payment = $25,000 − 20,480.96 = $4,519.04 64) A

= $5,022.10 65) C

= $1,532.60 66) B

= $10,412.27 67) C

68) B

69) D 70) C

Version 1

71) D 72) B

73) C

74) B

75) A

= $6,246.34 76) B 77) C

= $12,112.05 78) C

79) C

Version 1

First, solve for payment: Next, solve for time reamaining when balance = $50,000:

80) A

= $297.22 81) D

Total value of payments = $11,680.36 × 30 = $350,411 Total Interest paid = $350,411 − $120,000 = $230,411 82) D

Value of loan at start of last year = $11,680.36 ÷ 1.09 = $10,715.93 Interest on loan in last year = 0.09 × $10,715.93 = $964.43 83) D 84) A

$315.47 − ($315.47 ÷ 1.1) = $28.68 85) A

Payment = $75,000 ÷ [(1 ÷ 0.01) − 1 ÷ 0.01(1.01)360raise to the power of 360 ] Payment = $771.46 86) C

= $149,138.24 87) B 88) A

Payment = $50,000 ÷ [(1.0910raise to the power of 10 − 1) ÷ 0.09] Payment = $3,291.00 89) B

Financial calculator: n = 30; PV = −50,000; PMT = −6,000; FV = 1,000,000; CPT I/Y = 7.24%, or Excel function Rate(nper, PMT, PV, FV)

Version 1

90) B

= $388,017.16 91) B

92) A

= $1,067,477.62 93) C

94) B

FV = $2,000 {[(1 + 0.09)40raise to the power of 40 − 1] ÷ 0.09} FV = $675,764.89 95) B

(1.03)12raise to the power of 12 − 1 = 0.4258, or 42.58% 96) C

FV = PV(1 + r)traise to the power of t 10 = 1(1 + i)40raise to the power of 40 r = 5.93% Real rate = (1.0593 ÷ 1.04) − 1 = 0.0186, or 1.86% 97) C 98) A

Real rate = (1.0619 ÷ 1.025) − 1 = 0.036 $1,000,000 = PMT {(1 ÷ 0.036) − [1 ÷ 0.036(1.036)25raise to the power of 25 ]} PMT = $61,334.36

Version 1

99) B

1 + real interest rate = (1 + nominal interest rate) ÷ (1 + inflation) 1 + real interest rate = 1.12 ÷ 1.06 Real interest rate = 5.66% 100) 101)

C C 1 + nominal rate = (1 + real rate) × (1 + inflation rate) Nominal rate = (1.04 × 1.035) − 1 Nominal rate = 7.64% 102)

C FV = PV (1 + r)traise to the power of t $9,848.21 = $5,000 × [1 + (r ÷ 2)]10 × 2raise to the power of 10 × 2 r = 6.89% 103) 104)

D B Effective interest rate = e0.1raise to the power of 0.1 − 1 = 0.10517, or 10.517% 105) 106)

A C APR = 1.4% × 12 = 16.80% 107) 108)

D D APR = [(1.1608)0.25raise to the power of 0.25 − 1] × 4 APR = 0.1519, or 15.19% 109)

B EAR = [1 + (0.08 ÷ 12)]12raise to the power of 12 − 1 = 8.30% EAR = [1 + (0.085 ÷ 2)]2raise to the power of 2 − 1 = 8.68% The depositor will prefer the option with the higher EAR (effective annual rate). 110)

B EAR = [1 + (0.10 ÷ 12)] 12raise to the power of 12 − 1 = 0.1047, or 10.47% 111)

D APR = [(1.1526)1 ÷ 52raise to the power of 1 ÷ 52 − 1] × 52 = 0.1422, or 14.22%

Version 1

112)

B EAR = [1 + (0.09 ÷ 12)]12raise to the power of 12 − 1 = 0.0938, or 9.38% 113) 114)

C B Interest = $1,000(e0.13raise to the power of 0.13 ) − $1,000 = $138.83 115) 116)

B B FV = PV × (1 + r)traise to the power of t $1,900 = $1,000 × (1 + r)9raise to the power of 9 r = 1.91 ÷ 9raise to the power of 1 ÷ 9 − 1 r = 0.0739, or 7.39% 117)

B PV = FV ÷ (1 + r)traise to the power of t PV = $50,000 ÷ 1.107raise to the power of 7 PV = $25,657.91 118)

D PV = FV ÷ (1 + r)traise to the power of t PV = 1 ÷ 1.085raise to the power of 5 PV = 0.6806 119)

A Difference = FV ÷ (1 + r)t − 1raise to the power of t − 1 − FV ÷ (1 + r) Difference = $10,000 ÷ 1.084raise to the power of 4 − $10,000 ÷ 1.085raise to the power of 5 Difference = $544.47 120)

C FV = PV(1 + r)traise to the power of t $10,000 = $5,000(1 + r)5raise to the power of 5 r = 21 ÷ 5raise to the power of 1 ÷ 5 − 1 r = 0.1487, or 14.87% 121) 122)

B B

Version 1

$25,000 − 4,000 = $522.59 {(1 ÷ r) − [1 ÷ r(1 + r)48raise to the power of 48 ]} Using a financial calculator or Excel, r = 0.0075 APR = 0.0075 × 12 APR = 0.09, or 9% 123)

A EAR = (1 + 0.0125)12raise to the power of 12 − 1 = 0.1608, or 16.08% APR = 1.25% × 12 = 15.00% 124)

D Additional deposit = $150,000 ÷ 1.0818raise to the power of 18 − $150,000 ÷ 1.1118raise to the power of 18 Additional deposit = $14,614.03 125)

A Annual payment = $5,000,000 ÷ 20 = $250,000 = $2,833,898.81 126)

PMT = $804.62 PMT = $978.89 Total difference = ($804.62 × 12 × 30) − ($978.89 × 12 × 15) = $113,465 127)

128)

B EAR = 1.01512raise to the power of 12 − 1 = 0.1956, or 19.56% 129)

Version 1

PMT = $865.85 PMT = $1,178.39 Total difference = ($865.85 × 12 × 30) − ($1,178.39 × 12 × 15) = $99,595.80 130)

C PV = $28,000 ÷ 1.0725 + $35,000 ÷ 1.07252raise to the power of 2 + $42,000 ÷ 1.07253raise to the power of 3 PV = $90,580.55 131)

A FV = ($42,000 × 1.0452raise to the power of 2 ) + ($54,000 × 1.045) + $58,000 FV = $160,295.05 132)

Principal payment = $20,105.74 − ($50,000 × 0.1) Principal payment = $15,105.74

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) When a bond matures, the issuer repays the bond’s face value. ⊚ true ⊚ false 2) When the market interest rate exceeds the coupon rate, bonds sell for less than face value. ⊚ true ⊚ false 3) Current yield overstates the return of premium bonds since investors who buy a bond at a

premium face a capital loss over the life of the bond. ⊚ true ⊚ false 4) A bond's rate of return is equal to its coupon payment divided by the price paid for the bond. ⊚ true ⊚ false 5) A bond's bid price will be lower than the ask price. ⊚ true ⊚ false 6) A long-term investor would more likely be interested in a bond's current yield rather than its

yield to maturity. ⊚ true ⊚ false 7) Bonds that have a Standard & Poor's rating of BBB or better are considered to be investment-

grade bonds. ⊚ true ⊚ false 8) Speculative-grade bonds have default risk; investment grade bonds do not. ⊚ true ⊚ false

Version 1

9) TIPS are unlike most bonds in that their cash flows increase when the national rate of gross

domestic product increases. ⊚ true ⊚ false 10) The return to bondholders is guaranteed to equal the yield to maturity only if the bond is held

until maturity. ⊚ true ⊚ false 11) It would be realistic to read an ask price listed as 100.127 and a bid price of 100.143. ⊚ true ⊚ false 12) All indexed bonds in the United States are known as Treasury Interest-Paid Securities, or

TIPS. ⊚ true ⊚ false 13) The current yield measures the bond's total rate of return. ⊚ true ⊚ false 14) When a financial calculator or spreadsheet program finds a bond's yield to maturity, it uses a

trial-and-error process. ⊚ true ⊚ false 15) Even when the yield curve is upward-sloping, investors might rationally stay away from

long-term bonds. ⊚ true ⊚ false 16) Bonds with a rating of Ba or below by Moody's are referred to as speculative grade, high-

yield, or junk bonds. ⊚ true ⊚ false

Version 1

17) Bonds rated BB or above by Standard & Poor's are called investment grade. ⊚ true ⊚ false 18) Bonds rated Ba by Moody's have the same safety rating as the bonds rated BB by Standard &

Poor's. ⊚ true ⊚ false 19) Zero-coupon bonds are issued at prices below face value, and the investor's return comes

from the difference between the purchase price and the payment of face value at maturity. ⊚ true ⊚ false 20) Issuers compensate investors for default risk by putting a high face value on their bonds. ⊚ true ⊚ false 21) Credit risk implies that the promised yield to maturity on the bond is higher than the expected

yield. ⊚ true ⊚ false 22) Bond ratings measure a bond's credit risk. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 23) How much does the $1,360 to be received upon a bond's maturity in 4 years add to the bond's price if the appropriate discount rate is 9%? A) $398.54 B) $509.60 C) $870.40 D) $963.46

Version 1

24) How much would an investor expect to pay for a $1,100 par value bond with an annual

coupon of 9% that matures in 5 years if the interest rate is 7%? A) $1,190.20 B) $766.42 C) $1,183.40 D) $1,235.31 25) Consider a 3-year bond with a par value of $1,280 and an annual coupon of 5%. If interest

rates change from 5% to 3% the bond's price will: A) increase by $32.59. B) decrease by $32.59. C) increase by $72.41. D) decrease by $72.41. 26) You purchased a 6% annual coupon bond at face value and sold it one year later for

$1,016.48. What was your rate of return on this investment if the face value at maturity was $1,000? A) 4.35% B) 6.28% C) 7.65% D) 6.21% 27) Rosita purchased a bond for $990 that had a 7% coupon and semiannual interest payments.

She sold the bond after 6 months and earned a total return of 4.8% on this investment. At what price, did she sell the bond? A) $1,002.52 B) $975.33 C) $982.11 D) $1,004.23 28) A bond has a coupon rate of 5%, pays interest semiannually, sells for $963, and matures in 3

years. What is its yield to maturity? A) 3.19% B) 3.89% C) 6.37% D) 8.11%

Version 1

29) A bond has a face value of $1,000, has 5 years until maturity, and an annual coupon rate of

7.50%? It yields 5.50% currently. By how much will the price change over the next year if the yield remains constant? A) Zero B) Decline by $91.22 C) Decline by $15.30 D) Rise by $15.30 30) What is the amount of the annual coupon payment for a bond that has 6 years until maturity,

sells for $1,065, and has a yield to maturity of 9.52%? A) $103.29 B) $99.76 C) $106.16 D) $109.92 31) Two years ago bonds were issued at par with 10 years until maturity and a 7.40% annual

coupon. If interest rates for that grade of bond are currently 8.65%, what will be the market price of these bonds? A) $918.11 B) $929.91 C) $988.63 D) $1,000.00 32) What is the total return to an investor who buys a bond for $1,117 when the bond has an

annual coupon of 6% and 5 years until maturity, then sells the bond after 1 year for $1,102? A) 4.03% B) 4.09% C) 4.51% D) 6.00% 33) How much would an investor lose the first year if she purchased a 30-year zero-coupon bond

with a $1,000 par value and a yield to maturity of 12.00% only to see market interest rates increase to 14.00% one year later? A) $11.00 B) $24.00 C) $15.00 D) $16.73

Version 1

34) How much should you be prepared to pay for a 10-year bond with a coupon of 6.80%

semiannual payments, and a semiannually compounded yield of 8.30%? A) $899.41 B) $900.68 C) $942.21 D) $1,317.98 35) An investor buys a 5-year, 7% coupon bond for $969, holds it for 1 year, and then sells the

bond for $979. What was the investor's rate of return? A) 7.00% B) 7.23% C) 7.65% D) 8.26% 36) If a bond offers an investor 12.20% in nominal return during a year in which the rate of

inflation is 5.20%, then her real return is: A) 6.65%. B) 6.23%. C) 15.36%. D) 10.48%. 37) If you purchase a 5-year, zero-coupon bond for $679.51, how much could it be sold for 3

years later if interest rates have remained stable? A) $842.00 B) $917.38 C) $856.80 D) $905.03 38) The coupon rate of a bond equals: A) its yield to maturity. B) a defined percentage of its face value. C) the yield to maturity when the bond sells at a discount. D) the annual interest divided by the current market price. 39) Periodic receipts of interest by the bondholder are known as: A) the coupon rate. B) principal payments. C) coupon payments. D) the default premium.

Version 1

40) As the coupon rate of a bond increases, the bond's: A) face value increases. B) current price decreases. C) interest payments increase. D) maturity date is extended. 41) Assume a bond is currently selling at par value. What will happen in the future if the yield on

the bond is lower than the coupon rate? A) The price of the bond will increase. B) The coupon rate of the bond will increase. C) The par value of the bond will decrease. D) The coupon payments will be adjusted to the new discount rate. 42) If a bond’s asked price is 97.162, the investor: A) receives 97.162% of the stated coupon payments. B) receives $971.62 upon the maturity date of the bond. C) pays 97.162% of face value for the bond. D) pays $10,971.62 for a $10,000 face value bond. 43) How much does the $1,000 to be received upon a bond's maturity in 4 years add to the bond's

price if the appropriate discount rate is 6%? A) $209.91 B) $260.00 C) $760.00 D) $792.09 44) What happens to a discount bond as the time to maturity decreases? A) The coupon rate increases. B) The bond price increases. C) The coupon rate decreases. D) The bond price decreases. 45) How much should you pay for a $1,000 bond with 10% coupon, annual payments, and 5

years to maturity if the interest rate is 12%? A) $927.90 B) $981.40 C) $1,000.00 D) $1,075.82

Version 1

46) How much would an investor expect to pay for a $1,000 par value bond with a 9% annual

coupon that matures in 5 years if the interest rate is 7%? A) $696.74 B) $1,075.82 C) $1,082.00 D) $1,123.01 47) Which of the following statements is correct for a 10% coupon bond that has a current yield

of 7%? A) The face value of the bond has decreased. B) The bond's maturity value exceeds the bond's price. C) The bond's internal rate of return is 7%. D) The bond's market value is higher than its face value. 48) If an investor purchases a bond when its current yield is higher than the coupon rate, then the

bond's price will be expected to: A) decline over time, reaching par value at maturity. B) increase over time, reaching par value at maturity. C) be less than the face value at maturity. D) exceed the face value at maturity. 49) The current yield of a bond can be calculated by: A) multiplying the price by the coupon rate. B) dividing the price by the annual coupon payments. C) dividing the price by the par value. D) dividing the annual coupon payments by the price. 50) What is the current yield of a bond with a 6% coupon, 4 years until maturity, and a price

quote of 84? A) 6.00% B) 7.14% C) 5.04% D) 6.38% 51) What is the coupon rate for a bond with 6 years until maturity, a price of $984.32, and a yield

to maturity of 7%? Interest is paid semi-annually. A) 3.34% B) 3.50% C) 6.68% D) 7.00%

Version 1

52) A bond's par value can also be called its: A) coupon payment. B) present value. C) market value. D) face value. 53) A bond's yield to maturity takes into consideration: A) current yield but not any price changes. B) price changes but not the current yield. C) both the current yield and any price changes. D) neither the current yield nor any price changes. 54) The discount rate that makes the present value of a bond's payments equal to its price is

termed the: A) dividend yield. B) yield to maturity. C) current yield. D) coupon rate. 55) What is the coupon rate for a bond with 3 years until maturity, a price of $1,053.46, and a

yield to maturity of 6%? Interest is paid annually. A) 6% B) 8% C) 10% D) 11% 56) What price will be paid for a Eurobond with an ask price of 116.08 if the face value is 30,000

euros? A) 25,844 euros B) 30,000 euros C) 34,824 euros D) 35,406 euros 57) What is the yield to maturity for a bond paying $100 annually that has 6 years until maturity

and sells for $1,000? A) 6.0% B) 8.5% C) 10.0% D) 12.5%

Version 1

58) Consider a 3-year bond with a par value of $1,000 and an 8% annual coupon. If interest rates

change from 8% to 6% the bond's price will: A) increase by $51.54. B) decrease by $51.54. C) increase by $53.46. D) decrease by $53.46. 59) A Eurobond with a par value of 30,000 euros is priced at 108.40 of par and has 10 years

remaining until maturity. The bond has an 8% coupon rate, paid semi-annually. What is the amount of the next interest payment? A) 1,200 euros B) 2,400 euros C) 4,000 euros D) 8,000 euros 60) Which one of the following bond values will change when interest rates change? A) The expected cash flows B) The present value C) The coupon payment D) The maturity value 61) What happens to the coupon rate of a $1,000 face value bond that pays $80 annually in

interest if market interest rates change from 9% to 10%? A) The coupon rate increases to 10%. B) The coupon rate remains at 9%. C) The coupon rate remains at 8%. D) The coupon rate decreases to 8%. 62) Which one of the following is fixed for the life of a given bond? A) Current price B) Current yield C) Yield to maturity D) Coupon rate 63) What is the rate of return for an investor who pays $1,054.47 for a 3-year bond with an

annual coupon payment of 6.5% and sells the bond 1 year later for $1,037.19? A) 4.53% B) 5.33% C) 5.16% D) 4.92%

Version 1

64) If a bond investor's yield for a particular period does not change, then during that period, the

bond's return: A) is zero. B) increases. C) equals the yield. D) is indeterminate. 65) An investor purchases a Eurobond for 108.93 and sells it one year later at 107.30. The bond

pays an annual coupon of 6% and has 10 years until maturity. If the par value of the bond is 30,000 euros, what is the rate of return on the bond over year? A) 3.0% B) 4.0% C) 6.0% D) 8.0% 66) What is the relationship between a bondholder's rate of return and the bond's yield to

maturity if he does not hold the bond until it matures? A) The rate of return will be lower than the yield to maturity. B) The rate of return will be higher than the yield to maturity. C) The rate of return will equal the yield to maturity. D) It could be higher or lower. 67) If the coupon rate on an outstanding bond is lower than the relevant current interest rate, then

the yield to maturity will be: A) lower than current interest rates. B) equal to the coupon rate. C) higher than the coupon rate. D) lower than the coupon rate. 68) If a 4-year bond with a 7% coupon and a 10% yield to maturity is currently worth $904.90,

how much will it be worth 1 year from now if interest rates are constant? A) $904.90 B) $925.39 C) $947.93 D) $1,000.00

Version 1

69) What price will be paid for a U.S. Treasury bond with an ask price of 135.4062 if the face

value is $100,000? A) $100,135.41 B) $135,000.41 C) $136,269.38 D) $135,406.20 70) You purchased a 6% annual coupon bond at face value and sold it one year later for

$1,015.16. What was your rate of return on this investment if the face value at maturity was $1,000? A) 4.48% B) 6.15% C) 7.52% D) 6.07% 71) How does a bond dealer generate profits when trading bonds? A) By maintaining bid prices lower than ask prices B) By maintaining bid prices higher than ask prices C) By retaining the bond’s next coupon payment D) By lowering the bond’s coupon rate upon resale 72) A bond is priced at $1,100, has 10 years remaining until maturity, and has a 10% coupon,

paid semiannually. What is the amount of the next interest payment? A) $50 B) $55 C) $100 D) $110 73) The yield curve depicts the current relationship between: A) bond yields and default risk. B) bond maturity and bond ratings. C) bond yields and maturity. D) promised yields and default premiums. 74) When the yield curve is upward-sloping, then: A) short-maturity bonds offer the highest coupon rates. B) long-maturity bonds are priced above par value. C) short-maturity bonds yield less than long-maturity bonds. D) long-maturity bonds increase in price when interest rates increase.

Version 1

75) Nominal U.S. Treasury bond yields: A) are constant over time. B) are equal to the real yields. C) include a default premium. D) include an inflation premium. 76) Which one of these is included in the yield of a bond with a low credit rating but not included

in a U.S. Treasury bond yield? Assume both bonds are selling at a premium. A) Real rate of return B) Inflation premium C) Default premium D) Loss of premium 77) The purpose of a floating-rate bond is to: A) save interest expense for corporate issuers. B) avoid making interest payments until maturity. C) shift the yield curve. D) offer rates that adjust to current market conditions. 78) Which of the following would not be associated with a zero-coupon bond? A) Yield to maturity B) Discount bond C) Current yield D) Interest-rate risk 79) Which one of the following bonds would be likely to exhibit a greater degree of interest rate

risk? A) A zero-coupon bond with 20 years until maturity B) A coupon-paying bond with 20 years until maturity C) A floating-rate bond with 20 years until maturity D) A zero-coupon bond with 30 years until maturity 80) A "convertible bond" provides the option to convert: A) a bond into shares of common stock. B) fixed-rate coupon payments into variable-rate payments. C) a zero-coupon bond to a coupon-paying bond. D) a junk bond to a zero-coupon investment-grade bond.

Version 1

81) Rosita purchased a bond for $989 that had a 7% coupon and semiannual interest payments.

She sold the bond after 6 months and earned a total return of 4.8% on this investment. At what price, did she sell the bond? A) $1,001.47 B) $974.28 C) $981.06 D) $1,003.18 82) A U.S. Treasury security that pays a fixed coupon and has an initial maturity of 2 to 10 years

is called a: A) TIPS. B) Treasury bill. C) Treasury bond. D) Treasury note. 83) Which one of the following must be correct for a bond currently selling at a premium? A) Its coupon rate is variable. B) Its current yield is lower than its coupon rate. C) Its yield to maturity is higher than its coupon rate. D) Its coupon rate is lower than the current market rate on similar bonds. 84) A bond has a coupon rate of 8%, pays interest semiannually, sells for $960, and matures in 3

years. What is its yield to maturity? A) 4.78% B) 5.48% C) 9.57% D) 12.17% 85) Which type of bond is certain to provide a capital loss if held to maturity? A) Discount bond B) Premium bond C) Zero-coupon bond D) Junk bond 86) Investors who purchase bonds having lower credit ratings should expect: A) lower yields to maturity. B) higher default possibilities. C) lower coupon payments. D) higher purchase prices.

Version 1

87) A bond has a face value of $1,000, has 5 years until maturity, and an annual coupon rate of

7%? It yields 5% currently. By how much will the price change over the next year if the yield remains constant? A) Zero B) Decline by $86.59 C) Decline by $15.67 D) Rise by $15.67 88) If a bond is priced at par value, then: A) it has a very low level of default risk. B) its coupon rate equals its yield to maturity. C) it must be a zero-coupon bond. D) the bond is quite close to maturity. 89) The existence of an upward-sloping yield curve suggests that: A) bonds should be selling at a discount to par value. B) bonds will not return as much as common stocks. C) interest rates may be increasing in the future. D) real interest rates will be increasing soon. 90) What is the amount of the annual coupon payment for a bond that has 6 years until maturity,

sells for $1,050, and has a yield to maturity of 9.37%? A) $98.64 B) $95.27 C) $101.38 D) $104.97 91) This morning, you purchased a TIPS. Which one of these should you expect to occur if you

hold this bond during an inflationary period? A) The coupon payment will increase in real terms. B) The maturity value will increase in nominal terms. C) The market price will remain constant at par. D) The market price will decrease. 92) Many investors may be drawn to municipal bonds because of the bonds': A) speculative grade ratings. B) high coupon payments. C) long periods until maturity. D) income exemption from federal taxes.

Version 1

93) Two years ago bonds were issued at par with 10 years until maturity and a 7% annual

coupon. If interest rates for that grade of bond are currently 8.25%, what will be the market price of these bonds? A) $917.06 B) $928.84 C) $987.50 D) $1,000.00 94) If a bond offers a current yield of 5% and a yield to maturity of 5.45%, then the: A) bond is selling at a discount. B) bond has a high default premium. C) promised yield is not likely to materialize. D) bond must be a Treasury Inflation-Protected Security. 95) What is the total return to an investor who buys a bond for $1,100 when the bond has a 9%

annual coupon and 5 years until maturity, then sells the bond after 1 year for $1,085? A) 6.82% B) 6.91% C) 7.64% D) 9.00% 96) How much would an investor lose the first year if she purchased a 30-year zero-coupon bond

with a $1,000 par value and a 10% yield to maturity, only to see market interest rates increase to 12% one year later? A) $19.93 B) $20.00 C) $23.93 D) $25.66 97) Assume a bond has been owned by four different investors during its 20-year history. Which

one of the following is most likely to have been different for each of these owners? A) Coupon rate B) Coupon frequency C) Par value D) Yield to maturity

Version 1

98) If an investor purchases a 3%, 5-year TIPS at its par value of $1,000 and the CPI increases

3% over each of the next 5 years, what will be the real value of the principal at maturity? A) $1,000.00 B) $1,030.00 C) $1,060.90 D) $1,061.36 99) Which one of the following is correct concerning real interest rates? A) Real interest rates are constant. B) Real interest rates must be positive. C) Real interest rates must be less than nominal interest rates. D) Real interest rates, if positive, increase purchasing power over time. 100)

An investor holds two bonds, one with 5 years until maturity and the other with 20 years until maturity. Which of the following is more likely if interest rates suddenly increase by 2%? A) The 5-year bond will decrease more in price. B) The 20-year bond will decrease more in price. C) Both bonds will decrease in price by the same proportion. D) Neither bond will decrease in price, but their yields will increase.

101)

How much should you be prepared to pay for a 10-year bond with an annual coupon of 6% and a yield to maturity of 7.5%? A) $411.84 B) $897.04 C) $985.00 D) $1,000.00

102)

How much should you be prepared to pay for a 10-year bond with a 6% coupon, semiannual payments, and a semiannually compounded yield of 7.5%? A) $895.78 B) $897.04 C) $938.40 D) $1,312.66

Version 1

103)

The market price of a bond with 12 years until maturity and an annual coupon rate of 8% increased yesterday. Which one of these may have caused this price increase? A) The bond's rating was downgraded. B) The issuing firm announced the next interest payment. C) The issuing firm announced that its annual earnings met investor expectations. D) Market interest rates decreased.

104)

An investor buys a 5-year, 9% coupon bond for $975, holds it for 1 year, and then sells the bond for $985. What was the investor's rate of return? A) 9.00% B) 9.23% C) 9.65% D) 10.26%

105)

An investor buys a 10-year, 7% coupon bond for $1,050, holds it for 1 year, and then sells it for $1,040. What was the investor's rate of return? A) 5.71% B) 6.00% C) 6.67% D) 7.00%

106)

An investor purchased a fixed-coupon bond at a time when the bond's yield to maturity was 6.9%. The investor sold the bond prior to maturity and realized a total return of 7.1%. Which of these most likely occurred while he owned the bond? A) The bond's current yield increased above the bond's coupon rate. B) The inflation rate increased. C) Market interest rates declined. D) Market interest rates increased.

107)

A bond has an ask quote of 99.5625 and a bid quote of 99.5475. How much will the bond dealer make on the purchase and resale of a $100,000 bond? A) $150 B) $1,500 C) $15 D) $1.50

Version 1

108)

What are the conditions imposed on a debt issuer that are designed to protect bondholders? A) Collateral agreements B) Vanilla wrappers C) Protective covenants D) Default provisions

109)

The holder of which one of these securities has first claim on the assets of a firm? A) Senior debt B) Common stock C) Subordinated debt D) Preferred stock

110)

When market interest rates exceed a bond's coupon rate, the bond will: A) sell for less than par value. B) sell for more than par value. C) decrease its coupon rate. D) increase its coupon rate.

111)

Which one of the following is most likely for a CCC-rated bond, compared to a BBBrated bond? A) The CCC bond will have a variable-coupon rate. B) The CCC bond will have a shorter term. C) The CCC bond will offer a higher expected yield to maturity. D) The CCC bond will have a higher price for the same term.

112)

Which of these bond ratings is the lowest of Moody's investment-grade ratings? A) A B) Ba C) Aa D) Baa

113)

If a bond offers an investor 11% in nominal return during a year in which the rate of inflation is 4%, then her real return is: A) 6.73%. B) 6.31%. C) 15.44%. D) 10.56%.

Version 1

114)

What nominal return would an investor need to receive if he desires a real return of 4% and the rate of inflation is 5%? A) 4.20% B) 8.64% C) 9.00% D) 9.20%

115)

If you purchase a 5-year, zero-coupon bond for $691.72, how much could it be sold for 3 years later if interest rates have remained stable? A) $848.12 B) $923.50 C) $862.92 D) $911.15

116)

An investor buys a 10-year annual coupon bond at a yield of 8.7% and sells it 2 years later when it still yields 8.7%. What is his rate of return over this period? A) 0.0% B) 8.7% C) Cannot say without knowing the coupon. D) 17.4%

117)

What causes bonds to sell for a premium? A) Investment-quality ratings B) Long periods until maturity C) Coupon rates that exceed market rates D) Speculative-grade ratings

118)

The current yield tends to overstate a bond's total return when the bond sells for a premium because: A) the bond's price will decline each year. B) coupon payments can change at any time. C) bonds selling for a premium have low default risk. D) taxes must be paid on the current yield.

119)

The current yield tends to understate a bond's total return when the bond sells for a discount because: A) increases in interest rates will increase the current yield. B) the bond's price will increase each year. C) current yields show only nominal returns. D) the bond may have a higher face value.

Version 1

120)

When comparing a highly liquid bond with a comparable but less liquid bond, the highly liquid bond is most apt to have a: A) lower yield. B) shorter maturity. C) higher yield. D) longer maturity.

Version 1

Answer Key Test name: Ch06 1) TRUE 2) TRUE 3) TRUE 4) FALSE 5) TRUE 6) FALSE 7) TRUE 8) FALSE 9) FALSE 10) TRUE 11) FALSE 12) FALSE 13) FALSE 14) TRUE 15) TRUE 16) TRUE 17) FALSE 18) TRUE 19) TRUE 20) FALSE 21) TRUE 22) TRUE 23) D

$1,360 ÷ 1.094raise to the power of 4 = $963.46 24) A

25) C

This is a price increase of $72.41, since the bond has sold at par. 26) C

Version 1

Rate of return = [$1,016.48 + (0.06 × $1,000) − $1,000] ÷ $1,000 = 0.0765, or 7.65% 27) A

28) C

Using a financial calculator: n = 6; PV = −$963; PMT = $25; FV = $1,000, CPT I/Y = 3.1873% YTM = 2 × 3.1873% = 6.37% 29) C

Price today = $75 × [1 ÷ 0.055 + 1 ÷ (0.055 × 1.0554raise to the power of 4 )] + $1,075 ÷ 1.0555raise to the power of 5 = $1,085.41 Price next year = $75 × [1 ÷ 0.055 + 1 ÷ (0.055 × 1.0553raise to the power of 3 )] + $1,075 ÷ 1.0554raise to the power of 4 = $1,070.10 Price declines by $15.30. 30) D

31) B

32) A

Total return = [$1,102 + (0.06 × $1,000) − $1,117] ÷ $1,117 = 0.0403, or 4.03% 33) A

Price = $1,000 ÷ 1.12030raise to the power of 30 = $33.38 New price = $1,000 ÷ 1.14029raise to the power of 29 = $22.37 Loss = $33.38 − $22.37 = $11.00 34) A

Semiannual interest rate = 0.083 ÷ 2 = 0.0415 Price = [(0.068 ÷ 2) × $1,000)] {(1 ÷ 0.0415) − [1 ÷ 0.0415(1.0415)10 × 2raise to the power of 10 × 2 ]} + $1,000 ÷ 1.041510 × 2raise to the power of 10 × 2 Price = $899.41

Version 1

35) D

Rate of return = [$979 + (0.07 × $1,000) − $969] ÷ $969 = 0.0826, or 8.26% 36) A

1 + real return = 1.1220 ÷ 1.0520 − 1 = 0.0665, or 6.65% 37) C

$679.51 = $1,000 ÷ (1 + i)5raise to the power of 5 i = 0.0803 Price = $1,000 ÷ 1.08032raise to the power of 2 Price = $856.80 38) B 39) C 40) C 41) A 42) C 43) D

$1,000 ÷ 1.064raise to the power of 4 = $792.09 44) B 45) A

46) C

47) D 48) B 49) D 50) B

Current yield = $60 ÷ (0.84 × $1,000) = 0.0714, or 7.14% 51) C

Version 1

Coupon Rate = ($33.38 × 2) ÷ $1,000 = 0.0668, or 6.68% 52) D 53) C 54) B 55) B

Coupon Rate = $80 ÷ $1,000 = 0.08 = 8% 56) C

Price = 116.08 × 30,000 euros = 34,824 euros 57) C

Since the bond is selling at par, the yield to maturity must equal the coupon rate which is: Coupon rate = $100 ÷ $1,000 = 0.10, or 10% 58) C

This is a price increase of $53.46, since the bond sold at par. 59) A

Coupon payment = (0.08 × 30,000) ÷ 2 = 1,200 60) B 61) C 62) D 63) A

Rate of return = [$1,037.19 + (0.065 × $1,000) − $1,054.47] ÷ $1,054.47 = 0.0453, or 4.53% 64) C 65) B

Rate of return = [107.30 − 108.93 + 6] ÷ 108.93 = 0.0401, or 4.01% 66) D 67) C

Version 1

68) B

69) D

Price = 1.354062 × $100,000 = $135,406.20 70) C

Rate of return = [$1,015.16 + (0.06 × $1,000) − $1,000] ÷ $1,000 = 0.0752, or 7.52% 71) A 72) A

Coupon payment = (0.10 × $1,000) ÷ 2 = $50 73) C 74) C 75) D 76) C 77) D 78) C 79) D 80) A 81) A

82) D 83) B 84) C

Using a financial calculator: n = 6; PV = −$960; PMT = $40; FV = $1,000, CPT I/Y = 4.7826% YTM = 2 × 4.7826% = 9.57% 85) B 86) B 87) C

Version 1

Price today = $70 × [1 ÷ 0.05 + 1 ÷ (0.05 × 1.054raise to the power of 4 )] + $1,070 ÷ 1.055raise to the power of 5 = $1,086.59 Price next year = $70 × [1 ÷ 0.05 + 1 ÷ (0.05 × 1.053raise to the power of 3 )] + $1,070 ÷ 1.054raise to the power of 4 = $1,070.92 Price declines by $15.67. 88) B 89) C 90) D

91) B 92) D 93) B

94) A 95) A

Total return = [$1,085 + (0.09 × $1,000) − $1,100] ÷ $1,100 = 0.0682, or 6.82% 96) A

Price = $1,000 ÷ 1.1030raise to the power of 30 = $57.31 New price = $1,000 ÷ 1.1229raise to the power of 29 = $37.38 Loss = $57.31 − $37.38 = $19.93 97) D 98) A

The real value of the principal will remain constant at the par value. 99) D 100) B 101) B

Price = (0.06 × $1,000) {(1 ÷ 0.075) − [1 ÷ 0.075(1.075)10raise to the power of 10 ]} + $1,000 ÷ 1.07510raise to the power of 10 Price = $897.04 102)

Version 1

Semiannual interest rate = 0.075 ÷ 2 = 0.0375 Price = [(0.06 ÷ 2) × $1,000)] {(1 ÷ 0.0375) − [1 ÷ 0.0375(1.0375)10 × 2raise to the power of 10 × 2 ]} + $1,000 ÷ 1.037510 × 2raise to the power of 10 × 2 Price = $895.78 103) 104)

D D Rate of return = [$985 + (0.09 × $1,000) − $975] ÷ $975 = 0.1026, or 10.26% 105)

A Rate of return = [$1,040 + (0.07 × $1,000) − $1,050] ÷ $1,050 = 0.0571, or 5.71% 106) 107)

C C Dealer profit = (0.995625 − 0.995475) × $100,000 = $15 108) 109) 110) 111) 112) 113)

C A A C D A 1 + real return = 1.11 ÷ 1.04 − 1 = 0.0673, or 6.73% 114)

D Nominal return = (1.04 × 1.05) − 1 = 0.0920, or 9.20% 115)

C $691.72 = $1,000 ÷ (1 + i)5raise to the power of 5 i = 0.0765 Price = $1,000 ÷ 1.07652raise to the power of 2 Price = $862.92 116) 117) 118) 119) 120)

B C A B A

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) The dividend discount model states that the value of a stock is the present value of the dividends it will pay over the investor's horizon, plus the present value of the expected stock price at the end of that horizon. ⊚ true ⊚ false 2) An excess of market value over the book value of equity can be attributed to going concern

value. ⊚ true ⊚ false 3) Securities with the same expected risk should offer the same expected rate of return. ⊚ true ⊚ false 4) If investors believe a company will have the opportunity to make very profitable investments

in the future, they will pay more for the company's stock today. ⊚ true ⊚ false 5) The dividend discount model should not be used to value stocks if the dividend does not

grow. ⊚ true ⊚ false 6) If the stock prices follow a random walk, successive stock prices are not related. ⊚ true ⊚ false 7) The liquidation value of a firm is equal to the book value of the firm. ⊚ true ⊚ false 8) Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend

payout ratio. ⊚ true ⊚ false

Version 1

9) If the market is efficient, stock prices should be expected to react only to new information. ⊚ true ⊚ false 10) If stock prices follow a random walk, their prices bear no relation to the company’s real

activities. ⊚ true ⊚ false 11) A negative free cash flow for a business is always sign that it is not performing well. ⊚ true ⊚ false 12) Evidence that stock prices follow a random walk does not imply that there aren’t predictable

cycles in prices. ⊚ true ⊚ false 13) Market efficiency implies that security prices impound new information quickly. ⊚ true ⊚ false 14) If security prices follow a random walk, then on any particular day the odds are that an

increase or decrease in price is about equally likely. ⊚ true ⊚ false 15) Many professional investors attempt to beat the market by buying index funds. ⊚ true ⊚ false 16) Market efficiency implies that one could earn above-average risk-adjusted returns by

examining the history of a firm's stock price. ⊚ true ⊚ false 17) Market value, unlike book value and liquidation value, treats the firm as a going concern. ⊚ true ⊚ false

Version 1

18) The dividend yield of a stock is much like the current yield of a bond. Both ignore

prospective capital gains or losses. ⊚ true ⊚ false 19) Historically, since 1926, growth stocks have consistently earned higher average returns than

value stocks. ⊚ true ⊚ false 20) A majority of active managers consistently earn higher returns than a simple a simple

strategy of just buying a slice of the entire large-cap universe. ⊚ true ⊚ false 21) The dividend discount model states that today's stock price equals the present value of all

expected future dividends. ⊚ true ⊚ false MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 22) Wilt's has earnings per share of $3.52 and dividends per share of $0.53. What is the firm's sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%? A) 2.32% B) 1.59% C) 12.14% D) 15.46% 23) A firm has 128,500 shares of stock outstanding, a sustainable rate of growth of 4.0%, and

$699,200 in next year’s free cash flow. What value would you place on a share of this firm's stock if you require a 15.7% rate of return? A) $42.23 B) $46.51 C) $47.57 D) $54.08

Version 1

24) What dividend yield would be reported in the financial press for a stock that currently pays a

$1.45 dividend per quarter and the most recent stock price was $50? A) 3.1% B) 5.0% C) 11.6% D) 6.3% 25) What is the current price of a share of stock for a firm with $5.26 million in balance-sheet

equity, 526,000 shares of stock outstanding, and a price/book value ratio of 5.30? A) $3.30 B) $23.00 C) $33.00 D) $53.00 26) A stock paying $13 in annual dividends currently sells for $88 and has an expected return of

14%. What might investors expect to pay for the stock one year from now after the next dividend has been paid? A) $75.32 B) $87.32 C) $88.32 D) $100.32 27) A stock currently sells for $80 per share, has an expected return of 16%, and an expected

capital gain rate of 11%. What is the amount of the expected dividend? A) $4.00 B) $4.27 C) $4.54 D) $5.08 28) Dani's just paid an annual dividend of $7.00 per share. What is the dividend expected to be in

five years if the growth rate is 6.2%? A) $9.07 B) $9.46 C) $9.16 D) $9.55

Version 1

29) What should be the price for a common stock paying $3.88 annually in dividends if the

growth rate is zero and the discount rate is 8%? A) $25.14 B) $31.04 C) $46.56 D) $48.50 30) What would be the approximate expected price of a stock when dividends are expected to

grow at a 28% rate in each of years 2 and 3, and then grow at a constant rate of 6% if the stock's required return is 14% and next year's dividend will be $4.40? A) $76.48 B) $70.97 C) $77.53 D) $83.31 31) A stock is expected to pay dividends of $1.30 per share in year 1 and $1.45 per share in year

2. After that, the dividend is expected to increase by 2.5% annually. What is the current value of the stock at a discount rate of 15.0%? A) $11.22 B) $12.42 C) $11.64 D) $13.74 32) What is the value of the expected dividend per share for a stock that has a required return of

17%, a price of $52, and a constant-growth rate of 13%? A) $2.08 B) $4.16 C) $5.20 D) $8.32 33) Suzi owns 190 shares of AB stock. She expects to receive $274 in dividends next year.

Investors expect the stock to sell for $64 a share one year from now. What is the intrinsic value of this stock if the dividend payout ratio is 40% and the discount rate is 13.5%? A) $55.25 B) $57.66 C) $55.56 D) $60.80

Version 1

34) What should be the current price of a share of stock if a $6.05 dividend was just paid, the

stock has a required return of 16%, and a constant dividend growth rate of 2%? A) $22.34 B) $22.05 C) $41.93 D) $44.08 35) How much of a stock's $48 price is reflected in PVGO if it expects to earn $4 per share, has

an expected dividend of $3.40, and a required return of 20%? A) $0 B) $24 C) $26 D) $28 36) Suppose that the total value of dividends to be paid by companies in the Narnian stock

market index is $100 billion. Investors expect dividends to grow over the long term by 8% annually, and they require a 10% return. Now a collapse in the economy leads investors to revise their growth estimate down to 7%. By how much should market values change? A) −33.33% B) zero C) −56.00% D) +56.00% 37) The growth of mature companies is primarily funded by: A) issuing new shares of stock. B) issuing new debt securities. C) reinvesting company earnings. D) increasing accounts payable. 38) The sustainable growth rate represents the _____________ rate at which a firm can grow: A) maximum; while maintaining a constant debt-equity ratio. B) maximum; based solely on internal financing. C) minimum; while maintaining a constant debt-equity ratio. D) minimum; based solely on internal financing.

Version 1

39) Wilt's has earnings per share of $2.98 and dividends per share of $0.35. What is the firm's

sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%? A) 2.14% B) 1.71% C) 12.89% D) 16.06% 40) The sustainable rate of growth: A) increases as the dividend payout ratio increases. B) must be moderate over the long-term even if it is high in the short-term. C) assumes the debt-equity ratio will increase at the same rate as the growth rate. D) must exceed the required rate of return to be used in the dividend discount model. 41) For a firm that repurchases its stock, firm value is most easily estimated by discounting

_____________ A) dividends plus repurchases per share. B) repurchases rather than dividends. C) free cash flows. D) pre-repurchase earnings per share. 42) A firm has 120,000 shares of stock outstanding, a sustainable rate of growth of 3.8%, and

$648,200 in next year’s free cash flow. What value would you place on a share of this firm's stock if you require a 14% rate of return? A) $48.09 B) $52.96 C) $54.02 D) $61.58 43) Which item indicates a flaw in the efficient market hypothesis? A) A bubble in asset prices B) Inflation fears increase interest rates C) Insiders earn excess returns D) Market indexes drop when GDP falls 44) The semi-strong form of the efficient market hypothesis states that: A) the efficient market hypothesis is only half true. B) professional investors make superior profits but amateurs can’t. C) stock prices do not follow a random walk. D) prices reflect all publicly available information.

Version 1

45) If the general sentiment of investors is pessimistic, stock prices are more apt to: A) increase significantly. B) increase slightly. C) remain constant. D) decline. 46) If investors expect a 14% return on a $50 stock that pays a dividend of $2.50, what is the

implied capital gain rate? A) 5% B) 7% C) 9% D) 14% 47) Which of these statements is correct? Free cash flow is: A) available to be paid out to investors as interest or dividends, or to repay debt or buy

back stock. B) positive if the company is issuing debt or stock. C) equal to net income. D) another term for retained earnings. 48) If markets are efficient, when new information about a stock becomes available, the price

will: A) remain unchanged because it already reflects this information. B) accurately and rapidly adjust to include this new information. C) adjust to accurately reflect this new information over the course of the next few days. D) most likely increase because all new information has a positive effect on stock prices. 49) Which statement is correct? A) Stock repurchases invalidate the dividend discount model. B) Stock repurchases do not add value to a business and can be ignored. C) When there are repurchases, it is simpler to value a business by discounting the free

cash flow. D) Stock repurchases increase the number of shares and make it difficult to forecast dividends per share.

Version 1

50) What dividend yield would be reported in the financial press for a stock that currently pays a

$1 dividend per quarter and the most recent stock price was $40? A) 2.5% B) 4.0% C) 10.0% D) 5.0% 51) Which of the following values treats the firm as a going concern? A) Market value B) Book value C) Liquidation value D) Both market and book values 52) A stock is selling for $37.50 and is expected to pay a dividend of $3 at the end of the year. If

investors expect a return of 14%, what must be the sustainable growth rate? A) 4% B) 5% C) 6% D) 7% 53) If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year and the dividend payout

ratio is 40%, what is the stock's current price? A) $24.30 B) $18.00 C) $22.22 D) $40.50 54) With respect to the notion that stock prices follow a random walk, many researchers have

concluded that: A) stock prices reflect a majority of available information about the firm. B) successive price changes are predictable. C) past stock price changes provide little useful information about future stock price changes. D) stock prices always rise excessively in January.

Version 1

55) What is the current price of a share of stock for a firm with $5 million in balance-sheet

equity, 500,000 shares of stock outstanding, and a price/book value ratio of 4? A) $2.50 B) $10.00 C) $20.00 D) $40.00 56) A firm's liquidation value is the amount: A) necessary to repurchase all outstanding shares of common stock. B) realized from selling all assets and paying off all creditors. C) a purchaser would pay to acquire all of the firm's assets. D) shown on the balance sheet as total owners' equity. 57) Which one of the following is least likely to account for an excess of market value over book

value of equity? A) Inaccurate depreciation methods B) High rate of return on assets C) The presence of growth opportunities D) Valuable off-balance sheet assets 58) Firms with valuable intangible assets are more likely to show a(n): A) excess of book value over market value of equity. B) high going-concern value. C) low liquidation value. D) low P/E ratio. 59) Which of the following is inconsistent with a firm that sells for very near book value? A) Low current earnings B) Few, if any, intangible assets C) High future earning power D) Low, unstable dividend payment 60) A stock paying $5 in annual dividends currently sells for $80 and has an expected return of

14%. What might investors expect to pay for the stock one year from now after the next dividend has been paid? A) $82.20 B) $86.20 C) $87.20 D) $91.20

Version 1

61) A stock currently sells for $50 per share, has an expected return of 15%, and an expected

capital gain rate of 10%. What is the amount of the expected dividend? A) $2.50 B) $2.75 C) $3.00 D) $3.50 62) The expected return on a common stock is equal to: A) [(1 + dividend yield) × (1 + capital gain rate)] − 1. B) the capital gain rate + dividend yield. C) (1 + capital gain rate) ÷ (1 + dividend yield). D) the capital gain rate − dividend yield. 63) It is possible to ignore cash dividends that occur very far into the future when using a

dividend discount model because those dividends: A) will most likely be paid to a different investor. B) will most likely not be paid. C) have an insignificant present value. D) have a minimal, if any, potential rate of growth. 64) If the dividend yield for year 1 is expected to be 5% based on a stock price of $25, what will

the year 4 dividend be if dividends grow annually at a constant rate of 6%? A) $1.33 B) $1.49 C) $1.58 D) $1.67 65) Dani's just paid an annual dividend of $6 per share. What is the dividend expected to be in

five years if the growth rate is 4.2%? A) $7.07 B) $7.37 C) $7.14 D) $7.44 66) The value of common stock will likely decrease if: A) the investment horizon decreases. B) the growth rate of dividends increases. C) the discount rate increases. D) dividends are discounted back to the present.

Version 1

67) When valuing stock with the dividend discount model, the present value of future dividends

will: A) change depending on the time horizon selected. B) remain constant regardless of the time horizon selected. C) remain constant regardless of the rate of growth. D) always equal the present value of the terminal price. 68) What should be the price for a common stock paying $3.50 annually in dividends if the

growth rate is zero and the discount rate is 8%? A) $22.86 B) $28.00 C) $42.00 D) $43.75 69) What should you pay for a stock if next year's annual dividend is forecast to be $5.25, the

constant-growth rate is 2.85%, and you require a 15.5% rate of return? A) $31.25 B) $38.87 C) $41.50 D) $42.68 70) What price would you pay today for a stock if you require a rate of return of 13%, the

dividend growth rate is 3.6%, and the firm recently paid an annual dividend of $2.50? A) $27.55 B) $30.28 C) $26.60 D) $31.37 71) What constant-growth rate in dividends is expected for a stock valued at $32.40 if next year's

dividend is forecast at $2.20 and the appropriate discount rate is 13.6%? A) 7.02% B) 6.59% C) 6.81% D) 7.38%

Version 1

72) What rate of return is expected from a stock that sells for $30 per share, pays $1.54 annually

in dividends, and is expected to sell for $32.80 per share in one year? A) 15.03% B) 14.28% C) 14.09% D) 14.47% 73) ABC common stock is expected to have extraordinary growth in earnings and dividends of

20% per year for 2 years, after which the growth rate will settle into a constant 6%. If the discount rate is 15% and the most recent dividend was $2.50, what should be the approximate current share price? A) $31.16 B) $33.23 C) $37.39 D) $47.77 74) What would be the approximate expected price of a stock when dividends are expected to

grow at a 25% rate in each of years 2 and 3, and then grow at a constant rate of 5% if the stock's required return is 13% and next year's dividend will be $4.00? A) $67.60 B) $62.08 C) $68.64 D) $76.44 75) A company with a return on equity of 15% and a plowback ratio of 60% would expect a

constant-growth rate of: A) 4%. B) 9%. C) 21%. D) 25%. 76) What is the plowback ratio for a firm that has earnings per share of $2.68 and pays out $1.75

per share in dividends? A) 28.20% B) 34.70% C) 66.67% D) 71.80%

Version 1

77) A positive value for PVGO suggests that the firm has: A) a positive return on equity. B) a positive plowback ratio. C) investment opportunities with superior returns. D) a high rate of constant growth. 78) Which of the following situations accurately describes a growth stock, assuming that each

firm has a required return of 12%? A) A firm with PVGO = $0. B) A firm with investment opportunities yielding 10%. C) A firm with investment opportunities yielding 15%. D) A firm with PVGO < $0. 79) Other things equal, a firm's sustainable growth rate could increase as a result of: A) increasing the plowback ratio. B) increasing the payout ratio. C) decreasing the return on equity. D) increasing total assets. 80) Under which of the following forms of market efficiency would stock prices always reflect

fair value? A) Weak-form efficiency B) Semi-strong-form efficiency C) Strong-form efficiency D) Semi-weak-form efficiency 81) Investors are willing to purchase stocks having high P/E ratios because: A) they expect these shares to sell for a lower price. B) they expect these shares to offer higher dividend payments. C) these shares are accompanied by guaranteed earnings. D) they expect these shares to have greater growth opportunities. 82) Which of the following is least likely to contribute to going concern value? A) High liquidation value B) Extra earning power C) Future investment opportunities D) Intangible assets

Version 1

83) What happens to a firm that reinvests its earnings at a rate equal to the firm's required return? A) Its stock price will remain constant. B) Its stock price will increase by the sustainable growth rate. C) Its stock price will decline unless the dividend payout ratio is zero. D) Its stock price will decline unless the plowback rate exceeds the required return. 84) What can be expected to happen when stocks having the same expected risk do not have the

same expected return? A) At least one of the stocks becomes temporarily mispriced. B) This is a common occurrence indicating that one stock has more PVGO. C) This cannot happen if the shares are traded in an auction market. D) The expected risk levels will change until the expected returns are equal. 85) The terminal value of a share of stock: A) is similar to the maturity value of a bond. B) refers to the share value at the end of an investor's holding period. C) is the value received by investors upon liquidation of the firm. D) is the price for shares traded through a dealers' market. 86) A stock is expected to pay dividends of $1.20 per share in year 1 and $1.35 per share in year

2. After that, the dividend is expected to increase by 2.5% annually. What is the current value of the stock at a discount rate of 14.5%? A) $11.29 B) $10.87 C) $12.07 D) $13.39 87) Jefferson's recently paid an annual dividend of $1.31 per share. The dividend is expected to

decrease by 4% each year. How much should you pay for this stock today if your required return is 16%? A) $6.29 B) $5.74 C) $10.48 D) $11.57 88) Which one of the following is more likely to be responsible for a firm having a low PVGO? A) ROE exceeds required return B) Plowback is very high C) Market value of equity is close to book value D) Book value of equity is low

Version 1

89) What is the most likely value of the PVGO for a stock with a current price of $50, expected

earnings of $6 per share, and a required return of 20%? A) $10 B) $20 C) $25 D) $30 90) What is the expected constant-growth rate of dividends for a stock with a current price of

$87, an expected dividend payment of $5.40 per share, and a required return of 16%? A) 8.48% B) 6.25% C) 9.79% D) 5.23% 91) Which of the following is true for a firm having a stock price of $42, an expected dividend of

$3, and a sustainable growth rate of 8%? A) It has a required return of 15.14%. B) It has a dividend yield of 7.35%. C) The stock price is expected to be $45 next year. D) It has a capital gain rate of 7.14%. 92) What is the value of the expected dividend per share for a stock that has a required return of

16%, a price of $45, and a constant-growth rate of 12%? A) $1.80 B) $3.60 C) $4.50 D) $7.20 93) What is the required return for a stock that has a constant-growth rate of 3.3%, a price of $25,

an expected dividend of $2.10, and a P/E ratio of 14.4? A) 12.40% B) 10.92% C) 11.70% D) 11.26%

Version 1

94) What should be the price of a stock that offers a $4.32 annual dividend with no prospects of

growth, and has a required return of 12.5%? A) $0 B) $4.86 C) $34.56 D) $30.24 95) Psychologists have observed that: A) once investors have made a loss, they become much more willing to take risks. B) investors tend to place too much faith in their ability to spot mispriced stocks. C) when forecasting the future, people tend to place too little weight on recent events. D) investors like stocks of companies whose names begin with letters that occur early in

the alphabet. 96) If The Wall Street Journal lists a stock's dividend as $1, then it is most likely the case that the

stock: A) pays $1 per share per quarter. B) paid $.25 per share per quarter for the past year. C) paid $1 during the past quarter, with no future dividends forecast. D) is expected to pay a dividend of $1 per share at the end of next year. 97) Suzi owns 100 shares of AB stock. She expects to receive $238 in dividends next year.

Investors expect the stock to sell for $46 a share one year from now. What is the intrinsic value of this stock if the dividend payout ratio is 40% and the discount rate is 13.5%? A) $38.19 B) $42.63 C) $40.53 D) $45.77 98) What is the minimum amount shareholders should expect to receive in the event of a

complete corporate liquidation? A) Market value of equity B) Book value of equity C) Zero D) Shareholders may be required to pay to be liquidated

Version 1

99) If the price of a stock falls on 4 consecutive days of trading, then stock prices: A) cannot be following a random walk. B) can still be following a random walk. C) are almost certain to increase the following day. D) are almost certain to decrease the following day. 100)

What should be the stock value one year from today for a stock that currently sells for $35, has a required return of 15%, an expected dividend of $2.80, and a constant dividend growth rate of 7%? A) $37.45 B) $37.80 C) $40.25 D) $43.05

101)

The required return on an equity security is comprised of a: A) dividend yield and ROE. B) current yield and a terminal value. C) sustainable growth rate and a plowback yield. D) dividend yield and a capital gains yield.

102)

What should be the current price of a share of stock if a $5 dividend was just paid, the stock has a required return of 20%, and a constant dividend growth rate of 6%? A) $19.23 B) $25.00 C) $35.71 D) $37.86

103)

What should be the current price of a stock if the expected dividend is $5, the stock has a required return of 20%, and a constant dividend growth rate of 6%? A) $19.23 B) $25.00 C) $35.71 D) $37.86

104)

Reinvesting earnings into a firm will not increase the stock price unless: A) the new paradigm of stock pricing is maintained. B) true depreciation is less than reported depreciation. C) the firm's dividends are growing also. D) the return on the new investments exceeds the firm's required return.

Version 1

105)

What proportion of earnings is being plowed back into the firm if the sustainable growth rate is 8% and the firm's ROE is 20%? A) 60% B) 80% C) 20% D) 40%

106)

How much of a stock's $30 price is reflected in PVGO if it expects to earn $4 per share, has an expected dividend of $2.50, and a required return of 20%? A) $0 B) $6 C) $8 D) $10

107)

What is the expected constant-growth rate of dividends for a stock currently priced at $50, that just paid a dividend of $4, and has a required return of 18%? A) 3.41% B) 5.50% C) 9.26% D) 12.5%

108)

According to random walk theory, what are the (approximate) odds that a stock will increase in price today after having increased on two consecutive days of trading? A) 0% B) 25% C) 50% D) 100%

109)

If the liquidation value of a corporation exceeds the market value of the equity, then the: A) firm has no value as a going concern. B) firm's stock will sell for book value. C) firm is not taking advantage of available growth opportunities. D) dividend payout ratio has been too high.

110)

In a valuation of a nonconstant dividend growth stock, the terminal value represents the: A) point at which the present value of future dividends equals zero. B) maturity date of the stock. C) present value of future dividends from that point on. D) highest value that the stock will attain.

Version 1

111)

Which one of the following situations is most likely to occur today for a stock that went down in price yesterday? A) The stock will increase in price. B) The stock will decrease in price. C) The stock has a 30% chance of decreasing in price. D) The stock has no predictable price-change pattern.

112)

Based on the random walk theory, if a stock's price decreased last week, then this week the price: A) will reverse last week's loss and go up. B) will continue last week's decline. C) will stand still until new information is released. D) has an equal chance of going either up or down.

113)

Research indicates that the correlation coefficient between successive days' stock price changes is: A) quite close to +1. B) quite close to −1. C) quite close to zero. D) directly related to the stock's beta.

114)

An analyst who relies on past cycles of stock pricing to make investment decisions is: A) performing fundamental analysis. B) relying on strong-form market efficiency. C) assuming that the market is not even weak-form efficient. D) relying on the random walk of stock prices.

115)

Which statement is correct? A) When stock prices barely change for a while, they are said to be stuck in a "bubble." B) Bubbles can result when prices rise rapidly; investors buy assuming prices will continue to rise. C) Most bubbles with hindsight can be justified by the improved fundamentals. D) "Bubbles" is another term for stocks in high-tech industries.

116)

If it proves possible to make abnormal profits based on information regarding past stock prices, then the market is: A) weak-form efficient. B) not weak-form efficient. C) semi-strong-form efficient. D) strong-form efficient.

Version 1

117)

Which statement is correct? A) The momentum factor refers to the tendency for stock price changes to reverse. B) The momentum factor refers to the tendency for stock price changes to persist for a while and then revert. C) The momentum factor implies that stock prices are rather like a pendulum. D) The momentum factor is inconsistent with the strong form of the efficient market hypothesis.

118)

Which statement is correct? A) It is much easier to judge whether the absolute level of stock prices is correct rather than whether their relative levels are correct. B) It is much easier to judge whether relative stock prices are correct than to judge whether their absolute level is correct. C) Most tests of market efficiency are concerned with the absolute level of stock prices. D) If relative prices are correct, then absolute prices must be correct also.

119)

Market efficiency implies A) that investors are irrational. B) that there is no point to buying common stocks. C) that consistently superior performance is very difficult even for professional investors. D) that there are no taxes.

120)

If no price change occurs in a stock on the day that it announces its next dividend, it can be assumed that: A) the stock market is inefficient. B) the dividend was reduced. C) the market was expecting this information. D) technical analysts are not following this stock.

121)

When investors are not capable of making superior investment decisions on a consistent basis based on past prices or public or private information, the market is said to be: A) weak-form efficient. B) semi-strong-form efficient. C) strong-form efficient. D) fundamentally efficient.

Version 1

122)

Evidence that newly issued stocks tend to underperform the market over the following years: A) is a natural result of risk aversion. B) is exactly what you would expect in an efficient market. C) is inconsistent with the semi-strong form of the efficient market hypothesis. D) is evidence against the random walk hypothesis.

123)

For corporate financial managers an important lesson of market efficiency is to: A) trust market prices unless you have a clear advantage that ensures the odds are in your favor. B) issue stock after a rise in price. C) be on the lookout for undervalued companies to take over. D) your company should be able to make healthy profits from its foreign exchange dealings.

124)

When new information becomes available in the market, evidence generally suggests that: A) insiders will be the only investors to gain. B) it takes at least ten trading days for stock prices to adjust. C) stock prices will adjust to the information rapidly. D) transaction costs will erase any benefit of trading on the information.

125)

Suppose that the total value of dividends to be paid by companies in the Narnian stock market index is $100 billion. Investors expect dividends to grow over the long term by 5% annually, and they require a 10% return. Now a collapse in the economy leads investors to revise their growth estimate down to 4%. By how much should market values change? A) −16.67% B) zero C) −20% D) +20%

126)

Your broker suggests that you can make consistent excess profits by purchasing stocks on the 20th of the month and selling them on the last day of the month. If this is true, then: A) the market is only semi-strong-form efficient, but not weak-form efficient. B) the market violates at least weak-form efficiency. C) insiders will be the only investors to profit. D) prices follow a random walk.

Version 1

127)

If a firm unexpectedly raises its dividend permanently and by a substantial amount, the firm's stock price: A) should rise, given dividend discount models. B) should decline, given discounted cash flow analysis. C) will remain constant, due to market efficiency. D) remain constant, due to random walk behavior.

128)

The statement that there are no free lunches on Wall Street suggests that: A) the market is weak-form inefficient. B) there is no return to technical or fundamental analysis. C) security prices reflect all available information. D) food stocks offer the lowest rates of return.

Version 1

Answer Key Test name: Ch07 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) FALSE 6) FALSE 7) FALSE 8) FALSE 9) TRUE 10) FALSE 11) FALSE 12) FALSE 13) TRUE 14) TRUE 15) FALSE 16) FALSE 17) TRUE 18) TRUE 19) FALSE 20) FALSE 21) TRUE 22) D

Sustainable growth rate = ROE × plowback ratio Sustainable growth rate = 0.182 × [($3.52 − 0.53) ÷ $3.52] Sustainable growth rate = 0.1546, or 15.46% 23) B

24) C

Dividend yield = ($1.45 × 4) ÷ $50 = 0.116, or 11.6% 25) D

Price = 5.30 × ($5,260,000 ÷ 526,000) = $53.00

Version 1

26) B

27) A

Dividend yield = 0.16 − 0.11 = 0.05 Expected dividend = 0.05 × $80 = $4.00 28) B

29) D

Price = $3.88 ÷ 0.08 = $48.50 30) C

31) A

32) A

33) B

34) D

35) D

PVGO = $48.00 − ($4 ÷ 0.2) = $28 36) A

37) C

Version 1

38) A 39) D

Sustainable growth rate = ROE × plowback ratio Sustainable growth rate = 0.182 × [($2.98 − 0.35) ÷ $2.98] Sustainable growth rate = 0.1606, or 16.06% 40) B 41) C 42) B

43) A 44) D 45) D 46) C

Capital gain rate = 0.14 − $2.50 ÷ $50 = 0.09, or 9% 47) A 48) B 49) C 50) C

Dividend yield = ($1 × 4) ÷ $40 = 0.100, or 10.0% 51) A 52) C

53) D

Price = 13.5 × $3 = $40.50 54) C 55) D

Price = 4 × ($5,000,000 ÷ 500,000) = $40 56) B 57) A 58) B 59) C

Version 1

60) B

61) A

Dividend yield = 0.15 − 0.10 = 0.05 Expected dividend = 0.05 × $50 = $2.50 62) B 63) C 64) B

65) B

66) C 67) B 68) D

Price = $3.50 ÷ 0.08 = $43.75 69) C

Price = $5.25 ÷ (0.155 − 0.0285) = $41.50 70) A

71) C

72) D

73) C

74) C

Version 1

75) B

g = 0.15 × 0.60 = 0.09, or 9% 76) B

Plowback ratio = ($2.68 − 1.75) ÷ $2.68 = 0.3470, or 34.70% 77) C 78) C 79) A 80) C 81) D 82) A 83) A 84) A 85) B 86) B

87) A

88) C 89) B

With a 100% payout ratio, the stock would be valued at $30 ($6 ÷ 0.20 = $30). Thus, the $20 of additional price must represent the PVGO. 90) C

91) A

Required return = $3 ÷ $42 + 0.08 = 0.1514, or 15.14% 92) A

93) C

Version 1

94) C

P = $4.32 ÷ 0.125 = $34.56 95) B 96) B 97) B

98) C 99) B 100) A

101) 102)

D D

103)

104) 105)

D D 8% = 20% × plowback → Plowback = 40% 106)

D PVGO = $30.00 − ($4.00 ÷ 0.2) = $10.00 107)

C $50.00 = $4.00 × (1 + g) ÷ (0.18 − g) → g = 9.26% 108) 109) 110) 111) 112) 113)

C A C D D C

Version 1

114) 115) 116) 117) 118) 119) 120) 121) 122) 123) 124) 125)

C B B B B C C C C A C A

126) 127) 128)

B A C

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) As the opportunity cost of capital decreases, the net present value of a project increases. ⊚ true ⊚ false 2) The IRR is the rate of return on the cash flows of the investment, also known as the

opportunity cost of capital. ⊚ true ⊚ false 3) Projects with an NPV of zero decrease shareholders' wealth by the cost of the project. ⊚ true ⊚ false 4) When calculating IRR with a trial and error process, discount rates should be raised when

NPV is positive. ⊚ true ⊚ false 5) Unlike using IRR, selecting projects according to their NPV will always lead to a correct

accept-reject decision. ⊚ true ⊚ false 6) For mutually exclusive projects, the project with the higher IRR is the correct selection, even

if a different project has the higher NPV. ⊚ true ⊚ false 7) When using a profitability index to select projects, a high value is preferred over a low value. ⊚ true ⊚ false 8) A project's payback period is the length of time necessary to generate an NPV of zero. ⊚ true ⊚ false

Version 1

9) The payback period considers all project cash flows. ⊚ true ⊚ false 10) Both the NPV and the internal rate of return methods recognize that the timing of cash flows

affects project value. ⊚ true ⊚ false 11) If a project has multiple IRRs, the lowest one is incorrect. ⊚ true ⊚ false 12) Because of deficiencies associated with the payback method, it is seldom used in corporate

financial analysis today. ⊚ true ⊚ false 13) A risky dollar is worth more than a safe one. ⊚ true ⊚ false 14) When choosing among mutually exclusive projects with similar lives, the choice is easy

using the NPV rule. As long as at least one project has positive NPV, simply choose the project with the highest NPV. ⊚ true ⊚ false 15) When we compare assets with different lives, we should select the one that has the lowest

equivalent annual cost. ⊚ true ⊚ false 16) For many firms the limits on capital funds are "soft." By this we mean that the capital

rationing is not imposed by investors. ⊚ true ⊚ false

Version 1

17) Soft rationing should never cost the firm anything. ⊚ true ⊚ false 18) For most managers, discounted cash-flow analysis is in fact the dominant tool for project

evaluation. ⊚ true ⊚ false 19) The payback rule states that a project is acceptable if you get your money back within a

specified period. ⊚ true ⊚ false 20) The payback rule always makes shareholders better off. ⊚ true ⊚ false 21) When you have to choose between projects with different lives, you should put them on an

equal footing by computing the equivalent annual annuity or benefit of the two projects. ⊚ true ⊚ false 22) When you are considering whether to replace an aging machine with a new one, you should

compare the equivalent annual cost of operating the old one with the equivalent annual cost of the new one. ⊚ true ⊚ false 23) The equivalent annual cost method should be used when comparing projects with different

life spans and different initial investments. ⊚ true ⊚ false

Version 1

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 24) What is the maximum that should be invested in a project at time zero if the inflows are estimated at $53,000 annually for 3 years, and the cost of capital is 9%? A) $139,260.00 B) $108,845.68 C) $115,740.00 D) $134,158.62 25) What is the maximum amount a firm should pay for a project that will return $17,000

annually for 5 years if the opportunity cost is 10%? A) $27,378.68 B) $64,443.38 C) $70,878.78 D) $54,424.02 26) What is the IRR for a project that costs $108,000 and provides annual cash inflows of

$31,600 for 6 years starting one year from today? A) 18.91% B) 15.67% C) 14.84% D) 20.09% 27) Using the Profitability Index rule, which of the four projects is the best investment? Project NPV Investment A $ 3.6 million $ 4.1 million B $ 2.5 million $ 3.8 million C $ 4.8 million $ 6.9 million D $ 5.7 million $ 8.9 million A) Project C B) Project D C) Project A D) Project B 28) What is the IRR of a project that costs $108,800 and provides cash inflows of $18,600

annually for 6 years? A) 0.73% B) 1.55% C) 7.32% D) 15.55%

Version 1

29) If a project costs $74,750 and returns $19,000 per year for 5 years, what is its IRR? A) 8.56% B) 6.97% C) 8.08% D) 7.25% 30) What is the NPV for the following project cash flows at a discount rate of 15%?

, A) −$415.12 B) −$244.42 C) $244.42 D) $415.12

.

31) Which mutually exclusive project would you select, if both are priced at $1,330 and your

required return is 16%: Project A with three annual cash flows of $1,260; or Project B, with 3 years of zero cash flow followed by 3 years of $2,025 annually? A) Project B B) Project A C) You are indifferent since the NPVs are equal. D) Neither project should be selected. 32) What is the profitability index for a project costing $41,400 and returning $18,000 annually

for 4 years at an opportunity cost of capital of 13%? A) 0.293 B) 0.674 C) 1.054 D) 1.816 33) Which of the following statements is true for a project with a $22,100 initial cost, cash

inflows of $7,367 per year for 6 years, and a discount rate of 10%? A) Its profitability index is 0.452. B) Its IRR is 17.85%. C) Its IRR is 17.85%. D) Its profitability index is 0.452.

Version 1

34) What is the minimum cash flow that could be received at the end of year 3 to make the

following project "acceptable"? Initial cost = $105,600; cash flows at end of years 1 and 2 = $36,960; opportunity cost of capital = 10%. A) $32,420 B) $32,926 C) $42,182 D) $55,176 35) If a project's IRR is 13% and the project provides annual cash flows of $16,200 for 4 years,

how much did the project cost? A) $48,186.44 B) $55,777.55 C) $45,478.66 D) $52,651.48 36) A polisher costs $11,600 and will cost $21,600 a year to operate and maintain. If the discount

rate is 12% and the polisher will last for 5 years, what is the equivalent annual cost of the tool? A) $21,591.13 B) $19,343.02 C) $24,367.82 D) $24,817.95 E) $21,591.13 37) A company owns a tract of timber that will keep growing for a number of years. It calculates

that the timber’s value less the cost of harvesting is currently $48,000 and that this figure will grow by 10% in the next year and by 5% in the following year. If the cost of capital is 8%, when should the company harvest the timber? A) Today B) Year 1 C) Year 2 D) Harvest a third of the timber each year 38) You can continue to use your less efficient machine at a cost of $8,300 annually.

Alternatively, you can purchase a more efficient machine for $12,300 plus $5,300 annual maintenance. If the new machine lasts 5 years and the cost of capital is 15%, you should: A) buy the new machine and save $615 in equivalent annual costs. B) buy the new machine and save $477 in equivalent annual costs. C) keep the old machine and save $477 in equivalent annual costs. D) keep the old machine and save $669 in equivalent annual costs.

Version 1

39) A project's opportunity cost of capital is: A) the return that shareholders could expect to earn by investing in the financial markets. B) the return earned by investing in the project. C) equal to the average return on all company projects. D) designed to be less than the project's IRR. 40) Which one of the following statements is correct for a project with a positive NPV? A) The IRR must be greater than 0. B) Accepting the project has an indeterminate effect on shareholders. C) The discount rate exceeds the cost of capital. D) The profitability index equals 1. 41) If the net present value of a project that costs $20,000 is $5,000 when the discount rate is

10%, then the: A) project's IRR equals 10%. B) project's rate of return is greater than 10%. C) net present value of the cash inflows is $4,500. D) project's cash inflows total $25,000. 42) What is the NPV of a project that costs $100,000 and returns $50,000 annually for 3 years if

the opportunity cost of capital is 14%? A) $13,397.57 B) $14,473.44 C) $16,081.60 D) $33,748.58 43) The decision rule for net present value is to: A) accept all projects with cash inflows exceeding the initial cost. B) reject all projects with rates of return exceeding the opportunity cost of capital. C) accept all projects with positive net present values. D) reject all projects lasting longer than 10 years.

Version 1

44) Given the various investment options listed, what investment criteria concept might make an

investor select Project B over other projects? Project A B C D

NPV $ 1.3 million $ 2.2 million $ 3.5 million $ 4.6 million

Profitability Index 0.23 0.54 0.49 0.38

A) The Gold Standard B) The Rate of Return rule C) Capital rationing D) Selection bias 45) If a project’s NPV is calculated to be negative what should a project manager do? A) The discount rate should be decreased. B) The profitability index should be calculated. C) The present value of the project cost should be determined. D) The project should be rejected. 46) Which one of the following changes will increase the NPV of a project? A) A decrease in the discount rate B) A decrease in the size of the cash inflows C) An increase in the initial cost of the project D) A decrease in the number of cash inflows 47) What is the maximum that should be invested in a project at time zero if the inflows are

estimated at $50,000 annually for 3 years, and the cost of capital is 9%? A) $101,251.79 B) $109,200.00 C) $126,564.73 D) $130,800.00 48) When a manager does not accept a positive-NPV project, shareholders face an opportunity

cost in the amount of the: A) project's initial cost. B) project's NPV. C) project's discounted cash inflows. D) soft capital rationing budget.

Version 1

49) What is the maximum amount a firm should pay for a project that will return $15,000

annually for 5 years if the opportunity cost is 10%? A) $24,157.65 B) $56,861.80 C) $62,540.10 D) $48,021.19 50) Which of the following projects would you feel safest in accepting? Assume the opportunity

cost of capital to be 12% for each project. A) "A" has a small, but negative, NPV. B) "B" has a positive NPV when discounted at 10%. C) "C's" cost of capital exceeds its rate of return. D) "D" has a zero NPV when discounted at 14%. 51) As the discount rate is increased, the NPV of a specific project will: A) increase. B) decrease. C) remain constant. D) decrease to zero, then remain constant. 52) A project requires an initial outlay of $10 million. If the cost of capital exceeds the project

IRR, then the project has a(n): A) positive NPV. B) negative NPV. C) acceptable payback period. D) positive profitability index. 53) Using the "gold standard" of investment criteria, which project should be selected? Project NPV Investment A $ 2.3 million $ 5.2 million B $ 1.2 million $ 2.8 million C $ 3.5 million $ 6.9 million D $ 4.4 million $ 8.9 million A) Project A B) Project B C) Project C D) Project D

Version 1

54) The modified internal rate of return can be used to correct for: A) negative NPV calculations. B) multiple internal rates of return. C) undefined payback periods. D) borrowing projects. 55) The internal rate of return is most reliable when evaluating: A) a single project with alternating cash inflows and outflows over several years. B) mutually exclusive projects of differing sizes. C) a single project with only cash inflows following the initial cash outflow. D) a single project with cash outflows at time 0 and the final year and inflows in all other

time periods. 56) When a project's internal rate of return equals its opportunity cost of capital, then the: A) project should be rejected. B) project has no cash inflows. C) net present value will be positive. D) net present value will be zero. 57) Firms that make investment decisions based on the payback rule may be biased toward

rejecting projects: A) with short lives. B) with long lives. C) with late cash inflows. D) that have negative NPVs. 58) One way to increase the NPV of a project is to decrease the: A) project's payback period. B) profitability index. C) time until the receipt of cash inflows. D) number of project IRRs. 59) What is the IRR for a project that costs $100,000 and provides annual cash inflows of

$30,000 for 6 years starting one year from today? A) 19.91% B) 16.67% C) 15.84% D) 22.09%

Version 1

60) Using the Profitability Index rule, which of the four projects is the best investment? Project NPV Investment A $ 2.3 million $ 5.2 million B $ 1.2 million $ 2.8 million C $ 3.5 million $ 6.9 million D $ 4.4 million $ 8.9 million A) Project A B) Project B C) Project C D) Project D 61) What is the IRR of a project that costs $100,000 and provides cash inflows of $17,000

annually for 6 years? A) 0.57% B) 1.21% C) 5.69% D) 12.10% 62) An investment costs $100,000 and provides a cash inflow of $17,000 per year. If the discount

rate is 13.1%, how long must the cash inflows last for it to be an acceptable investment? A) 24 years B) 6 years C) 10 years D) 12 years 63) If a project costs $72,000 and returns $18,500 per year for 5 years, what is its IRR? A) 8.98% B) 7.39% C) 8.50% D) 7.67% 64) If the IRR for a project is 15%, then the project's NPV would be: A) negative at a discount rate of 10%. B) positive at a discount rate of 20%. C) negative at a discount rate of 20%. D) positive at a discount rate of 15%.

Version 1

65) As long as the NPV of a project declines smoothly with increases in the discount rate, the

project is acceptable if its: A) internal rate of return is positive. B) payback period is greater than one. C) rate of return exceeds the cost of capital. D) cash inflows equal the initial cost. 66) A project can have as many different internal rates of return as it has: A) cash inflows. B) cash outflows. C) periods of cash flow. D) changes in the sign of the cash flows. 67) What is the NPV for the following project cash flows at a discount rate of 15%?

. A) −$308.70 B) −$138.00 C) $138.00 D) $308.70 68) What is the IRR of a project with the following cash flows:

? A) Zero B) 10% C) 18% D) 5%

69) A project costing $20,000 generates cash inflows of $9,000 annually for the first 3 years,

followed by cash outflows of $1,000 annually for 2 years. At most, this project has _________ IRR(s). A) one B) two C) three D) five

Version 1

70) How many IRRs are possible for the following set of cash flows?

. A) One B) Two C) Three D) Four 71) Given a particular set of project cash flows, which one of the following statements must be

correct? A) There can be only one NPV for the project. B) There can be only one IRR for the project. C) There can be more than one IRR for the project. D) There can be up to two profitability indexes for any project. 72) When projects are mutually exclusive, you should choose the project with the: A) longer life. B) larger initial size. C) highest IRR. D) highest NPV. 73) When managers select correctly from among mutually exclusive projects, they: A) may give up rate of return for NPV. B) may give up NPV for rate of return. C) have a tendency to select the largest project. D) focus on the payback method to avoid conflicting signals. 74) When evaluating mutually exclusive projects, remember: A) the project with the higher IRR may have the higher NPV at one discount rate and a

lower NPV at another. B) cash flows cannot be discounted when considering mutually exclusive projects. C) mutually exclusive projects produce negative IRR values. D) mutually exclusive projects always have multiple IRRs.

Version 1

75) A firm plans to use the profitability index to select between two mutually exclusive

investments. If no capital rationing has been imposed, which of the following statements is correct? A) Select the project with the higher profitability index B) Select the project with the lower profitability index C) Without capital rationing, both projects can be selected D) Without capital rationing, the NPV method must be used instead 76) When managers cannot determine whether to invest now or wait until costs decrease later,

the rule should be to: A) postpone until costs reach their lowest level. B) invest now to maximize the NPV. C) postpone until the opportunity cost reaches its lowest level. D) invest at the date that provides the highest NPV today. 77) You are analyzing a project that is equivalent to borrowing money. This project's: A) NPV graph rises as discount rates decrease. B) initial cash flow is an outflow of funds. C) value increases when the cost of capital increases. D) acceptance requires its IRR to exceed the cost of capital. 78) If two machines produce the same product but have different lives, you should choose the

machine with the: A) highest IRR. B) longest life. C) lowest equivalent annual cost. D) highest NPV, discounted at the opportunity cost of capital. 79) Which mutually exclusive project would you select, if both are priced at $1,000 and your

required return is 15%: Project A with three annual cash flows of $1,000; or Project B, with 3 years of zero cash flow followed by 3 years of $1,500 annually? A) Project A B) Project B C) You are indifferent since the NPVs are equal. D) Neither project should be selected.

Version 1

80) What is the possible cost of capital rationing? A) The firm may have excess fixed assets. B) The firm is likely to take too many risky projects. C) The firm may miss out on positive NPV opportunities. D) The firm may have too high a cost of capital. 81) Soft capital rationing: A) is costly to shareholders. B) is used to evaluate mutually exclusive projects. C) should be costless to the shareholders of the firm. D) solves the problem of investment timing. 82) Soft capital rationing is imposed upon a firm by _____________, while hard capital rationing

is imposed by _____________. A) management; the capital market B) the capital market; management C) the government; the capital market D) the capital market; the government 83) If a project has a cost of $50,000 and a profitability index of 0.45, then: A) it has a negative NPV. B) its NPV could be positive or negative depending on the cost of capital. C) its cash flow is $100,000. D) it has a positive NPV. 84) In simple cases when hard capital rationing exists, projects may be evaluated by: A) the payback period. B) mutually exclusive IRRs. C) a profitability index. D) the modified internal rate of return. 85) Use of a profitability index to evaluate mutually exclusive projects in the absence of capital

rationing: A) will provide the same rankings as an NPV criterion. B) will maximize NPV, but not IRR. C) can result in misguided selections. D) is technically impossible.

Version 1

86) The profitability index selects projects based on the: A) highest net discounted value at time zero. B) highest internal rate of return. C) largest dollar investment per rate of return. D) largest return per dollar invested. 87) Which of the following investment criteria takes the time value of money into consideration? A) Net present value only B) Profitability index and net present value only C) Internal rate of return and net present value only D) Profitability index, internal rate of return, and net present value 88) When calculating a project's payback period, cash flows are: A) discounted at the opportunity cost of capital. B) discounted at the internal rate of return. C) discounted at the risk-free rate of return. D) not discounted at all. 89) What is the profitability index for a project costing $40,000 and returning $15,000 annually

for 4 years at an opportunity cost of capital of 12%? A) 0.139 B) 0.320 C) 0.500 D) 0.861 90) Which of the following statements is true for a project with a $20,000 initial cost, cash

inflows of $6,667 per year for 6 years, and a discount rate of 15%? A) Its payback period is 3 years. B) Its NPV is $2,094. C) Its IRR is 17.85%. D) Its profitability index is 0.104. 91) The "gold standard" of investment criteria refers to the: A) net present value rule. B) internal rate of return rule. C) payback rule. D) profitability index rule.

Version 1

92) Which of the following investment decision rules tends to improperly reject long-lived

projects? A) Net present value B) Internal rate of return C) Payback period D) Profitability index 93) The ratio of net present value to initial investment is known as the: A) net present value. B) internal rate of return. C) payback period. D) profitability index. 94) For mutually exclusive projects, the IRR can be used to select the best project: A) by calculating the modified internal rate of return. B) by calculating the IRR based on incremental cash flows. C) by using the discount rate to calculate the IRR. D) never. IRR cannot be utilized for mutually exclusive projects. 95) The opportunity cost of capital is equal to: A) the discount rate that makes the project NPV equal zero. B) the return that shareholders could expect by investing their money in the financial

markets. C) a project's internal rate of return. D) the average rate of return for a firm's projects. 96) Occasionally projects may have positive initial cash flows. Such projects: A) are like lending money. B) are like borrowing money. C) have no IRR. D) their IRR increases as the cost of capital increases. 97) A project with an IRR that is less than the opportunity cost of capital should be: A) accepted for all projects. B) accepted only for projects with a positive initial cash flow. C) accepted only for projects with a negative initial cash flow. D) rejected for all projects.

Version 1

98) If a project's expected rate of return exceeds its opportunity cost of capital, one would expect

the: A) profitability index to be negative. B) opportunity cost of capital to be too low. C) project to have a positive NPV. D) NPV to be zero. 99) Which one of the following should be assumed about a project that requires a $100,000

investment at time zero, then returns $20,000 annually for 5 years? A) The NPV is negative. B) The NPV is zero. C) The profitability index is 1.0. D) The IRR is negative. 100)

If two projects offer the same positive NPV, then they: A) also have the same IRR. B) have the same payback period. C) are mutually exclusive projects. D) add the same amount of value to the firm.

101)

What is the minimum cash flow that could be received at the end of year 3 to make the following project "acceptable"? Initial cost = $100,000; cash flows at end of years 1 and 2 = $35,000; opportunity cost of capital = 10%. A) $29,494 B) $30,000 C) $39,256 D) $52,250

102)

According to the NPV rule, all projects should be accepted if NPV is positive when discounted at the: A) internal rate of return. B) opportunity cost of capital. C) risk-free interest rate. D) accounting rate of return.

Version 1

103)

If a project's IRR is 13% and the project provides annual cash flows of $15,000 for 4 years, how much did the project cost? A) $44,617.07 B) $52,208.18 C) $41,909.29 D) $49,082.11

104)

A project's payback period is determined to be 4 years. If it is later discovered that additional cash flows will be generated in years 5 and 6, then the project's payback period will: A) be reduced. B) be increased. C) be unchanged. D) change but the discount rate must be known to determine the nature of the change.

105)

A polisher costs $10,000 and will cost $20,000 a year to operate and maintain. If the discount rate is 10% and the polisher will last for 5 years, what is the equivalent annual cost of the tool? A) $17,163.04 B) $22,187.84 C) $22,637.97 D) $19,411.15

106)

Selecting the project(s) with the highest NPV(s) is not the correct decision rule when: A) there is capital rationing. B) there are mutually exclusive projects. C) projects are long-lived. D) projects are independent.

107)

The investment timing problem arises when: A) cash flows may occur at the beginning or end of each time period. B) there is a choice between using the payback or NPV rules. C) the project has a positive initial cash flow. D) investment can occur now or at some future point.

Version 1

108)

A company owns a tract of timber that will keep growing for a number of years. It calculates that the timber’s value less the cost of harvesting is currently $50,000 and that this figure will grow by 10% in the next year and by 5% in the following year. If the cost of capital is 8%, when should the company harvest the timber? A) Today B) Year 1 C) Year 2 D) Harvest a third of the timber each year

109)

To justify postponing a project for one year, the NPV needs to increase over that year by a rate that is equal to or greater than: A) the project's IRR. B) the risk-free rate. C) the cost of capital. D) zero.

110)

What happens to the equivalent annual cost of a project as the opportunity cost of capital decreases? A) It increases. B) It decreases. C) It is not affected. D) It depends on whether or not the projects are mutually exclusive.

111)

What is the equivalent annual cost for a project that requires a $40,000 investment at time zero, and a $10,000 annual expense during each of the next 4 years, if the opportunity cost of capital is 10%? A) $20,000.00 B) $21,356.95 C) $22,618.83 D) $25,237.66

112)

A currently used machine costs $10,000 annually to run. What is the maximum that should be paid to replace the machine with one that will last 3 years and cost only $4,000 annually to run? The opportunity cost of capital is 12%. A) $15,209.84 B) $9,607.33 C) $14,410.99 D) $10,338.56

Version 1

113)

Because of its age, your car costs $4,000 annually in maintenance expense. You could replace it with a newer vehicle costing $8,000. Both vehicles would be expected to last 4 more years, at which point they will be valueless. If your opportunity cost is 8%, by how much must maintenance expense decrease on the newer vehicle to justify its purchase? A) $1,625.40 B) $1,584.63 C) $1,469.08 D) $1,409.54

114)

Projects A and B are mutually exclusive lending projects. Project A has an IRR of 20% while Project B has an IRR of 30%. You would be more likely to choose B unless: A) Project B has a longer life than Project A. B) Project A has more risk than Project B. C) Project A is twice the size of Project B. D) Project B has a larger cash inflow in year 1 than Project A.

115)

What is the decision rule in the case of sign changes that produce multiple IRRs for a project? A) Select the lowest IRR to be conservative. B) Select the highest IRR to maximize the benefits. C) Any or all of the IRRs are justified to use. D) Calculate the modified internal rate of return.

116)

If a project has a payback period of 5 years and a cost of capital of 10%, then the discounted payback will: A) exceed 5 years. B) be less than 5 years. C) decrease if the cost of capital increases. D) decrease if the payback period increases due to revised cash flows.

117)

You can continue to use your less efficient machine at a cost of $8,000 annually. Alternatively, you can purchase a more efficient machine for $12,000 plus $5,000 annual maintenance. If the new machine lasts 5 years and the cost of capital is 15%, you should: A) buy the new machine and save $600 in equivalent annual costs. B) buy the new machine and save $388 in equivalent annual costs. C) keep the old machine and save $388 in equivalent annual costs. D) keep the old machine and save $580 in equivalent annual costs.

Version 1

118)

A firm is considering a project with the following cash flows: Time 0 = +$20,000, Years 1-5 = −$4,500. Should the project be accepted if the cost of capital is 10%? A) Yes; The IRR of the project is 4.06%. B) Yes; The IRR of the project is 12.5%. C) No; The IRR of the project is 4.06%. D) No; The IRR of the project is 12.5%.

Version 1

Answer Key Test name: Ch08 1) TRUE 2) FALSE 3) FALSE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) FALSE 9) FALSE 10) TRUE 11) FALSE 12) FALSE 13) FALSE 14) TRUE 15) TRUE 16) TRUE 17) TRUE 18) TRUE 19) TRUE 20) FALSE 21) TRUE 22) TRUE 23) TRUE 24) D

The maximum investment would equate value of the inflows thereby producing a zero net present value.

with the present

25) B

The maximum investment would equate value of the inflows thereby producing a zero net present value.

with the present

26) A

Version 1

Using a financial calculator: n = 6; PV = −$108,000; PMT = $31,600; FV = 0; CPT I/Y = 18.91% 27) C Project A B C D

NPV $ 3.6 million $ 2.5 million $ 4.8 million $ 5.7 million

Investment $ 4.1 million $ 3.8 million $ 6.9 million $ 8.9 million

PI $3.6 ÷ $4.1 = 0.88 $2.5 ÷ $3.8 = 0.66 $4.8 ÷ $6.9 = 0.70 $5.7 ÷ $8.9 = 0.64

28) A

Using a financial calculator: n = 6; PV = −$108,800; PMT = $18,600; FV = 0; CPT I/Y = 0.73% 29) A

Using a financial calculator: n = 5; PV = −$74,750; PMT = $19,000; FV = 0; CPT I/Y = 8.56% 30) C

NPV = −$1,300 + $950[(1 ÷ 0.15) − 1 ÷ 0.15(1.15)2raise to the power of 2] = $244.42 31) A

Project A Project B NPV A @ 16% NPV B @ 16%

−1,330

1,260

−1,330

2,025

$ 1,499.82 $ 1,583.66

32) A

PI = {−$41,400 + $18,000[(1 ÷ 0.13) − 1 ÷ 0.13(1.13)4raise to the power of 4]} ÷ $41,400 = 0.293 33) A

Version 1

Payback = $22,100 ÷ $7,367 = 3 years NPV = −$22,100 + $7,367[(1 ÷ 0.10) − 1 ÷ 0.10(1.10)6raise to the power of 6] = $9,985 PI = $9,985 ÷ $22,100 = .452 IRR = 24.3% 34) D

NPV = 0 − $105,600 + $36,960 ÷ 1.1 + $36,960 ÷ 1.12raise to the power of 2 + $x ÷ 1.13raise to the power of 3; x = $55,176 A cash flow of $55,176 received in year 3, and discounted at 10%, would increase the NPV to zero. 35) A

PV = $16,200 [1 ÷ 0.13 − 1 ÷ (0.13 × 1.134raise to the power of 4)] = $48,186.44 36) D

The equivalent annual cost is the payment with the same present value 37) B

If harvested in year 1, the timber will have an NPV in year 1 of $48,000 × 1.10 = $52,800, and an NPV today of $52,800 ÷ 1.08 = $48,889 If harvested in year 2, it will have an NPV is year 2 of $52,800 × 1.05 = $55,440 and an NPV today of $55,440 ÷ 1.082raise to the power of 2 = $47,531 38) D

NPV = −$12,300 − $5,300[(1 ÷ 0.15) − 1 ÷ 0.15(1.15)5raise to the power of 5] = −$30,066.42 Using a financial calculator: N = 5; I = 15%; PV = −$30,066.42; FV = 0; CPT PMT = $8,969.28 Change in annual cost = $8,969.28 − $8,300 = $669.28 39) A 40) A 41) B 42) C

NPV = −$100,000 + $50,000[(1 ÷ 0.14) − 1 ÷ 0.14(1.14)3raise to the power of 3] = $16,081.60 43) C

Version 1

44) C

Capital rationing allows investors to select lower NPV projects if they do not have sufficient resources. 45) D 46) A 47) C

The maximum investment would equate value of the inflows thereby producing a zero net present value.

with the present

48) B 49) B

The maximum investment would equate value of the inflows thereby producing a zero net present value.

with the present

50) D 51) B 52) B 53) D

Project D should be selected because it has the highest NPV. The NPV is the Gold Standard of selection criteria. 54) B 55) C 56) D 57) B 58) C 59) A

Using a financial calculator: n = 6; PV = −$100,000; PMT = $30,000; FV = 0; CPT I/Y = 19.91% 60) C

Version 1

Project A B C D

NPV $ 2.3 million $ 1.2 million $ 3.5 million $ 4.4 million

Investment $ 5.2 million $ 2.8 million $ 6.9 million $ 8.9 million

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

61) A

Using a financial calculator: n = 6; PV = −$100,000; PMT = $17,000; FV = 0; CPT I/Y = 0.57% 62) D

NPV = 0 = −$100,000 + $17,000[1 ÷ 0.131 − 1 ÷ (0.131 × 1.131nraise to the power of n)] n = 12 years 63) A

Using a financial calculator: n = 5; PV = −$72,000; PMT = $18,500; FV = 0; CPT I/Y = 8.98% 64) C 65) C 66) D 67) C

NPV = −$1,000 + $700[(1 ÷ 0.15) − 1 ÷ 0.15(1.15)2raise to the power of 2] = $138.00 68) B 69) B 70) C 71) C 72) D 73) A 74) A 75) D 76) D 77) C 78) C 79) A

Version 1

Project A Project B NPV A @ 15% NPV B @ 15%

−1,000

1,000

−1,000

1,500

$ 1,283.23 $ 1,251.89

80) C 81) C 82) A 83) D 84) C 85) C 86) D 87) D 88) D 89) A

PI = {−$40,000 + $15,000[(1 ÷ 0.12) − 1 ÷ 0.12(1.12)4raise to the power of 4]} ÷ $40,000 = 0.139 90) A

Payback = $20,000 ÷ $6,667 = 3 years NPV = −$20,000 + $6,667[(1 ÷ 0.15) − 1 ÷ 0.15(1.15)6raise to the power of 6] = $5,231 PI = $5,231 ÷ $20,000 = 0.262 IRR = 24.3% 91) A 92) C 93) D 94) B 95) B 96) B 97) B 98) C 99) A 100) D

Version 1

101)

D NPV = 0 − $100,000 + $35,000 ÷ 1.1 + $35,000 ÷ 1.12raise to the power of 2 + $x ÷ 1.13raise to the power of 3; x = $52,250 A cash flow of $52,250 received in year 3, and discounted at 10%, would increase the NPV to zero. 102) 103)

B A PV = $15,000 [1 ÷ 0.13 − 1 ÷ (0.13 × 1.134raise to the power of 4)] = $44,617.07 104) 105)

C C

= $85,815.74 The equivalent annual cost is the payment with the same present value:

106) 107) 108)

A D B If harvested in year 1, the timber will have an NPV in year 1 of $50,000 × 1.10 = $55,000, and an NPV today of $55,000 ÷ 1.08 = $50,926 If harvested in year 2, it will have an NPV is year 2 of $55,000 × 1.05 = $57,750 and an NPV today of $57,750 ÷ 1.082raise to the power of 2 = $49,511 109) 110) 111)

C B C

= −$71,698.65 The equivalent annual cost is the payment with the same present value:

112)

C NPV = ($10,000 − $4,000)[(1 ÷ 0.12) − 1 ÷ 0.12(1.12)3raise to the power of 3] = $14,410.99 113)

Version 1

$8,000 = PMT [(1 ÷ 0.08) − 1 ÷ 0.08(1.08)4raise to the power of 4]; PMT = $2,415.37 Maintenance expense decrease required = $4,000 − 2,415.37 = $1,584.63 114) 115) 116) 117)

C D A D NPV = −$12,000 − $5,000[(1 ÷ 0.15) − 1 ÷ 0.15(1.15)5raise to the power of 5] = −$28,760.78 Using a financial calculator: N = 5; I = 15%; PV = −$28,760.78; FV = 0; CPT PMT = $8,579.79 Change in annual cost = $8,579.79 − $8,000 = $579.79 118)

A Using a financial calculator: n = 5; PV = $20,000; PMT = −$4,500; FV = 0; CPT i = 4.06% Given the cash flow signs, it resembles borrowing at 4.06% and, therefore, it is acceptable if this is less than the cost of capital.

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) Capital budgeting analysis focuses on cash flow as opposed to profits. ⊚ true ⊚ false 2) Accurate capital budgeting analysis depends on total cash flows as opposed to incremental

cash flows. ⊚ true ⊚ false 3) Sunk costs influence capital budgeting decisions only when the sunk costs exceed future cash

inflows. ⊚ true ⊚ false 4) Opportunity costs are evaluated for investment decisions at their historical cost. ⊚ true ⊚ false 5) The method of financing a project affects the determination of its cash flows for capital

budgeting purposes. ⊚ true ⊚ false 6) In project analysis, allocations of overhead should be limited to those that represent

additional expense. ⊚ true ⊚ false 7) A reduction in working capital increases cash flows. ⊚ true ⊚ false 8) The present value of the total depreciation tax shield will be higher when an asset uses bonus

depreciation than when depreciated straight-line. ⊚ true ⊚ false

Version 1

9) If a firm sells an asset for more than its value in the IRS’s books, the resulting net cash flow

will be less than the sales price. ⊚ true ⊚ false 10) When a firm makes an investment in working capital, the cash is usually recovered later. ⊚ true ⊚ false 11) Discounting real cash flows with real interest rates provides an overly optimistic idea of a

project's value. ⊚ true ⊚ false 12) Sunk costs remain the same whether or not you accept the project. ⊚ true ⊚ false 13) Sunk costs do not affect the net present value of a project. ⊚ true ⊚ false 14) Investments in working capital, just like investments in plant and equipment, result in cash

inflows. ⊚ true ⊚ false 15) An asset amortized using bonus depreciation will have depreciation expense in 6 different

years. ⊚ true ⊚ false 16) A project will always generate extra overhead costs. ⊚ true ⊚ false 17) Discounting real cash flows at a nominal rate is a serious mistake. ⊚ true ⊚ false

Version 1

18) Suppose you finance a project partly with debt. You should neither subtract the debt proceeds

from the project's required investment, nor would you recognize the interest and principal payments on the debt as cash outflows. ⊚ true ⊚ false 19) When you finance a project partly with debt, you should still view the project as if it were

all-equity financed, treating all cash outflows required for the project as coming from stockholders, and all cash inflows as going to them. ⊚ true ⊚ false 20) As a project comes to its end, there is a disinvestment in working capital, which also

generates positive cash flow as inventories are sold off and accounts receivable are collected. ⊚ true ⊚ false 21) The total depreciation tax shield equals the product of depreciation and the tax rate. ⊚ true ⊚ false 22) Cash flow from operations = (revenues − cash expenses) × (1 − tax rate) + (depreciation × tax

rate). ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 23) What is the effect on a firm's net working capital if a new project requires an increase of $39,000 in inventory, an increase of $19,000 in accounts receivable, an expenditure of $53,000 on machinery, and an increase of $23,600 in accounts payable? A) −$14,000 B) $28,000 C) $34,400 D) $76,600

Version 1

24) A project is expected to increase inventory by $23,000, increase accounts payable by

$12,400, and decrease accounts receivable by $1,600. What is the project's cash flow from net working capital at time zero? A) −$12,200 B) $12,200 C) −$9,000 D) $9,000 25) Net working capital is expected to increase by $33,000 in year 5 of a project. If this extra

working capital is recovered when the project ends in year 6, what is the effect on the project's net present value if the cost of capital is 11%? A) NPV will not be affected because the $33,000 will all be recouped. B) NPV will increase by $19,583.89. C) NPV will decrease by $33,000. D) NPV will decrease by $1,940.75. 26) Your forecast shows $590,000 annually in sales for each of the next 3 years. If your second

and third year predictions have failed to incorporate the 2% expected annual inflation, how far off in total dollar sales is your 3-year forecast? A) $35,636 B) $71,862 C) $62,009 D) $89,975 27) What is the annual depreciation tax shield for a profitable firm in the 21% tax bracket with

$106,000 of annual depreciation expense? A) $11,130 B) $22,260 C) $37,100 D) $68,900 28) What is the operating cash flow for a firm with $522,000 profit before tax, $122,000

depreciation expense, and a 21% tax rate? A) $534,380 B) $369,680 C) $247,680 D) $326,980

Version 1

29) A firm plans to invest $60,000 in R&D that will be depreciated straight-line over 5 years.

What is the present value of the resulting depreciation tax shield if the tax rate is 21% and the discount rate is 10%? A) $8,240.01 B) $9,552.78 C) $12,600.00 D) $47,400.00 30) What is the undiscounted cash flow in the final year of an investment, assuming $23,000

after-tax cash flows from operations, $2,300 from the sale of a fully depreciated machine, a $3,300 investment in working capital, and a 21% tax rate? A) $20,982 B) $27,927 C) $28,117 D) $30,900 31) At a cost of capital of 12%, a project's NPV is $105,000 if you invest today. By what amount

must the initial cost of the project decrease before you would wish to wait 2 years before investing? Assume all else is held constant. A) $20,407 B) $25,022 C) $26,712 D) $28,402 32) A project costs $13,800 and is expected to provide a real cash inflow of $15,000 at the end of

each of years 1 through 5. Calculate the net present value of this project if inflation is expected to be 4% in each year and the firm employs a nominal discount rate of 10.76%. A) $56,578.32 B) $48,535.19 C) $56,193.12 D) $44,407.48 33) An investment today of $25,750 promises to return $10,750 annually for the next 3 years.

What is the real rate of return on this investment if inflation averages 6% annually during the period? A) 5.81% B) 12.26% C) 6.07% D) 8.00%

Version 1

34) What nominal annual return is required on an investment for an investor to experience a

15.50% gain in purchasing power? Assume inflation is 4%. A) 11.19% B) 9.43% C) 15.50% D) 20.12% 35) What is the NPV of a 6-year project that costs $114,000, has annual revenues of $55,600, and

annual costs of $16,400? Assume the investment can be depreciated for tax purposes straightline over 6 years, the corporate tax rate is 21%, and the discount rate is 14%. A) −$16,155.03 B) $21,940.04 C) $3,541.58 D) $15,347.33 36) What rate of nominal growth is expected in sales if they are currently $1,100,000 and are

expected to reach $1,700,000 in 5 years? Assume an inflation rate of 3.5%. A) 3.09% B) 9.10% C) 11.59% D) 25.73% 37) A firm invests $10.85 million in a new stamping machine. It depreciates straight-line for tax

purposes over 5 years. The tax rate is 21%, inflation is 3% a year, and the discount rate is 8%. What is the PV of the depreciation tax shield? A) $651,000 B) $1,819,478 C) $2,722,037 D) $3,255,000 38) Corporate income statements are designed primarily to show: A) cash flows during a period. B) account balances at the end of a period. C) performance during a period. D) market values of assets and liabilities.

Version 1

39) Projects that have negative NPVs should be: A) depreciated over a longer time period. B) charged less in overhead costs. C) discounted using lower rates. D) rejected or abandoned. 40) If the adoption of a new product will reduce the sales of an existing product, then the project

cash flows should: A) reflect only the sales of the new product. B) include only the reduction amount. C) be reduced by the cash that would have been generated by those sales. D) be adjusted upward by the reduction amount. 41) Which one of these represents a cash outflow for a project? A) A sunk cost B) Increase in accounts receivable C) Depreciation D) Accrued expenses 42) Bonus depreciation allows an increase in: A) total depreciation over the asset's life. B) depreciation in the first year only. C) real but not nominal depreciation expense. D) the asset's depreciable cost basis. 43) The rationale for not including sunk costs in capital budgeting decisions is that they: A) are usually small in magnitude. B) revert at the end of the investment. C) have no incremental effect on project cash flows. D) reduce the project's net present value. 44) You are considering the introduction of a new product that will require an investment in new

machinery. Which one of these will lower the net present value of that project? A) A reduction in the firm's total variable costs due to the purchase of the new machine B) A loss of sales of existing products due to the introduction of the new product C) The increase in annual depreciation resulting from the asset purchase D) The sale of the machine after it is fully depreciated

Version 1

45) When is it appropriate to include sunk costs in the evaluation of a project? A) Whenever they are relatively large B) If they improve the project's NPV C) If they are considered to be overhead costs D) Never 46) A firm invests in a 7-year project that requires the purchase of a $135,000 machine tool. This

will be depreciated using 100% bonus depreciation in the first year and will have no salvage value. When will this equipment affect the project's tax payments? A) Every year for 5 years B) At the time of purchase only C) It will have no impact D) Every year for 7 years 47) The opportunity cost of an asset: A) should be depreciated annually. B) should be included in the project cash flows. C) is typically ignored in capital budgeting. D) is important only for parcels of land. 48) Which one of the following is least likely to influence the opportunity cost of an asset? A) Its current market value B) Alternative uses for the asset C) The current demand for the asset D) Its current book value 49) Assume your firm has an unused machine that originally cost $75,000, has a book value of

$20,000, and a market value of $25,000. Ignoring taxes, what is the opportunity cost of using this machine? A) $75,000 B) $25,000 C) $20,000 D) $5,000 50) Which one of the following changes in working capital is least likely if sales increase? A) An increase in inventories B) An increase in accounts payable C) A decrease in accounts receivable D) An increase in notes payable

Version 1

51) A proposed project requires an initial investment of $8,500 in current assets, 75% of which

will be financed with accounts payable. The project will have: A) an initial cash outflow of $8,500 at time zero for net working capital. B) a cash outflow for net working capital at the end of the project. C) a cash inflow at the end of the project from net working capital. D) a cash outflow for net working capital every year of the project's life. 52) Under bonus depreciation: A) all assets are depreciated over 5 years. B) depreciable percentages decline throughout the asset's class life. C) straight-line depreciation percentages are doubled. D) assets are fully expensed when purchased. 53) Bonus depreciation: A) allows for more total depreciation over the asset's life. B) decreases the depreciation tax shield. C) increases the depreciation tax shield. D) allows for assets to be depreciated more rapidly. 54) In which of the following cases will a cash investment in net working capital be most likely? A) Inventory levels will be reduced when the project is introduced. B) All sales related to the project will be cash sales to a subsidiary. C) The project will increase inventory more than accounts payable. D) The project will require additional inventory which will be financed by a supplier. 55) What is the effect on a firm's net working capital if a new project requires a $30,000 increase

in inventory, a $10,000 increase in accounts receivable, a $35,000 expenditure on machinery, and a $20,000 increase in accounts payable? A) −$5,000 B) $10,000 C) $20,000 D) $55,000

Version 1

56) A project is expected to increase inventory by $17,000, increase accounts payable by

$10,000, and decrease accounts receivable by $1,000. What is the project's cash flow from net working capital at time zero? A) −$8,000 B) $8,000 C) −$6,000 D) $6,000 57) Net working capital is expected to increase by $25,000 in year 5 of a project. If this extra

working capital is recovered when the project ends in year 6, what is the effect on the project's net present value if the cost of capital is 15%? A) NPV will not be affected because the $25,000 will all be recouped. B) NPV will increase by $12,429.42. C) NPV will decrease by $25,000. D) NPV will decrease by $1,621.23. 58) Investments in working capital: A) are simply accounting entries and do not affect NPV. B) do not matter because the cash is generally recovered when the project ends. C) increase NPV because they make the project more valuable. D) reduce project NPV. 59) Changes in net working capital can occur at: A) the beginning of a project. B) the end of a project. C) any time during the life of a project. D) the beginning of any accounting period. 60) What effect is likely at the end of the life of a project that required a $20,000 investment in

net working capital? A) The $20,000 must now be paid by the firm. B) The firm receives a $20,000 cash inflow. C) Taxable income is reduced by $20,000. D) No effects are expected because the $20,000 is now a sunk cost. 61) Allocations of overheads should not affect a project's incremental cash flows unless the: A) project actually changes the total amount of overhead expenses. B) overhead will not be recovered at the end of the project. C) overhead is not currently fully allocated to existing projects. D) accountant is required to allocate costs to this project.

Version 1

62) The NPV of an investment proposal becomes negative solely as a result of allocating a

portion of the corporation president's salary. It is most likely the case that: A) the project should be accepted. B) rejecting the project is the correct decision. C) the allocation should be postponed until the project is accepted. D) the salary should be considered an opportunity cost of the project. 63) The correct method to handle overhead costs in capital budgeting is to: A) allocate a portion to each project. B) allocate them to projects with the highest NPVs. C) ignore all except incremental amounts. D) ignore them in all cases. 64) Which one of the following would not be expected to affect the decision of whether to

undertake an investment? A) Income tax rates B) Estimates of future inflation rates C) Sales reductions in other products caused by this investment D) Cost of the feasibility study that was conducted for this project 65) Which one of the following methods will provide a correct analysis for capital budgeting

purposes? A) Discounting real cash flows with real rates. B) Discounting real cash flows with nominal rates. C) Discounting nominal cash flows with real rates. D) Discounting nominal cash flows with either real or nominal rates. 66) The likely effect of discounting nominal cash flows with real interest rates will be to: A) make an investment's NPV appear more attractive. B) make an investment's NPV appear less attractive. C) correctly calculate an investment's NPV if inflation is expected. D) correctly calculate an investment's NPV, regardless of expected inflation. 67) Your forecast shows $500,000 annually in sales for each of the next 3 years. If your second

and third year predictions have failed to incorporate the 3% expected annual inflation, how far off in total dollar sales is your 3-year forecast? A) $45,450 B) $60,900 C) $52,550 D) $76,250

Version 1

68) Which one of the following would be more apt to make an unacceptable project appear

acceptable? A) Discounting real cash flows with real rates B) Discounting nominal cash flows with real rates C) Discounting real cash flows with nominal rates D) Discounting nominal cash flows with nominal rates 69) Capital budgeting proposals should be evaluated as if the project were financed: A) entirely by debt. B) entirely by equity. C) half by debt and half by equity. D) with the highest cost source of funds, to be safe. 70) When calculating cash flow from operations, one should: A) subtract depreciation since it represents the cost of replacing worn-out equipment. B) deduct the depreciation tax shield from after-tax profit. C) use after-tax profit and ignore depreciation. D) add depreciation to after-tax profit. 71) The recovery of an additional investment in working capital is likely to: A) occur at the end of a project's life. B) occur at the beginning of a project's life. C) occur whenever the project first shows a profit. D) be a sunk cost. 72) In what manner does depreciation expense affect investment projects? A) It reduces cash flows by the amount of the depreciation expense. B) It increases cash flows by the amount of the depreciation expense. C) It reduces taxable income by the amount of the depreciation expense. D) It reduces taxes by the amount of the depreciation expense. 73) Given a positive discount rate, which one of the following changes would increase the NPV

of a project? A) Increasing the firm's opportunity cost of capital. B) Reducing the amount of working capital that is needed. C) Spreading the total cash inflows over a longer time interval. D) Increasing the project's estimated expenses.

Version 1

74) What is the annual depreciation tax shield for a profitable firm in the 21% tax bracket with

$100,000 of annual depreciation expense? A) $10,500 B) $21,000 C) $35,000 D) $65,000 75) What is the amount of the annual depreciation tax shield for a firm with $200,000 in net

income, $75,000 in depreciation expense, and a 21% tax rate? A) $15,750 B) $43,750 C) $70,000 D) $75,000 76) What is the operating cash flow for a firm with $500,000 profit before tax, $100,000

depreciation expense, and a 21% tax rate? A) $260,000 B) $325,000 C) $360,000 D) $495,000 77) A tax shield is equal to the reduction in a firm's: A) total tax liability resulting from a tax deductible expense. B) taxable income resulting from depreciation. C) taxable income resulting from a decrease in long-term debt. D) net income caused by depreciation. 78) Which one of the following categories would be least likely to require annual adjustments in

a capital budgeting analysis due to the effects of inflation? A) Sales B) Expenses C) Working capital D) Depreciation expense 79) Why is bonus depreciation often favored for the corporation's set of tax books? A) It increases the total depreciation tax shield over the project's life. B) It reduces the total amount of taxes paid over the project's life. C) It increases net accounting profits over the project's life. D) It allows the depreciation tax savings to be realized earlier.

Version 1

80) A firm plans to invest $50,000 in R&D that will be depreciated straight-line over 5 years.

What is the present value of the resulting depreciation tax shield if the tax rate is 21% and the discount rate is 10%? A) $6,866.67 B) $7,960.65 C) $10,500.00 D) $39,500.00 81) The present value of the depreciation tax shield at any given discount rate is: A) equal for all depreciation methods. B) higher with bonus depreciation than with straight-line depreciation. C) higher for the 7-year recovery period than for the 5-year recovery period class. D) likely to increase annually due to inflation. 82) When the real rate of interest is less than the nominal rate of interest, then: A) disinflation must be occurring. B) investment returns cannot increase the purchasing power of an investment. C) nominal cash flows should be discounted with real rates. D) the rate of inflation must be positive. 83) When a depreciable asset is ultimately sold, the sales price is: A) fully taxable. B) nontaxable. C) nontaxable only if accelerated depreciation was used. D) taxable to the extent that the sales price exceeds book value. 84) Which one of the following statements regarding depreciation is correct? A) The depreciation tax shield adjusts annually with the level of inflation. B) The real amount of annual depreciation is fixed, thus the higher the rate of inflation,

the higher the depreciation tax shield. C) Tax law allows immediate expensing to be used for tax purposes for certain assets. D) Bonus depreciation can be used for accounting purposes but not for tax purposes. 85) The statement "We've got too much invested in that project to pull out now" possibly

illustrates the desire to: A) switch to an accelerated method of depreciation. B) reduce net working capital assigned to the project. C) reduce discount rates to improve NPV. D) recognize sunk costs.

Version 1

86) What is the undiscounted cash flow in the final year of an investment, assuming $10,000

after-tax cash flows from operations, $1,000 from the sale of a fully depreciated machine, a $2,000 investment in working capital, and a 21% tax rate? A) $8,450 B) $12,600 C) $12,790 D) $14,000 87) At a 13% cost of capital, a project's NPV is $100,000 if you invest today. By what amount

must the initial cost of the project decrease before you would wish to wait 2 years before investing? Assume all else is held constant. A) $21,685 B) $26,000 C) $27,690 D) $29,380 88) Which of the following correctly adjusts for depreciation when calculating a project’s

operating cash flow? A) (Revenues − cash expenses) × (1 − tax rate) + (tax rate × depreciation) B) Pretax profit + depreciation tax shield C) After-tax profit − depreciation D) Subtract depreciation since it is not a cash flow. 89) A new inventory system will immediately reduce inventory levels by $100,000. If this

reduction is permanent and the cost of capital is 13%, how does the net working capital change affect company value? A) Company value increases by $100,000. B) NPV increases by $13,000. C) Company value will not change. D) Company value increases by $769,231. 90) The opportunity cost of a resource should be considered in project analysis, unless: A) negative cash flows result from its use. B) the resource was purchased in a prior time period. C) the resource has been fully depreciated. D) the resource has no identifiable market value or alternative use within the firm.

Version 1

91) A new project requires an increase in both current assets and current liabilities of $125,000

each. What is the overall impact on the net working capital investment? A) An increase of zero B) An increase of $125,000 C) An increase of $250,000 D) An increase of $62,500, when averaged over the life of the project 92) The primary difficulty in the allocation of overhead costs to prospective projects is that the: A) allocation will reduce the project's NPV. B) discount rate is unknown. C) costs may not represent an incremental expense. D) expenses may have been previously allocated. 93) If inflation is forecast to increase, which of the company’s following cash flows is most

likely to change? A) The depreciation tax shield B) Labor costs C) Costs of raw materials purchased on a fixed price contract D) Interest payments on its long-term debt 94) A project costs $12,800 and is expected to provide a real cash inflow of $10,000 at the end of

each of years 1 through 5. Calculate the net present value of this project if inflation is expected to be 4% in each year and the firm employs a nominal discount rate of 10.76%. A) $33,522.30 B) $28,756.79 C) $33,294.07 D) $26,311.15 95) An investment today of $25,000 promises to return $10,000 annually for the next 3 years.

What is the real rate of return on this investment if inflation averages 6% annually during the period? A) 3.49% B) 9.78% C) 4.84% D) 6.38%

Version 1

96) What nominal annual return is required on an investment for an investor to experience a 12%

gain in purchasing power? Assume inflation is 4%. A) 7.69% B) 9.29% C) 12.00% D) 16.48% 97) What is the NPV of a 6-year project that costs $100,000, has annual revenues of $50,000, and

annual costs of $15,000? Assume the investment can be depreciated for tax purposes straightline over 6 years, the corporate tax rate is 21%, and the discount rate is 14%. A) −$15,560.04 B) $21,131.99 C) $3,411.14 D) $14,782.09 98) An investment of $120,000 can be depreciated for tax purposes straight-line over 6 years.

The corporate tax rate is 21%. When calculating cash flow: A) the company should deduct a depreciation tax shield of $4,200 a year from after-tax (revenues less cash expenses). B) the company should add a depreciation tax shield of $4,200 a year to after-tax (revenues less cash expenses). C) the company should add a depreciation tax shield of $20,000 a year to after-tax (revenues less cash expenses). D) no adjustment should be made for depreciation since it is not a cash expense. 99) A project that increased sales was accompanied by a $50,000 increase in inventory, a

$20,000 increase in accounts receivable, and a $25,000 increase in accounts payable. Assuming these amounts remain constant, by how much has net working capital increased? A) $5,000 B) $25,000 C) $30,000 D) $45,000 100)

Which of the following costs probably should not be allocated to the investment needed for a new project? A) Project's required increase in accounts receivable B) New warehouse, built for this project C) A portion of the vice president's salary D) Labor expense for employees involved in the project

Version 1

101)

A parcel of corporate land was recently chosen as the new plant site. What cost allocation should the land receive, based on the following: original cost of $200,000, highest market value during time of ownership of $300,000, net book value of $200,000, a recent offer to purchase for $250,000? A) $200,000 B) $250,000 C) $275,000 D) $300,000

102)

Which of the following is true of the depreciation tax shield? A) It increases annually with the rate of inflation. B) It decreases annually in nominal terms. C) It is not altered by inflation. D) The real value of the depreciation is fixed.

103)

Assuming an asset has been fully depreciated, which one of the following statements is correct? A) Its market value is zero. B) Its book value is zero. C) Its book value is the current market value. D) It has neither a book value nor a market value.

104)

New projects can have multiple effects on a firm. Which one of the following appears to be a positive indirect effect? A) Additional working capital will be required at the start of the project. B) The sales force will need to be increased over the life of the project. C) Sales of replacement parts are expected in the future. D) The cost of employee benefits will increase due to new hires.

105)

New projects or products can provide positive indirect effects as well as negative effects. Which one of the following appears to be a negative indirect effect? A) The new machine required for the project uses less electricity than the existing machine. B) Orders for your complementary products are expected to increase. C) Customer orders of supplies for the firm’s existing products are expected to decrease. D) Variable costs are expected to decrease since the firm can order larger quantities.

Version 1

106)

Lew's Metals has a machine sitting idle in its warehouse. The machine originally cost $213,000, has a current book value of $32,300, has a scrap metal value of $13,000, and a market value of $46,900. The machine is totally paid for. What value should be placed on this machine if it is used for a new project? A) $0 B) $13,000 C) $32,300 D) $46,900

107)

A project requires an additional commitment of $100,000 in net working capital in each of years 1 to 4. These extra investments can be recovered in year 5 when the project comes to an end. What is the effect on NPV? A) NPV is reduced by $100,000. B) NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for 4 years. C) NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for each of years 1 to 4 minus the discounted value of the $400,000 that is recovered in year 5. D) No opportunity cost is involved.

108)

The additional inventory investment that is often required for new projects is partially offset by: A) switching to accelerated depreciation methods. B) reducing accounts receivable. C) decreasing equipment purchases. D) increasing accounts payable.

109)

What rate of nominal growth is expected in sales if they are currently $1,000,000 and are expected to reach $1,600,000 in 5 years? Assume an inflation rate of 3.5%. A) 3.20% B) 9.86% C) 12.00% D) 26.49%

110)

What is the effect of using bonus depreciation rather than straight-line depreciation? A) It increases the NPV. B) The total amount of depreciation is increased. C) It allows asset book values to increase with market values. D) It increases gross fixed assets.

Version 1

111)

A firm invests $10 million in a new stamping machine. It depreciates it straight-line for tax purposes over 5 years. The tax rate is 21%, inflation is 4% a year, and the discount rate is 8%. What is the PV of the depreciation tax shield? A) $600,000 B) $1,676,938 C) $2,579,497 D) $3,000,000

112)

Capital budgeting projects typically assume that all cash flows transpire at the end of the year. The reason for this is that: A) less tax liability results from this practice. B) balance sheets are prepared at the end of the year. C) it simplifies the analysis and the resulting errors are usually small compared with the errors in forecasting future cash flows. D) most corporations collect their cash at the end of the year.

113)

Which one of the following is not accurate in depicting the cash flows from operations for an all-equity firm? A) (revenues − cash expenses)(1 − tax rate) + (depreciation × tax rate) B) (revenues − expenses − taxes) C) (net profit + depreciation) D) (revenues − cash expenses − taxes)

114)

Which of the following typically results from using straight-line depreciation rather than bonus depreciation in the set of books for shareholders? A) Net income appears higher during the early periods of depreciation. B) Less money is paid to the Internal Revenue Service over an asset's life. C) Financial managers have more funds from operations available over the asset's life. D) Cash flow from operations will be higher in the second year of the asset's life.

115)

When you evaluate a proposed project you should: A) allocate a percentage of current overhead costs to the project. B) include all indirect effects. C) include sunk costs. D) ignore opportunity costs.

Version 1

116)

Which one of the following formulas is incorrect? A) Operating cash flow = revenues − cash expenses − taxes B) Operating cash flow = net profit + depreciation C) Depreciation tax shield = depreciation × (1 − tax rate) D) Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (depreciation × tax rate)

117)

Which one of these statements is incorrect? A) Real cash flows must be discounted at a real discount rate. B) (1 + real rate of interest) = (1 + nominal rate of interest) ÷ (1 + inflation rate). C) The actual real rate of interest almost equals "nominal rate of interest − inflation rate." D) Inflation rate = nominal rate ÷ real rate − 1.

118)

Which of the following statements regarding investment in working capital is incorrect? A) An investment in working capital, unlike an investment in plant and equipment, represents a positive cash flow when the investment is made. B) Net working capital cash flow is measured by the change in working capital, not the level of working capital. C) Net working capital may change during the life of a project. D) Working capital is generally recovered at the end of a project.

Version 1

Answer Key Test name: Ch09 1) TRUE 2) FALSE 3) FALSE 4) FALSE 5) FALSE 6) TRUE 7) TRUE 8) TRUE 9) TRUE 10) TRUE 11) FALSE 12) TRUE 13) TRUE 14) FALSE 15) FALSE 16) FALSE 17) TRUE 18) TRUE 19) TRUE 20) TRUE 21) TRUE 22) TRUE 23) C

Change in NWC = $39,000 + 19,000 − 23,600 = $34,400 24) C

25) D

ΔNPV = −$33,000 ÷ 1.115raise to the power of 5 + 33,000 ÷ 1.116raise to the power of 6 = −$1,940.75 26) A

Version 1

Difference = $590,000 + ($590,000 × 1.02) + ($590,000 × 1.022raise to the power of 2 ) − ($590,000 × 3) = $35,636 27) B

Depreciation tax shield = $106,000 × 0.21 = $22,260 28) A

OCF = $522,000 × (1 − 0.21) + $122,000 = $534,380 29) B

Annual depreciation tax shield = $60,000 ÷ 5 × 0.21 = $2,520

30) C

31) C

Required decrease = $105,000 × (1.12)2raise to the power of 2 − $105,000 = $26,712 32) B

Real rate = 1.1076 ÷ 1.04 − 1 = 0.065 33) A

Using a financial calculator: n = 3, PV = −$25,750, PMT = $10,750, FV = $0, CPT i/Y = 12.157% Real return = 1.12157 ÷ 1.06 − 1 = 0.0581, or 5.81% 34) D

Nominal rate = 1.1550 × 1.04 − 1 = 0.2012, or 20.12% 35) B

Version 1

= (55,600 − 16,400) × (1 − 0.21) + (0.21 × 114,000 ÷ 6) = $34,958 = $21,940.04 36) B

($1,700,000 ÷ $1,100,000)⅕raise to the power of ⅕ − 1 = 0.0910, or 9.10% 37) B

Annual depreciation tax shield = 0.21 × $10.85 million ÷ 5 = $455,700 38) C 39) D 40) C 41) B 42) B 43) C 44) B 45) D 46) B 47) B 48) D 49) B 50) C 51) C 52) D 53) D 54) C 55) C

Change in NWC = $30,000 + 10,000 − 20,000 = $20,000 56) C

57) D

Version 1

ΔNPV = −$25,000 ÷ 1.155raise to the power of 5 + 25,000 ÷ 1.156raise to the power of 6 = −$1,621.23 58) D 59) C 60) B 61) A 62) A 63) C 64) D 65) A 66) A 67) A

Difference = $500,000 + ($500,000 × 1.03) + ($500,000 × 1.032raise to the power of 2 ) − ($500,000 × 3) = $45,450 68) B 69) B 70) D 71) A 72) C 73) B 74) B

Depreciation tax shield = $100,000 × 0.21 = $21,000 75) A

Depreciation tax shield = $75,000 × 0.21 = $15,750 76) D

OCF = $500,000 × (1 − 0.21) + $100,000 = $495,000 77) A 78) D 79) D 80) B

Annual depreciation tax shield = $50,000 ÷ 5 × 0.21 = $2,100 81) B

Version 1

82) D 83) D 84) C 85) D 86) C

87) C

Required decrease = $100,000 × (1.13)2raise to the power of 2 − $100,000 = $27,690 88) A 89) A 90) D 91) A 92) C 93) B 94) B

Real rate = 1.1076 ÷ 1.04 − 1 = 0.065 95) A

Using a financial calculator: n = 3, PV = −$25,000, PMT = $10,000, FV = $0, CPT i/Y = 9.701% Real return = 1.09701 ÷ 1.06 − 1 = 0.0349, or 3.49% 96) D

Nominal rate = 1.12 × 1.04 − 1 = 0.1648, or 16.48% 97) B

98) B 99) D

Version 1

ΔNWC = $50,000 + 20,000 − 25,000 = $45,000 100) 101) 102) 103) 104) 105) 106) 107) 108) 109)

C B C B C C D C D B ($1,600,000 ÷ $1,000,000)⅕raise to the power of 1/5 − 1 = 0.0986, or 9.86% 110) 111)

A B Annual depreciation tax shield = 0.21 × $10 million ÷ 5 = $420,000 112) 113) 114) 115) 116) 117) 118)

C B A B C D A

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) A capital budget shows a proposed list of investments. ⊚ true ⊚ false 2) The strategic planning portion of the capital budgeting process is essentially a "bottom-up"

process. ⊚ true ⊚ false 3) Competitive advantage is an important element of many successful capital budgeting

proposals. ⊚ true ⊚ false 4) While sensitivity analysis is forward-looking, scenario analysis attempts to reconstruct and

analyze the past. ⊚ true ⊚ false 5) The level of sales that produces a zero project NPV is referred to as the accounting break-

even point. ⊚ true ⊚ false 6) The NPV break-even level of sales will be higher than the accounting break-even level. ⊚ true ⊚ false 7) The degree of operating leverage (DOL) shows the relationship between sales and profits. ⊚ true ⊚ false 8) Operating leverage increases with fixed cost. ⊚ true ⊚ false

Version 1

9) If a large proportion of a firm's costs is fixed, a shortfall in sales will have a magnified effect

on the firm's profits. ⊚ true ⊚ false 10) The greater the DOL, the greater the protection against operating losses during economic

downturns. ⊚ true ⊚ false 11) A firm that employs largely agency staff is likely to have higher operating leverage than one

that employs its staff on long-term contracts. ⊚ true ⊚ false 12) The option to abandon a project becomes more valuable as the possible outcomes become

more varied. ⊚ true ⊚ false 13) Conflicts of interest between shareholders and managers may result in the sacrifice of

attractive capital budgeting proposals. ⊚ true ⊚ false 14) Sensitivity analysis takes into consideration the interrelationship of variables. ⊚ true ⊚ false 15) Scenario analysis allows managers to look at different and sometimes inconsistent

combinations of variables. ⊚ true ⊚ false 16) "What-if" questions ask what will happen to a project in various circumstances. ⊚ true ⊚ false

Version 1

17) What-if analysis can help identify the inputs that are most worth refining before you commit

to a project. ⊚ true ⊚ false 18) The inputs that are most worth refining before you commit to a project are the ones that have

the greatest potential to alter project NPV. ⊚ true ⊚ false 19) Scenario analysis allows managers to look at different but consistent combinations of

interrelated variables. ⊚ true ⊚ false 20) A project that breaks even in accounting terms will have a negative NPV. ⊚ true ⊚ false 21) A project that simply breaks even on an accounting basis gives you your money back but

does not cover the opportunity cost of the capital tied up in the project. ⊚ true ⊚ false 22) Managers that accept projects that only break even on an accounting basis are helping their

shareholders. ⊚ true ⊚ false 23) The time value of money causes accounting break-even sales volume to be higher than NPV

break-even sales. ⊚ true ⊚ false

Version 1

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 24) What is the change in the NPV of a one-year project if fixed costs are increased from $440 to $700, assuming the firm is profitable, has a 21% tax rate, and a 12% cost of capital? A) −$260.00 B) −$220.89 C) −$194.32 D) −$183.39 25) What happens to the NPV of a two-year project if sales less costs are increased in each year

from $1,034 to $1,585? Assume the firm has a 21% tax rate, and a 15% cost of capital. A) NPV increases by $878.34. B) NPV increases by $707.65. C) NPV increases by $551.00. D) NPV increases by $348.10. 26) Assume a 5-year project has a base-case NPV of $219,000, a tax rate of 21%, and a cost of

capital of 14%. What will be the worst-case NPV if the annual after-tax cash flows are reduced in that scenario by $37,400 for each of the 5 years? A) −$90,602.77 B) −$117,918.43 C) $90,602.77 D) $117,918.43 27) A firm has fixed costs of $1.75 million and depreciation of $1.55 million. Variable costs are

64% of sales. What is the accounting break-even level of sales? A) $8.29 million B) $6.50 million C) $9.17 million D) $7.93 million 28) Calculate the ratio of variable costs to sales for a firm with a $3 million accounting break-

even revenue point, $1.58 million of fixed costs, and $640,000 of depreciation. A) 21% B) 26% C) 36% D) 41%

Version 1

29) What is the maximum percentage of variable costs to sales that a firm could have and still

break even with $5 million in revenues, $1.68 million in fixed costs, and $670,000 of depreciation? A) 47% B) 53% C) 63% D) 73% 30) A 6-year project has a zero NPV with sales of $6.35 million and a discount rate of 8%. The

annual cash inflows are equal to 10% of sales minus $450,000. What was the initial investment in the project assuming that none of the investment is recoverable when the project ends? A) $347,324 B) $855,233 C) $947,335 D) $2,242,107 31) A pro football team has an NPV of $238 million. There is a 70% chance the team will get a

new stadium within 1 year and the value of the team will increase to $388 million. To keep the team from moving, a rich local benefactor has offered to buy the team for $219 million today. Given a 12% discount rate, what is the most the current owner should be willing to offer the benefactor to keep the offer on the table until the end of the year? A) $82 million B) $60 million C) $147 million D) $160 million 32) Calculate the NPV break-even level of sales for a project requiring an investment of $3.2

million and providing annual cash flows equal to 15% of sales less $260,000. None of the initial investment is recoverable. Assume the project will generate these cash flows for 10 years and the discount rate is 10%. A) $3,465,086 B) $3,725,086 C) $5,205,235 D) $1,840,931

Version 1

33) Fixed costs including depreciation have increased at Leverage Incorporated, from $4.50

million to $5.80 million. Suppose that the company now breaks even on an accounting basis with sales of $20 million. What must be the break-even variable cost as a percentage of sales? A) 66.7% B) 63.3% C) 71.0% D) 74.2% 34) If the firm's degree of operating leverage is 6.0, what percentage change in sales will result in

a 3% rise in profits? A) 0.50% B) 0.50% C) 2.86% D) 1.13% 35) A project offers a 30% probability of a payoff after one year of $2.2 million and a 70%

chance of a payoff of $1.2 million. What is the maximum you would invest in this project today if the discount rate is 10%? A) $836,363.64 B) $1,363,636.36 C) $1,560,000.00 D) $1,716,000.00 36) If MacCaugh’s pilot project is successful, it will be able to build a plant with an NPV of

$2.09 million in 1 year’s time. Otherwise the pilot investment will be valueless. If the discount rate is 20% and the chances of success are 50%, how much can MacCaugh afford to spend on the pilot project? A) $1,045,000 B) $2,090,000 C) $1,741,667 D) $870,833

Version 1

37) A manufacturer contemplates a change in technology that would reduce fixed costs from

$824,000 to $624,000, and reduce depreciation expense from $149,000 to $124,000. However, the ratio of variable costs to sales would increase from 68% to 80%. What would be the change in the break-even level of revenues? A) Increase of $699,375 B) Increase of $657,070 C) Decrease of $657,070 D) Decrease of $431,675 38) What is the economic break-even level of sales for a project costing $4,150,000 and

generating annual cash flows equal to 0.30 × sales − $480,000? Assume the project will last 10 years and requires a discount rate of 12%. A) $2,282,146 B) $2,547,539 C) $4,048,281 D) $13,971,825 39) What level of management is responsible for originating capital budgeting proposals? A) Senior management B) Divisional management C) Lower management D) All levels of management 40) The capital budget should be consistent with the firm's: A) historical growth in sales. B) strategic plans. C) current level of debt. D) dividend policy. 41) Which one of the following would not be included as a traditional capital budgeting project? A) Machine replacement proposals B) Salary adjustment proposals C) New product proposals D) Plant expansion proposals 42) Which company is likely to have high operating leverage? A) A company with high fixed costs B) A company with high variable costs C) A company with low fixed costs D) A company with moderate variable costs

Version 1

43) Which one of the following capital budgeting proposals is most apt to be associated with a

conflict of interests? A) The proposal with the highest NPV B) The proposal with the longest payback period C) The proposal with the highest IRR and quickest payback D) The proposal to solve pollution problems cited by the EPA 44) Analysis indicates that a project's level of success is primarily dependent upon the firm

controlling the variable costs. What type of analysis was conducted? A) Sensitivity analysis B) Break-even analysis C) Ratio analysis D) Real option analysis 45) Which of the following project analysis techniques does not allow for alteration of multiple

variables simultaneously? A) Sensitivity analysis B) Scenario analysis C) Simulation analysis D) Monte Carlo analysis 46) Soft capital rationing may be beneficial to a firm if it: A) reduces a firm's taxes. B) weeds out proposals with NPVs that have been overstated. C) allows managers to select their favorite projects. D) lowers the cost of capital. 47) The purpose of sensitivity analysis is to show: A) the optimal level of capital expenditures. B) how price changes affect break-even volume. C) seasonal variation in product demand. D) how variables in a project affect profitability. 48) Decision trees are most useful when valuing which type of real option? A) Abandonment B) Expand C) Flexible facilities D) Timing

Version 1

49) Sensitivity analysis evaluates projects by: A) forecasting changes in interest rates that would increase financing costs. B) recording profitability changes while changing one variable at a time. C) ensuring that the project sponsor has the proper incentives. D) testing for interrelated variables. 50) What is the change in the NPV of a one-year project if fixed costs are increased from $400 to

$600, assuming the firm is profitable, has a 21% tax rate, and a 12% cost of capital? A) −$200.00 B) −$178.57 C) −$152.00 D) −$141.07 51) What happens to the NPV of a two-year project if sales less costs are increased in each year

from $1,000 to $1,500? Assume the firm has a 21% tax rate, and a 15% cost of capital. A) NPV increases by $812.85. B) NPV increases by $642.16. C) NPV increases by $500.00. D) NPV increases by $282.61. 52) Which one of the following appears to be a more likely result from using sensitivity analysis? A) Agreement on the appropriate discount rate B) Determination of whether to finance with debt or equity C) Isolation of the pivotal factor in project profitability D) Selection of the best capital budgeting project 53) If a 20% reduction in a project’s forecast sales would still result in a positive NPV, then

sensitivity analysis would suggest that: A) there is little point in further market research. B) a more detailed sales forecast is required. C) the initial sales forecasts were inflated. D) more of the company’s overhead costs can be allocated to this product. 54) If sensitivity analysis concludes that the largest impact on profits would come from changes

in the sales level, then: A) fixed costs should be traded for variable costs. B) variable costs should be traded for fixed costs. C) the project should not be undertaken. D) additional marketing analysis may be beneficial before proceeding.

Version 1

55) Which one of the following statements is correct concerning sensitivity analysis? A) It ignores interrelationships between variables. B) Several variables are allowed to change concurrently. C) It considers all feasible variable combinations. D) It can guarantee a project's success. 56) Sensitivity analysis: A) makes most sense when variables are interrelated. B) gives an idea of the combined effect of pessimistic outcomes. C) allows the manager to weight the various outcomes to provide a better estimate of

NPV. D) forces the manager to identify the underlying factors. 57) Which one of the following techniques may be more appropriate to analyze projects with

interrelated variables? A) Sensitivity analysis B) Scenario analysis C) Break-even analysis D) DOL analysis 58) Which one of the following descriptions is representative of scenario analysis? A) One variable at a time is allowed to change. B) It isolates the unknowns that belong in the model. C) Different combinations of variables are analyzed. D) It represents the "top-down" approach. 59) Which statement is not correct? A) Project proposers tend to be overconfident about the likely success of the project. B) Project proposers often exaggerate the likely profitability in order to gain acceptance. C) Overconfidence and enthusiasm can result in increased effort. D) Most project proposals are based on very conservative forecasts. 60) Assume a 5-year project has a base-case NPV of $213,000, a tax rate of 21%, and a cost of

capital of 14%. What will be the worst-case NPV if the annual after-tax cash flows are reduced in that scenario by $35,000 for each of the 5 years? A) −$92,842.17 B) −$120,157.83 C) $92,842.17 D) $120,157.83

Version 1

61) Which one of the following variables would you suspect to be least significant in a sensitivity

analysis of a fast-food establishment? A) Sales B) Depreciation C) Labor cost D) Food cost 62) A firm has fixed costs of $1.2 million and depreciation of $1 million. Variable costs are 64%

of sales. What is the accounting break-even level of sales? A) $5.23 million B) $3.44 million C) $6.11 million D) $4.87 million 63) Weston's has variable costs that average 68% of sales. If fixed costs increase by $1, what will

be the increase in the break-even level of revenues? A) An increase of $0.68 B) An increase of $1.00 C) An increase of $1.471 D) An increase of $3.125 64) The accounting break-even level of sales represents the point where: A) fixed costs are covered. B) variable costs are covered. C) fixed costs and variable costs are covered. D) sales are equal to the sum of fixed costs, variable costs, and depreciation. 65) The Corner Market has fixed costs of $1,600, depreciation of $1,200, a tax rate of 21%, and a

cost of capital of 12%. Variable costs represent 67% of sales. What minimum level of sales must the market obtain to avoid a net loss on its income statement? A) $8,484.85 B) $6,666.67 C) $7,033.33 D) $7,867.67

Version 1

66) Calculate the accounting break-even level of sales assuming $865,000 of fixed costs,

$400,000 depreciation expense, and a variable costs-to-sales ratio of 65%. A) $2,769,230.77 B) $3,614,285.71 C) $4,237,769.23 D) $1,946.153.85 67) What effect will a reduction in the cost of capital have on the accounting break-even level of

revenues? A) It raises the break-even level. B) It reduces the break-even level. C) It has no effect on the break-even level. D) This cannot be determined without knowing the length of the investment horizon. 68) Break-even revenues on an accounting basis typically indicate a: A) negative NPV. B) positive NPV. C) high degree of operating leverage. D) downturn in the business cycle. 69) The accounting break-even level of revenues represents the point at which the project has: A) zero pretax profit. B) zero net present value. C) covered all opportunity costs. D) covered the fixed and variable costs but not the depreciation. 70) Which one of the following changes might turn a negative NPV project into a positive NPV

project? A) A decrease in the estimated annual sales B) An increase in the discount rate C) An increase in the initial investment D) A decrease in the fixed costs 71) If project sales exceed the accounting break-even point, but the project has a negative EVA,

then the project has a: A) positive NPV but earns less than the discount rate. B) negative NPV but earns more than the discount rate. C) net loss on the income statement. D) net profit but negative NPV.

Version 1

72) A company has $3,000 per year in depreciation over a 6-year period. Due to tax code

changes, the company can switch to bonus depreciation and expense the entire investment immediately. What is the increase in PV of cash flows given a 21% corporate tax rate and a discount rate of 9%? Assume the bonus depreciation is taken at the end of year 1. A) $586.32 B) $641.76 C) $717.44 D) $865.69 73) Calculate the ratio of variable costs to sales for a firm with a $3 million accounting break-

even revenue point, $1.2 million of fixed costs, and $450,000 of depreciation. A) 40% B) 45% C) 55% D) 60% 74) What is the maximum percentage of variable costs to sales that a firm could have and still

break even with $5 million in revenues, $1 million of fixed costs, and $500,000 of depreciation? A) 30% B) 70% C) 80% D) 90% 75) A firm with 60% of sales going to variable costs has $1.5 million of fixed costs, $500,000 of

depreciation, and $3 million of sales. How does the current level of sales compare to the accounting break-even sales level? A) Current sales are $2 million below the break-even level. B) Current sales are $333,333 below the break-even level. C) Current sales are $800,000 below the break-even level. D) Current sales exceed the break-even level by $360,000. 76) A 6-year project has a zero NPV with sales of $5 million and a discount rate of 8%. The

annual cash inflows are equal to 10% of sales minus $300,000. What was the initial investment in the project assuming that none of the investment is recoverable when the project ends? A) $416,667 B) $924,576 C) $1,016,678 D) $2,311,450

Version 1

77) A pro football team has an NPV of $200 million. There is a 70% chance the team will get a

new stadium within 1 year and the value of the team will increase to $350 million. To keep the team from moving, a rich local benefactor has offered to buy the team for $200 million today. Given a 12% discount rate, what is the most the current owner should be willing to offer the benefactor to keep the offer on the table until the end of the year? A) $50 million B) $72 million C) $137 million D) $150 million 78) Calculate the NPV break-even level of sales for a project requiring an investment of $3

million and providing annual cash flows equal to 15% of sales less $250,000. None of the initial investment is recoverable. Assume the project will generate these cash flows for 10 years and the discount rate is 10%. A) $3,254,890 B) $3,504,890 C) $4,921,575 D) $1,686,667 79) If the level of sales is less than that calculated as the NPV break-even level, then the: A) project will break even in accounting terms. B) project's EVA will be greater than zero but less than the opportunity cost of capital. C) project will have a negative EVA. D) discount rate should be reduced. 80) One difference between an NPV break-even level of sales and an accounting break-even

level of sales is the: A) consideration of the opportunity cost of capital. B) consideration of interest expense. C) allowance of the sales level to vary in response to changes in demand. D) inclusion of income taxes. 81) A project that has zero economic value added: A) has a positive NPV. B) has an NPV of zero. C) has a negative NPV. D) is at the accounting break-even point.

Version 1

82) Which one of these projects would you always reject? A) High operating leverage, sales projected at the accounting break-even level, and no

option to abandon or expand B) High operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand C) Low operating leverage, sales projected at the accounting break-even level, and an option to abandon or expand D) Low operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand 83) Fixed costs including depreciation have increased at Leverage Incorporated, from $4 million

to $5.3 million. Suppose that the company now breaks even on an accounting basis with sales of $20 million. What must be the break-even variable cost as a percentage of sales? A) 69.2% B) 65.8% C) 73.5% D) 76.7% 84) Fixed costs: A) are a constant percentage of sales revenues. B) vary with the level of depreciation expense. C) are constant regardless of the level of output. D) are inversely related to the level of output. 85) A firm with high operating leverage is expected to: A) have high variable costs. B) have low fixed costs. C) have a high degree of profitability. D) perform particularly well when sales are high. 86) If the firm's degree of operating leverage is 4.5, what percentage change in sales will result in

a 3% rise in profits? A) 0.33% B) 0.67% C) 3.03% D) 1.50%

Version 1

87) If the firm's degree of operating leverage is 3.8, what percentage change in sales will result in

a 13.8% fall in profits? A) 0.28% B) −2.75% C) −3.63% D) 10.00% 88) If the proportion of fixed costs increases: A) DOL falls. B) DOL rises. C) the NPV break-even level of sales declines. D) the NPV of the cash flows declines. 89) What happens to a firm with high operating leverage when the overall level of sales is very

high? A) The firm is likely to have higher levels of fixed costs. B) The firm is likely to enjoy high profits. C) The firm will not break even in accounting terms. D) The firm will have a reduced level of depreciation. 90) For a firm with a DOL of 3.5, an increase in sales of 6% will: A) increase pretax profits by 3.5%. B) decrease pretax profits by 3.5%. C) increase pretax profits by 21.0%. D) increase pretax profits by 1.71%. 91) A firm with $800,000 of fixed costs including $200,000 of depreciation is expected to

produce $225,000 in profits. What is its DOL? A) 3.56 B) 3.67 C) 4.56 D) 4.67 92) If a firm's DOL is 3.6 with a profit of $2,000,000 and depreciation of $500,000, what are its

other fixed costs? A) $5,250,000 B) $4,700,000 C) $5,520,000 D) $5,800,000

Version 1

93) A firm with a DOL of 4.5 generates pretax profits of $1 million. If depreciation expense is

$600,000, what are its other fixed costs? A) $1.1 million B) $2.1 million C) $2.9 million D) $3.9 million 94) If a firm doubled its level of fixed costs but maintained its operating leverage, then one

explanation may be that: A) depreciation expense increased to offset the increase. B) sales revenue also doubled and the proportion of variable costs did not change. C) sales revenues declined and the proportion of variable costs doubled. D) pretax profits decreased. 95) A project offers a 30% probability of a payoff after one year of $2 million and a 70% chance

of a payoff of $1 million. What is the maximum you would invest in this project today if the discount rate is 10%? A) $818,181.82 B) $1,181,818.18 C) $1,300,000.00 D) $1,430,000.00 96) Decision trees: A) are an alternative to NPV analysis. B) recognize that managers may need to react to unexpected future events. C) are a way to adjust the discount rate to allow for uncertainty. D) lay out the different steps in preparing the capital budget. 97) If MacCaugh’s pilot project is successful, it will be able to build a plant with an NPV of $2

million in 1 year’s time. Otherwise the pilot investment will be valueless. If the discount rate is 20% and the chances of success are 50%, how much can MacCaugh afford to spend on the pilot project? A) $1,000,000 B) $2,000,000 C) $1,666,667 D) $833,333

Version 1

98) The branches on a decision tree: A) illustrate possible combinations of fixed and variable costs. B) are a convenient way to illustrate the results of a sensitivity analysis. C) show possible project break-even points. D) show possible management decisions and possible uncertain consequences. 99) The option for a firm to expand future production has most value when: A) future production will be profitable. B) the outlook for the business is very assured. C) the future is very uncertain. D) today's production costs are lower than in the future. 100)

The option to abandon a project inexpensively has particular value when: A) the equipment has a ready second-hand value. B) you can be confident about future profits. C) the project looks to have a very large NPV. D) the project has a low degree of operating leverage.

101)

The option to switch between using oil or natural gas in a power station is: A) an option to expand. B) an option to abandon. C) a production flexibility option. D) a timing option.

102)

A firm acquires a patent to produce a new enhanced type of transcripter. What is the real option? A) Abandonment option B) Timing option C) Option to change raw material inputs D) Expansion option

103)

A firm has a tract of timber. The future growth rate of the trees and the price of lumber are uncertain. The firm: A) has an expansion option. B) has an option to vary the production technology. C) should harvest the timber immediately if NPV is positive. D) has a timing option.

Version 1

104)

Recognizing that it may be in managers' best interests to be overly optimistic when proposing projects, how might firms effectively control this impulse? A) Employ capital rationing B) Require that all proposals be initiated from the lowest possible management level C) Fire managers if any of their proposals fail to produce the expected results D) Fund all project proposals

105)

One of the problems inherent in sensitivity analysis is that: A) it suggests when it may be useful to spend money to get a better estimate of sales or costs. B) most projects are equally sensitive to all variables. C) it ignores any interrelationships between variables. D) the cost of conducting the analysis is excessive.

106)

Which of the following correctly describes sensitivity analysis? A) Recalculation of project NPV by changing several inputs to new but consistent values B) Measures the degree to which fixed costs magnify the effect on profits of a shortfall in sales C) Analysis of how project NPV changes if different assumptions are made about a key variable D) Measures the future level of sales at which NPV equals zero

107)

The accounting break-even point for a project is that level of sales where: A) sales revenue equals variable costs. B) sales revenue equals variable plus fixed costs. C) the operating cash flow equals zero. D) profit equals zero.

108)

The greater the ratio of variable costs to sales, the: A) more each additional sale contributes to the coverage of fixed costs. B) lower the level of profitability. C) more units that must be sold to cover fixed charges. D) lower the benefit of conducting a sensitivity analysis.

109)

When the level of fixed costs is decreased, the break-even level of revenues: A) will automatically decrease. B) will automatically increase. C) may or may not change, depending on variable costs. D) will remain unchanged as long as depreciation remains constant.

Version 1

110)

A manufacturer contemplates a change in technology that would reduce fixed costs from $800,000 to $600,000, and reduce depreciation expense from $125,000 to $100,000. However, the ratio of variable costs to sales would increase from 68% to 80%. What would be the change in the break-even level of revenues? A) Increase of $609,375 B) Increase of $574,750 C) Decrease of $574,750 D) Decrease of $341,675

111)

In a graphic depiction of accounting break-even analysis, the greater the slope of the total cost line, the higher the: A) level of fixed costs. B) level of total revenue. C) number of units sold. D) percentage of variable costs to sales.

112)

What is the economic break-even level of sales for a project costing $4,000,000 and generating annual cash flows equal to 0.30 × sales − $450,000? Assume the project will last 10 years and requires a discount rate of 12%. A) $2,093,654 B) $2,359,047 C) $3,859,789 D) $13,783,333

113)

The opportunity to abandon a project loses some of its value when: A) fixed costs are high. B) markets are extremely competitive. C) the future is relatively certain. D) secondary markets exist and are active.

114)

Which one of the following sets of conditions represents the more suitable investment? A) Total revenues cover fixed and variable costs. B) An investment breaks even in an accounting sense. C) An investment breaks even in an economic sense. D) Total revenues exceed the costs of goods sold.

Version 1

115)

Positive NPV projects exist because: A) analysts select high discount rates. B) most projects are unique and innovative. C) cash-flow projections are extended into the future. D) firms hold competitive advantages.

116)

How much depreciation expense exists in a firm that has a break-even level of revenues of $2 million, fixed costs of $400,000, and a 60% ratio of variable costs to sales? A) $144,000 B) $266,667 C) $400,000 D) $666,667

117)

The accounting break-even point for a firm is a function of its: A) net cash flows and depreciation expense. B) fixed costs and gross profit on each sale. C) variable costs and tax rate. D) revenues and fixed costs.

118)

What is the level of profits for a firm in which DOL = 5 and fixed costs including depreciation = $300,000? A) $60,000 B) $75,000 C) $1,200,000 D) $1,500,000

119)

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

120)

The economic break-even point of a project can be found by: A) setting the discount rate equal to the DOL. B) solving for the annual sales that will equate total revenue with total cost. C) solving for the annual sales that will give the project an NPV of zero. D) solving for the level of sales that will give the project an IRR of zero.

Version 1

121)

Firms that lack competitive advantages will: A) have difficulty finding positive NPV projects for investment. B) be forced to capture larger market shares to be profitable. C) avoid the need to conduct sensitivity analyses. D) be forced to operate with a high degree of operating leverage.

Version 1

Answer Key Test name: Ch10 1) TRUE 2) FALSE 3) TRUE 4) FALSE 5) FALSE 6) TRUE 7) TRUE 8) TRUE 9) TRUE 10) FALSE 11) FALSE 12) TRUE 13) TRUE 14) FALSE 15) FALSE 16) TRUE 17) TRUE 18) TRUE 19) TRUE 20) TRUE 21) TRUE 22) FALSE 23) FALSE 24) D

ΔNPV = (−$440 + 700) × (1 − 0.21) ÷ 1.12 = −$183.39 25) B

ΔNPV = $551 × (1 − 0.21) ÷ 1.15 + $551 × (1 − 0.21) ÷ 1.152raise to the power of 2 = $707.65 26) C

27) C

Version 1

Profit margin = 1 − 0.64 = 0.36 Accounting B / E = ($1.75 million + 1.55 million) ÷ 0.36 = $9.17 million 28) B

Accounting B / E = $3 million = ($1.58 million + 0.64 million) ÷ x; x = 0.74 Variable costs to sales = 1 − 0.74 = 0.26, or 26% 29) B

Accounting B / E = $5 million = ($1.68 million + 0.67 million) ÷ x; x = 0.47 Variable costs to sales = 1 − 0.47 = 0.53, or 53% 30) B

31) A

Value of team with offer = (0.70 × $388 + 0.30 × $219) ÷ (1.12) = $301 million Value of team without offer = $219 million Value of offer to buy the team = $301 − 219 = $82 million 32) C

33) C

Accounting B / E = $20 million = $5.80 million ÷ (1 − x); x = 0.710, or 71.0% 34) B

ΔSales = 3% ÷ 6.0 = 0.50% 35) B

36) D

37) A

Version 1

ΔAccounting B / E = $3,740,000 − 3,040,625 = $699,375 38) C

39) D 40) B 41) B 42) A 43) C 44) A 45) A 46) B 47) D 48) A 49) B 50) D

ΔNPV = (−$600 + 400) × (1 − 0.21) ÷ 1.12 = −$141.07 51) B

ΔNPV = $500 × (1 − 0.21) ÷ 1.15 + $500 × (1 − 0.21) ÷ 1.152raise to the power of 2 = $642.16 52) C 53) A 54) D 55) A 56) D 57) B 58) C 59) D 60) C

61) B 62) C

Version 1

Profit margin = 1 − 0.64 = 0.36 Accounting B / E = ($1.2 million + 1 million) ÷ 0.36 = $6.11 million 63) D

ΔBreak-even revenues = $1 ÷ (1 − 0.68) = $3.125 64) D 65) A

Accounting B / E = ($1,600 + 1,200) ÷ (1 − 0.67) = $8,484.85 66) B

Accounting B / E = ($865,000 + 400,000) ÷ (1 − 0.65) = $3,614,285.71 67) C 68) A 69) A 70) D 71) D 72) B

Old tax savings per year = $3,000 × 0.21 = $630 PV of tax savings using a financial calculator: Pmt = −630, FV = 0, n = 6, i = 9, solve for PV = $2,826.13 PV of tax savings with bonus depreciation = ($3,000 × 6 × 0.21) ÷ 1.09 = $3,467.89 Increased savings = $3,467.89 − $2,826.13 = $641.76 73) B

Accounting B / E = $3 million = ($1.2 million + 0.45 million) ÷ x; x = 0.55 Variable costs to sales = 1 − 0.55 = 0.45, or 45% 74) B

Accounting B / E = $5 million = ($1 million + 0.5 million) ÷ x; x = 0.30 Variable costs to sales = 1 − 0.30 = 0.70, or 70% 75) A

Accounting B / E = ($1.5 million + 0.5 million) ÷ (1 − 0.60) = $5 million; Current sales are $2 million below the break-even level. 76) B

Version 1

77) B

Value of team with offer = (0.70 × $350 + $200 × 0.30) ÷ (1.12) = $272 million Value of team without offer = $200 million Value of offer to buy the team = $272 − 200 = $72 million 78) C

79) C 80) A 81) B 82) A 83) C

Accounting B / E = $20 million = $5.3 million ÷ (1 − x); x = 0.735, or 73.5% 84) C 85) D 86) B

ΔSales = 3% ÷ 4.5 = 0.67% 87) C

ΔSales = −13.8% ÷ 3.8 = −3.63% 88) B 89) B 90) C

ΔProfits = 6% × 3.5 = 21% 91) C

DOL = 1 + [$800,000 ÷ $225,000] = 4.56 92) B

DOL = 3.6 = 1 + (FC + $500,000) ÷ $2,000,000; FC = $4,700,000 93) C

Version 1

DOL= 4.5 = 1 + (FC + $600,000) ÷ $1,000,000 FC = $2,900,000 94) B 95) B

Investment = ($2,000,000 × 0.30 + $1,000,000 × 0.70) ÷ 1.10 = $1,181,818.18 96) B 97) D

98) D 99) C 100) 101) 102) 103) 104) 105) 106) 107) 108) 109) 110)

A C D D A C C D C C A

ΔAccounting B / E = $3,500,000 − 2,890,625 = $609,375 111) 112)

D C

113) 114) 115) 116)

C C D C

Version 1

$2,000,000 = ($400,000 + depreciation) ÷ (1 − 0.60); Depreciation = $400,000 117) 118)

B B DOL = 5 = 1 + ($300,000 ÷ profits); Profits = $75,000 119) 120) 121)

C C A

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) A market index is used to measure performance of a broad-based portfolio of stocks. ⊚ true ⊚ false 2) Stock market indexes are found in many countries outside the United States. ⊚ true ⊚ false 3) Long-term bonds are the only portfolio of securities found to be riskier than common stocks. ⊚ true ⊚ false 4) For investment horizons greater than 20 years, long-term bonds traditionally have

outperformed common stocks. ⊚ true ⊚ false 5) The S&P 500 accounts for most of the total market value of stocks traded in the United

States. ⊚ true ⊚ false 6) The expected return on an investment includes compensation for both the time value of

money and the risks assumed. ⊚ true ⊚ false 7) If one portfolio's variance exceeds that of another portfolio, its standard deviation will also be

greater than that of the other portfolio. ⊚ true ⊚ false 8) The market risk premium is the difference between the return on common stocks and the

risk-free interest rate. ⊚ true ⊚ false

Version 1

9) Market risk can be eliminated in a stock portfolio through diversification. ⊚ true ⊚ false 10) Macro risks are faced by all common stock investors, to varying degrees. ⊚ true ⊚ false 11) The risk that remains in a well-diversified stock portfolio is known as specific risk. ⊚ true ⊚ false 12) Cyclical stocks tend to perform well when other stocks are performing well also. ⊚ true ⊚ false 13) Average returns on high-risk assets are higher than those on low-risk assets. ⊚ true ⊚ false 14) The historical record fails to show that investors have received a risk premium for holding

risky assets. ⊚ true ⊚ false 15) Many investors who bought shares in the general stock market index in October 2007 saw

the value of their investment decline over the next one-and-a-half years. ⊚ true ⊚ false 16) Every additional stock added to a portfolio reduces the portfolio's level of risk by an equal

amount. ⊚ true ⊚ false 17) The expected return on an investment provides compensation to investors both for waiting

and for worrying. ⊚ true ⊚ false

Version 1

18) One estimate of the market risk premium is provided by the difference between the average

historical return on common stocks and the risk-free interest rate. ⊚ true ⊚ false 19) When using historical data to estimate the market risk premium, it is important to focus on

recent experience. ⊚ true ⊚ false 20) The mathematical measurement for volatility in the stock market is standard deviation. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 21) Sue purchased a stock for $25 a share, held it for one year, received a $1.37 dividend, and sold the stock for $26.48. What nominal rate of return did she earn? A) 11.40% B) 14.47% C) 12.33% D) 10.79% 22) Over a 20-year period an investment of $1,100 in common stocks returned an average of

11% in nominal terms and 4% in real terms. At the end of the 20 years, the portfolio value was: A) $1,980 in real terms. B) $4,485.42 in real terms. C) $8,676.82 in nominal terms. D) $8,868.54 in nominal terms. 23) A stock is expected to return 12% in a normal economy, return 20% if the economy booms,

and lose 9% if the economy moves into a recessionary period. Economists predict a 65% chance of a normal economy, a 25% chance of a boom, and a 10% chance of a recession. What is the expected return on the stock? A) 12.78% B) 12.86% C) 11.90% D) 12.03%

Version 1

24) Over the past 3 years an investment returned 22.50%, −16.50%, and 19.50%. What is the

variance of returns? A) 1,621 B) 363 C) 314 D) 942 25) Over the past 4 years an investment returned 19.9%, −10.9%, −13.9%, and 16.9%. What is

the standard deviation of returns? A) 11.1% B) 12.25% C) 13.1% D) 15.5% 26) Calculate the variance of returns for Alpha stock with the following historical rates of return:

2018: 20.15% 2019: 25.10% 2020: 30.10% A) 16.50 B) 33.50 C) 50.00 D) 100.00 27) What is the standard deviation of returns of a portfolio that produced returns of 10.12%,

15.24%, 25.36%, and 30.12%? A) 62.9% B) 31.3% C) 7.9% D) 5.2% 28) What is the standard deviation of returns of a portfolio that produced returns of 21.2%,

26.2%, and 31.2%? A) 2.43% B) 4.26% C) 18.11% D) 26.20%

Version 1

29) If the standard deviation of a portfolio's returns is known to be 30.5%, then its variance is: A) 30.50. B) 5.66. C) 93.49 D) 30.50. E) 930.25. F) 93.49 G) 930.25. 30) What is the expected return on a portfolio that will decline in value by 13.15% in a recession,

will increase by 16.15% in normal times, and will increase by 23.15% during boom times? Each scenario has an equal likelihood of occurrence. A) 8.72% B) 13.15% C) 13.58% D) 17.48% 31) If the toss of a coin comes down heads, you win a dollar. If it comes down tails, you lose

fifty five cents. How much would you expect to gain after 25 tosses? A) $5.63 B) $8.13 C) $10.63 D) $15.63 32) A project's expected return is 15.05%, which represents a 35.15% return in a boom and a

5.10% return in a stagnant economy. What is the probability of a boom if these are the only two economic states? A) 18.06% B) 24.95% C) 33.11% D) 50.20% 33) What is the return to an investor who purchases a stock for $33.75, receives a $3.00 dividend

at the end of the year, and then sells the share for $30.75? A) 0% B) −9% C) 9% D) 18%

Version 1

34) Stock A has an expected return of 15%; Stock B has an expected return of 8%. What is the

expected return on a portfolio that is comprised of 53% of Stock A and 47% of Stock B? A) 11.7% B) 10.3% C) 8.6% D) 13.9% 35) An investor holds a stock for one year. She then receives a dividend of $25 and sells the

stock for $135. If her return was 16%, at what price did she buy the stock? A) $129.31 B) $90.66 C) $165.06 D) $137.93 36) A share of stock currently sells for $60, pays an annual dividend of $4.00, and earned a rate

of return of 20% over the past year. What did this stock sell for one year ago? A) $42.00 B) $46.15 C) $48.46 D) $53.33 37) Sue purchased a stock for $25 a share, held it for one year, received a $1.34 dividend, and

sold the stock for $26.45. What nominal rate of return did she earn? A) 11.16% B) 14.23% C) 12.09% D) 10.55% 38) What is the percentage return on a stock that was purchased for $48.40, paid a $1.67

dividend, and was then sold after one year for $46.20? A) −2.50% B) −1.10% C) 0.23% D) −0.33%

Version 1

39) What was the percentage return on a non-dividend-paying stock that was purchased for

$40.00 and then sold after one year for $39.00? A) −2.50% B) −0.39% C) −0.04% D) −2.56% 40) An investor receives a 15% total return by purchasing a stock for $40 and selling it after one

year with a 5% capital gain. How much was received in dividend income during the year? A) $2.00 B) $2.20 C) $4.00 D) $4.40 41) How is it possible for real rates of return to increase during times when the rate of inflation

increases? A) Inflation increased more than the real return. B) Nominal returns actually decreased. C) Nominal returns increased more than inflation. D) Nominal returns increased less than inflation. 42) What nominal return was received by an investor when inflation averaged 3.46% and the real

rate of return was 2.5%? A) 0.96% B) 5.96% C) 6.05% D) 5.47% 43) Real rates of return are typically less than nominal rates of return due to: A) inflation. B) capital gains. C) dividend payments. D) depreciation.

Version 1

44) If a share of stock provided a 14.84% nominal rate of return over the previous year while the

real rate of return was 6.65%, then the inflation rate was: A) 8.89%. B) 7.68%. C) 8.03%. D) 9.12%. 45) The actual real rate of return on an investment will be positive as long as the: A) nominal return is positive. B) inflation rate is positive. C) nominal return exceeds the inflation rate. D) inflation rate exceeds the real return. 46) If inflation is 6%, what real rate of return is earned by an investor in a bond that was

purchased for $1,000, has an annual coupon of 8%, and was sold at the end of the year for $960? A) −1.89% B) 1.92% C) −2.66% D) 2.47% 47) The Dow Jones Industrial Average is: A) the most representative of the stock market indexes. B) an index of the 500 largest corporate stocks in America. C) an index of 30 major stocks. D) an equally weighted index of all stocks traded on the New York Stock Exchange. 48) Volatility is likely to be highest in which of the following investments? A) Common stocks B) Preferred stock C) Corporate bonds D) Treasury bonds 49) "Dow up 14. Story at 6:00." This means that: A) the Dow was up 14% during today's trading. B) 14 of the Dow's 30 stocks increased in price today. C) a share of Dow stock went up by $14 today. D) the Dow index increased by 14 points in today's trading.

Version 1

50) Although several stock indexes are available to inform investors of market changes, the Dow

Jones Industrial Average: A) is the broadest-based of the market indexes. B) is the only reliable market index. C) accounts for approximately 90% of U.S. market value. D) is one of the best-known of the U.S. market indexes. 51) Risks that are peculiar to a single firm: A) are called market risks. B) cannot be diversified away. C) are called specific risks. D) tend to cause stocks to move together. 52) Stock A has 10 million shares outstanding and Stock B has 5 million shares outstanding.

Both stocks sell for $10 a share. What is their relative weighting if both stocks are represented in the S&P 500? A) They have equal weighting, like all S&P 500 stocks. B) B has twice the weighting, to account for having fewer shares. C) A has twice the weighting, to account for having more shares. D) They are weighted according to their expected performance. 53) Which one of these is the safest investment? A) Corporate bonds B) Common stock C) U.S. Treasury bills D) Preferred stock 54) Although Standard and Poor's Composite Index contains a limited number of U.S. publicly

traded stocks, the Index represents: A) all stocks in the industrial sector. B) all stocks priced at $50 a share or more. C) approximately 60% of U.S. stocks traded, in market value. D) approximately 80% of U.S. stocks traded, in market value. 55) The primary difference between U.S. Treasury bills and U.S. Treasury bonds is that the bills: A) do not have default risk. B) have more price volatility. C) have a shorter maturity at time of issue. D) offer a higher return.

Version 1

56) Assume market interest rates have risen substantially in the 5 years since an investor

purchased Treasury bonds that were offering a 3% return over their 15-year life. If the investor sells now, he or she is likely to realize a total return that is: A) greater than 3%. B) less than 3%. C) equal to 1%. D) equal to 3%. 57) A maturity premium is offered on long-term Treasury bonds due to: A) the risk of changing interest rates. B) the risk of default. C) their specific risk. D) the uncertainty of their maturity date. 58) The idea that investors, on average, have earned a higher return from common stocks than

from Treasury bills supports the view that: A) investors are irrational. B) there is a relationship between risk and return. C) real rates of return will be lower during periods of price stability. D) stocks should be avoided when inflation is low. 59) Which combination of companies is likely to provide the best diversification benefit? A) Ford, Toyota, Nissan, GM B) Facebook, Twitter, Google, Amazon C) Tyson, Sony, Apple, Delta D) Walmart, Target, Home Depot, Lowes 60) Which one of the following guarantees is offered to common stock investors? A) Guarantee to receive dividends B) Guarantee to receive capital gains C) Guarantee only to receive a refund of principal D) No guarantees of any form 61) The wider the dispersion of returns on a stock, the: A) lower the expected rate of return. B) higher the standard deviation. C) lower the real rate of return. D) lower the variance.

Version 1

62) The variance of an investment's returns is a measure of the: A) volatility of the rates of return. B) probability of a negative return. C) historic return over long time periods. D) average value of the investment. 63) Which one of the following security classes has the highest standard deviation of returns? A) Common stocks B) Long-term Treasury bonds C) Treasury bills D) Corporate bonds 64) In a year in which common stocks offered an average return of 12% and Treasury bills

offered 3%. The risk premium for common stocks was: A) 1%. B) 3%. C) 12%. D) 9%. 65) Over a 20-year period an investment of $1,000 in common stocks returned an average of

11% in nominal terms and 4% in real terms. At the end of the 20 years, the portfolio value was: A) $1,800 in real terms. B) $3,679.19 in real terms. C) $7,870.59 in nominal terms. D) $8,062.31 in nominal terms. 66) A stock is expected to return 11% in a normal economy, return 19% if the economy booms,

and lose 8% if the economy moves into a recessionary period. Economists predict a 65% chance of a normal economy, a 25% chance of a boom, and a 10% chance of a recession. What is the expected return on the stock? A) 11.98% B) 12.06% C) 11.10% D) 11.23%

Version 1

67) When the annual rate of return on U.S. Treasury bills is historically high, investors expect the

return on the stock market: A) to be considerably lower than normal. B) to be about average. C) also to be high. D) to be approximately equal to zero. 68) Historical returns (1900-2019) suggest that in a year when Treasury bills offered 3.73%, the

approximate return on a portfolio of common stocks should be in the region of: A) 3.73%. B) 9.30%. C) 11.46%. D) 18.45%. 69) The appropriate opportunity cost of capital is the return that investors give up on alternative

investments that: A) possess the same level of risk. B) earn the risk-free rate of return. C) are included in the S&P 500 index. D) earn the average market rate of return. 70) An estimation of the opportunity cost of capital for projects that have an "average" level of

risk is the expected rate of return on: A) Treasury bills. B) the market portfolio. C) the market portfolio minus the rate of return on Treasury bills. D) Treasury bonds plus a maturity premium. 71) Over the past 3 years an investment returned 18%, −12%, and 15%. What is the variance of

returns? A) 231 B) 182 C) 546 D) 961

Version 1

72) Over the past 4 years an investment returned 18%, −9%, −12%, and 15%. What is the

standard deviation of returns? A) 9.2% B) 10.36% C) 11.2% D) 13.6% 73) The variance of a stock's returns can be calculated as the: A) average value of deviations from the mean. B) average value of squared deviations from the mean. C) square root of the average value of deviations from the mean. D) sum of the deviations from the mean. 74) Calculate the variance of returns for Alpha stock with the following historical rates of return:

2018: 20% 2019: 25% 2020: 30% A) 16.67 B) 33.33 C) 50.00 D) 100.00 75) What is the standard deviation of returns of a portfolio that produced returns of 10%, 15%,

25%, and 30%? A) 62.5% B) 31.1% C) 7.9% D) 5.2% 76) What is the standard deviation of returns of a portfolio that produced returns of 20%, 25%,

and 30%? A) 2.26% B) 4.08% C) 16.67% D) 25.00%

Version 1

77) If the standard deviation of a portfolio's returns is known to be 30%, then its variance is: A) 5.48. B) 30. C) 90.45. D) 900.00. 78) Since about 1900, the standard deviation of annual returns on a portfolio of U.S. common

stocks has been about: A) −10%. B) 6%. C) 20%. D) 12%. 79) What is the standard deviation of returns for an investment that is equally likely to return

100% as it is to provide a 100% loss? A) 0% B) 50% C) 71% D) 100% 80) What is the standard deviation of returns for an investment that is equally likely to return

100% as it is to provide a 100% loss? A) The individual stock's standard deviation will be lower. B) The individual stock's standard deviation will be higher. C) The standard deviations should be equal. D) There is no relationship. 81) The standard deviations of individual stocks are generally higher than the standard deviation

of the market portfolio because the market portfolio: A) offers lower returns. B) has less systematic risk. C) diversifies risk. D) has specific risk. 82) The benefits of portfolio diversification are highest when the individual securities within the

portfolio have returns that: A) vary directly with the rest of the portfolio. B) vary proportionally with the rest of the portfolio. C) are largely uncorrelated with the rest of the portfolio. D) are perfectly correlated with the market portfolio.

Version 1

83) The major benefit of diversification is the: A) increased expected return. B) removal of all negative risk assets from the portfolio. C) reduction in the portfolio's market risk. D) reduction in the portfolio's total risk. 84) Companies that are exposed to the business cycle: A) tend to have high market risk. B) tend to have low market risk. C) have negligible specific risk. D) are safe investments. 85) A firm is said to be countercyclical if its returns: A) continue to decrease, year after year. B) continue to increase, year after year. C) outperform when most stocks do poorly. D) are negative in real terms. 86) Industries that generally perform very well when the entire economy performs well and

perform very badly when the economy performs badly are called: A) diversified industries. B) cyclical industries. C) risk-free industries. D) specific-risk industries. 87) What is the expected return on a portfolio that will decline in value by 13% in a recession,

will increase by 16% in normal times, and will increase by 23% during boom times? Each scenario has an equal likelihood of occurrence. A) 8.67% B) 13.00% C) 13.43% D) 17.33% 88) The higher the standard deviation of a stock's returns, the: A) lower the level of specific risk. B) lower the expected rate of return. C) higher the accuracy of predictions of the stock's return for any given year. D) wider the dispersion of those returns over time.

Version 1

89) The incremental risk to a portfolio from adding another stock: A) is always greater than the average portfolio risk. B) is always less than the average portfolio risk. C) is always positive. D) may be either positive or negative. 90) In general, which stocks should be combined into a portfolio if the goal is the greatest

reduction possible in overall portfolio risk? A) Stocks with returns that are positively correlated B) Stocks with returns that are not correlated C) Stocks with returns that have the highest specific risk D) Stocks that have the highest expected returns 91) Which one of the following concerns is likely to be most important to portfolio investors

seeking diversification? A) Total volatility of individual securities B) Standard deviation of individual securities C) Correlation of returns between securities D) Achieving the risk-free rate of return 92) A stock investor owns a diversified portfolio of 25 stocks. What will be the most likely effect

on the portfolio's standard deviation if one more stock is added? A) A slight increase will occur B) A large increase will occur C) A slight decrease will occur D) A large decrease will occur 93) As you add more stocks to a portfolio: A) specific risk at first falls, then rises. B) market risk is increasingly diversified away. C) specific risk is increasingly diversified away. D) market risk declines but specific risk rises. 94) Risks that affect only a single firm are called: A) market risks. B) specific risks. C) systematic risks. D) risk premiums.

Version 1

95) Which one of the following risks can be progressively eliminated by adding stocks to a

portfolio? A) Systematic risk B) Specific risk C) Market risk D) Inflation rate risk 96) Which one of the following risks is most important to a well-diversified investor in common

stocks? A) Market risk B) Specific risk C) Unsystematic risk D) Diversifiable risk 97) Which one of the following risks would be classified as a specific risk for an auto

manufacturer? A) Interest rates B) Delays in launching a new model C) Business cycles D) Foreign exchange rates 98) Which statement is correct concerning macro risk exposure? A) All firms face equal macro risk exposure. B) Only portfolios of stocks face macro risk exposure. C) Macro risk exposure affects the cost of capital. D) Macro risk exposure is less important to diversified investors than micro risk

exposure. 99) Individual stocks are: A) exposed to the same amount of market risk. B) exposed to differing amounts of market risk. C) not exposed to market risk; only the general economy is subject to market risk. D) exposed to differing amounts of market risk but the same amount of specific risk. 100)

Which one of these is a specific risk? A) Revision to the corporate tax laws B) Inflation increase of 2.3% C) Deterioration in the overall economic outlook D) A fire at the company’s main factory

Version 1

101)

Which one of the following statements is incorrect concerning stock indexes? A) Indexes have been developed for foreign stocks. B) Some indexes cover only a specific market sector. C) Most indexes include all of the publicly-traded common stocks. D) Some indexes are equally weighted.

102)

Periods of market decline are called: A) discount factors. B) bull markets. C) coupons. D) bear markets.

103)

The fact that historical returns on Treasury bonds are less volatile than common stock returns indicates that: A) the variance of Treasury bond returns is zero. B) the standard deviation of Treasury bond returns is negative. C) the real return on Treasury bonds has been negative. D) common stocks should offer a higher return than Treasury bonds.

104)

If the toss of a coin comes down heads, you win a dollar. If it comes down tails, you lose fifty cents. How much would you expect to gain after 20 tosses? A) $5.00 B) $7.50 C) $10.00 D) $15.00

105)

A project's expected return is 15%, which represents a 35% return in a boom and a 5% return in a stagnant economy. What is the probability of a boom if these are the only two economic states? A) 18.33% B) 25.00% C) 33.33% D) 50.00%

106)

What is the return to an investor who purchases a stock for $30, receives a $1.50 dividend at the end of the year, and then sells the share for $28.50? A) −5% B) 0% C) 5% D) 10%

Version 1

107)

Stock A has an expected return of 15%; Stock B has an expected return of 8%. What is the expected return on a portfolio that is comprised of 60% of Stock A and 40% of Stock B? A) 12.2% B) 10.8% C) 9.1% D) 14.4%

108)

Which one of the following companies is most likely to be exposed to the least amount of macro risk? A) A producer of dog biscuits B) A regional airline C) A major commercial bank D) A machine tool manufacturer

109)

An investor holds a stock for one year. She then receives a dividend of $10 and sells the stock for $120. If her return was 16%, at what price did she buy the stock? A) $103.45 B) $64.80 C) $139.20 D) $112.07

110)

Which one of the following would you expect to represent the broadest-based index of U.S. stocks? A) Wilshire 5000 B) Dow Jones Industrial Average C) Standard and Poor's Composite D) Financial Times Index

111)

Treasury bonds have provided a higher historical return than Treasury bills, which can be attributed to their: A) greater default risk. B) higher level of specific risk. C) greater exposure to interest rate risk. D) illiquidity.

112)

Averaging the deviations from the mean for a portfolio of securities will: A) compute the standard deviation. B) compute the variance. C) equal zero. D) equal the number of securities in the portfolio.

Version 1

113)

One common reason for reporting standard deviations of percentage returns rather than variances is that standard deviations: A) are lower. B) are stated in understandable percentages. C) account properly for negative returns. D) take probability estimates into consideration.

114)

When viewing the long-term trend of the price volatility of U.S. stocks, it is readily apparent that volatility has: A) continually increased. B) continually decreased. C) increased and decreased but has no specific pattern. D) remained constant for years.

115)

If a stock's returns are volatile, then the stock: A) cannot be considered a negative-risk asset. B) can still be considered a negative-risk asset. C) has macro risk, but no specific risk. D) does not offer diversification potential.

116)

A good way to reduce macro risk in a stock portfolio is to invest in stocks that: A) have only specific risks. B) have diversified away the macro risk. C) have low exposure to business cycles. D) pay guaranteed dividends.

117)

Which one of the following firms is likely to exhibit the least macro risk exposure? A) Construction company B) Airline company C) Gold mining company D) Auto manufacturer

118)

Investment risk can best be described as the: A) dispersion of possible returns. B) elimination of macro risk through diversification. C) possibility of changes in the cost of capital. D) level of systematic risk for an undiversified investor.

Version 1

Answer Key Test name: Ch11 1) TRUE 2) TRUE 3) FALSE 4) FALSE 5) TRUE 6) TRUE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) FALSE 12) TRUE 13) TRUE 14) FALSE 15) TRUE 16) FALSE 17) TRUE 18) TRUE 19) FALSE 20) TRUE 21) A

R = ($26.48 + 1.37 − 25) ÷ $25 = 0.1140, or 11.40% 22) D

FVNominal = $1,100(1.11)20raise to the power of 20 = $8,868.54 FVReal = $1,100(1.04)20raise to the power of 20 = $2,410.24 23) C

E(R) = (0.65 × 0.12) + (0.25 × 0.20) + (0.10 × −0.09) = 0.1190, or 11.90% 24) C

25) D

Version 1

26) A

27) C

28) B

29) EGEG

30.52raise to the power of 2 = 930.25 30) A

31) A

Expected return = 25 × [($1 × 0.5) − ($0.55 × 0.5)] = $5.63 32) C

15.05% = 35.15% × (x) + 5.10% × (1 − x) x = 33.11% 33) A

r = ($30.75 + 3.00 − 33.75) ÷ $33.75 = 0% 34) A

Portfolio: 0.53 × 15% + 0.47 × 8% = 11.7% 35) D

Version 1

1.16 = ($135 + $25) ÷ P P = $137.93 36) D

37) A

R = ($26.45 + 1.34 − 25) ÷ $25 = 0.1116, or 11.16% 38) B

R = ($46.20 + 1.67 − 48.40) ÷ $48.40 = −0.0110, or −1.10% 39) A

R = ($39 − 40) ÷ $40 = −0.0250, or −2.50% 40) C

Dividend income = (0.15 − 0.05) × $40 = $4.00 41) C 42) C

R = (1.0346 × 1.025) − 1 = 0.0605, or 6.05% 43) A 44) B

h = 1.1484 ÷ 1.0665 − 1 = 0.0768, or 7.68% 45) C 46) A

Nominal return = [$960 + (0.08 × $1,000) − $1,000] ÷ $1,000 = 0.04 Real return = 1.04 ÷ 1.06 − 1 = −0.0189, or −1.89% 47) C 48) A 49) D 50) D 51) C 52) C 53) C 54) D

Version 1

55) C 56) B 57) A 58) B 59) C 60) D 61) B 62) A 63) A 64) D

Risk premium = 12% − 3% = 9% 65) D

FVNominal = $1,000(1.11)20raise to the power of 20 = $8,062.31 FVReal = $1,000(1.04)20raise to the power of 20 = $2,191.12 66) C

E(R) = (0.65 × 0.11) + (0.25 × 0.19) + (0.10 × −0.08) = 0.1110, or 11.10% 67) C 68) C

3.73% + 7.73% (historical risk premium on common stocks) = 11.46% 69) A 70) B 71) B

72) D

73) B 74) A

Version 1

75) C

76) B

77) D

302raise to the power of 2 = 900 78) C 79) D

Mean = 0.5 × 100% + 0.5 × −100% = 0% Variance = 0.5 × (100 − 0)2raise to the power of 2 + 0.5 × (−100 − 0)2raise to the power of 2 = 10,000 Standard Deviation = 10,0000.5raise to the power of 0.5 = 100% 80) B 81) C 82) C 83) D 84) A 85) C 86) B 87) A

88) D 89) D 90) B 91) C 92) C

Version 1

93) C 94) B 95) B 96) A 97) B 98) C 99) B 100) 101) 102) 103) 104)

D C D D A Expected return = 20 × [($1 × 0.5) − ($0.50 × 0.5)] = $5.00 105)

C 15% = 35% × (x) + 5% × (1 − x) x = 33.33% 106)

B r = ($28.50 + 1.50 − 30.00) ÷ $30.00 = 0% 107)

A Portfolio: 0.6 × 15% + 0.4 × 8% = 12.2% 108) 109)

A D 1.16 = ($120 + $10) ÷ P P = $112.07 110) 111) 112) 113) 114) 115) 116) 117) 118)

A C C B C B C C A

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) The capital asset pricing model (CAPM) assumes that the stock market is dominated by welldiversified investors who are concerned only with market risk. ⊚ true ⊚ false 2) The CAPM states that the expected risk premium on any security equals its beta times the

market risk premium. ⊚ true ⊚ false 3) The security market line displays the relationship between expected return and beta. ⊚ true ⊚ false 4) The security market line sets a standard for other investments—investors will be willing to

hold other investments only if they offer equally good prospects as shown by the points on the line. ⊚ true ⊚ false 5) The required risk premium for any given investment is defined by the security market line. ⊚ true ⊚ false 6) Empirical evidence suggests that over a long period of time returns are directly related to

beta. ⊚ true ⊚ false 7) There is little doubt that the CAPM captures everything that is going on in the market. ⊚ true ⊚ false 8) Beta measures the total risk of an individual security. ⊚ true ⊚ false

Version 1

9) The security market line provides a standard that can be used to make project

acceptance/rejection decisions. ⊚ true ⊚ false 10) If a low-risk company invests in a high-risk project, those cash flows should be discounted at

a high cost of capital. ⊚ true ⊚ false 11) The project cost of capital depends on the risk of the company undertaking the project. ⊚ true ⊚ false 12) Beta measures a stock's sensitivity to market risks. ⊚ true ⊚ false 13) The project cost of capital depends on how the capital is used. ⊚ true ⊚ false 14) Investors expect aggressive stocks to outperform the market in periods of strong economic

activity. ⊚ true ⊚ false 15) Defensive stocks typically provide relatively better returns during periods of economic

downturn since they are not very sensitive to market fluctuations. ⊚ true ⊚ false 16) Diversification decreases the variability of both specific and market risk. ⊚ true ⊚ false 17) Market risk premium is defined as the difference between the market rate of return and the

risk-free interest rate. ⊚ true ⊚ false

Version 1

18) According to the CAPM, a stock's expected return is positively related to its beta. ⊚ true ⊚ false 19) The CAPM is a theory of the relationship between risk and return that states that the expected

risk premium on any security equals its beta times the market return. ⊚ true ⊚ false 20) The stocks of gold-mining companies commonly have above-average volatility but relatively

low betas. ⊚ true ⊚ false 21) According to the capital asset pricing model, the expected rates of return for all projects lie

on the security market line. ⊚ true ⊚ false 22) As a project's beta increases, the project's opportunity cost of capital increases. ⊚ true ⊚ false 23) A project should be accepted if its return plots below the security market line. ⊚ true ⊚ false 24) The security market line shows how the expected rate of return depends on beta. ⊚ true ⊚ false 25) The required risk premium for any investment is given by the security market line. ⊚ true ⊚ false 26) Project cost of capital and company cost of capital are exactly equal. ⊚ true ⊚ false

Version 1

27) The project cost of capital depends on the use to which that capital is put. Therefore, it

depends on both the risk of the project and also on the risk of the company. ⊚ true ⊚ false 28) If a company with a low credit rating invests in a low-risk project, it should discount the cash

flows at a relatively high cost of capital. ⊚ true ⊚ false 29) If a project has a risk of a bad outcome, the company should always set a higher discount rate

to compensate. ⊚ true ⊚ false 30) A stock return that sits above the security market line is considered a good risk adjusted

investment. ⊚ true ⊚ false 31) The slope of the security market line for an index mutual fund should be steeper than that of

the S&P 500 index. ⊚ true ⊚ false MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 32) A stock has a beta of 1.80, the market risk premium is 7%, and the risk-free rate is 3%. What is the lowest return the company should accept on a new investment? A) 8.80% B) 14.20% C) 15.60% D) 20.80% 33) If a stock consistently goes down (up) by 1.69% when the market portfolio goes down (up)

by 1.23%, then its beta equals: A) 1.08. B) 1.28. C) 1.37. D) 1.44.

Version 1

34) A mutual fund returns 19%. If the risk-free rate is 2% and the beta of the fund is 2.00, what is

the implied market risk premium? A) 7.50% B) 8.50% C) 9.50% D) 10.50% 35) What is the beta of a 3-stock portfolio including 35% of stock A with a beta of 0.70, 25% of

stock B with a beta of 1.07, and 40% of stock C with a beta of 1.75? A) 0.86 B) 1.01 C) 1.18 D) 1.21 36) An investor wishes to invest equal amounts in three stocks and to achieve a portfolio beta of

1.4. If stock A has a beta of 0.7 and stock B has a beta of 1.3, what must be the beta of stock C? A) 0.5 B) 2.2 C) 1.4 D) 1.4 37) What is the standard deviation of the market portfolio if the standard deviation of a well-

diversified portfolio with a beta of 1.35 equals 39%? A) 28.89% B) 31.84% C) 52.65% D) 46.69% 38) A project has a beta of 1.41, the risk-free rate is 4.65%, and the market rate of return is

10.05%. What is the project's expected rate of return? A) 18.82% B) 14.17% C) 12.26% D) 18.14%

Version 1

39) A project has a beta of 0.94, the risk-free rate is 4.1%, and the market risk premium is 8.1%.

What is the project's expected rate of return? A) 7.73% B) 11.71% C) 8.35% D) 11.70% 40) The market rate of return is 12.5% and the risk-free rate is 3.5%. What will be the change in

a stock's expected rate of return if its beta increases from 1.6 to 1.8? A) 1.80% B) 2.50% C) 18.00% D) 25.00% 41) Calculate the risk premium on stock C given the following information: risk-free rate =

5.70%, market return = 13.70%, stock C’s beta = 2.00. A) 13.6% B) 16.0% C) 21.7% D) 23.9% 42) An investor expects a return of 23% on his portfolio with a beta of 1.30. If the expected

market risk premium increases from 8% to 10%, what return should he now expect on the portfolio? A) 25.1% B) 25.6% C) 27.6% D) 31.2% 43) What rate of return should an investor expect for a stock that has a beta of 0.6 when the

market is expected to yield 16% and Treasury bills offer 6%? A) 7.6% B) 9.6% C) 12.0% D) 12.4%

Version 1

44) What happens to the expected portfolio return if the portfolio beta increases from 1.3 to 1.8,

the risk-free rate decreases from 6.5 to 5.5%, and the market risk premium increases from 9.5 to 10.5%? A) It increases from 18.4% to 20.2%. B) It increases from 18.9% to 24.4%. C) It increases from 17.9% to 18.4%. D) It increases from 18.9% to 19.4%. 45) An investor divides her portfolio into three equal parts, with one part in Treasury bills, one

part in a market index, and one part in a mutual fund with beta of 1.24. What is the beta of the investor's overall portfolio? A) 0.75 B) 1.00 C) 1.25 D) .99 46) A project costs $7.64 million, and is expected to generate $2.60 million in cash flows for the

next 4 years. If the opportunity cost of capital is 15%, the project’s return would plot: A) above the security market line. B) below the security market line. C) on the security market line. D) on the security market line, with a beta of 2.6. 47) The expected return on a security includes a reward for: A) market risk and specific risk. B) specific risk. C) diversification and portfolio risk. D) time value of money and market risk. 48) If a security plots below the security market line, it is: A) ignoring all of the security's specific risk. B) underpriced, a situation that should be temporary. C) offering too little return to justify its risk. D) a defensive security, which expects to offer lower returns. 49) Macro events only are reflected in the performance of the market portfolio because: A) the market portfolio contains only risk-free securities. B) only macro events are tracked by economists. C) the specific risks have been diversified away. D) the firm-specific events would be too numerous to quantify.

Version 1

50) In practice, the market portfolio is often represented by: A) a portfolio of U.S. Treasury securities. B) a diversified stock market index. C) an investor's mutual fund portfolio. D) the historic record of stock market returns. 51) A stock's beta measures the: A) average return on the stock. B) sensitivity of the stock's returns to those of the market portfolio. C) difference between the return on the stock and the return on the market portfolio. D) market risk premium on the stock. 52) In theory, the "market portfolio" should contain: A) the securities of the S&P 500. B) the securities of the Dow. C) the securities of the S&P 500 and Treasury bills. D) all risky assets. 53) When the overall market is up by 10%, investors with portfolios of defensive stocks will

probably have: A) negative portfolio returns less than −10%. B) negative portfolio returns greater than −10%. C) positive portfolio returns less than 10%. D) positive portfolio returns greater than 10%. 54) When the overall market experiences a decline of 8%, investors with portfolios of aggressive

stocks will probably experience portfolio: A) losses of less than −8%. B) losses greater than −8%. C) gains of less than 8%. D) gains greater than 8%. 55) A stock has a beta of 1.5, the market risk premium is 6%, and the risk-free rate is 2%. What

is the lowest return the company should accept on a new investment? A) 7.50% B) 10.50% C) 11.00% D) 15.25%

Version 1

56) A stock with a beta greater than 1.0 would be termed: A) an aggressive stock, expected to increase more than the market increases. B) a defensive stock, expected to decrease more than the market increases. C) an aggressive stock, expected to decrease more than the market increases. D) a defensive stock, expected to increase more than the market decreases. 57) The value-weighted average of the betas for all stocks is: A) greater than 1.0; most stocks are aggressive. B) less than 1.0; most stocks are defensive. C) unknown; betas are continually changing. D) exactly 1.0; these stocks represent the market. 58) The slope of the line fitted to a plot of a stock's returns versus the market's returns measures

the: A) security market line. B) beta of the stock. C) market risk premium. D) capital asset pricing model. 59) If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by

1.2%, then its beta equals: A) 1.04. B) 1.24. C) 1.33. D) 1.40. 60) If the slope of the line measuring a stock's returns against the market's returns is positive,

then the stock: A) has a beta greater than 1.0. B) has no specific risk. C) has a positive beta. D) plots above the security market line. 61) If the line measuring a stock's historic returns against the market's historic returns has a slope

greater than 1.0, then the: A) stock is currently underpriced. B) market risk premium is increasing. C) stock has a significant amount of specific risk. D) stock has a beta exceeding 1.0.

Version 1

62) A mutual fund returns 14%. If the risk-free rate is 2% and the beta of the fund is 1.60, what is

the implied market risk premium? A) 6.50% B) 7.50% C) 8.50% D) 9.50% 63) What is the most likely explanation for a +20.0% return on a stock with a beta of 1.0 in a

month when the market returned +10.0%? A) The stock is aggressive. B) The market is undervalued. C) Favorable firm-specific news was reported. D) The beta is really less than 1.0. 64) If a stock's beta is 0.8 during a period when the market portfolio was down by 10%, then we

could expect this individual stock to: A) lose more than 10%. B) lose, but less than 10%. C) gain more than 10%. D) gain, but less than 10%. 65) A stock’s total risk depends on the stock's _________ and _________. A) beta; specific risk B) beta; market risk C) specific risk; firm-specific risk D) aggressive risk; defensive risk 66) Estimate a stock's beta based on the following information: Month Stock Return Market Return 1 +1.5% +1.1% 2 +2.0% +1.4% 3 −2.5% −2.0% A) Greater than 1.0 B) Less than 1.0 C) Equal to 1.0 D) Indeterminate

Version 1

67) If you were willing to bet that the overall stock market was heading up on a sustained basis,

it would be more profitable to invest in: A) high beta stocks. B) low beta stocks. C) stocks with large amounts of specific risk. D) stocks that plot above the security market line. 68) What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of

stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73? A) 1.0 B) 1.17 C) 1.22 D) 1.25 69) You want to construct a portfolio containing equal amounts of U.S. Treasury bills and two

stocks. If the beta of the first stock is 1.23 and the beta of the portfolio is 1.0, what does the beta of the second stock have to be? A) 0.77 B) 1.23 C) 0.23 D) 1.77 70) An investor wishes to invest equal amounts in three stocks and to achieve a portfolio beta of

1.2. If stock A has a beta of 0.9 and stock B has a beta of 1.1, what must be the beta of stock C? A) 0.7 B) 1.6 C) 1.2 D) 1.8 71) What is the standard deviation of the market portfolio if the standard deviation of a well-

diversified portfolio with a beta of 1.25 equals 20%? A) 16.00% B) 18.75% C) 25.00% D) 32.50%

Version 1

72) What is the beta of a U.S. Treasury bill? A) 1.0 B) −1.0 C) 0 D) Unknown 73) One of the easiest methods of diversifying away firm-specific risks is to: A) buy only stocks with a beta of 1.0. B) build a portfolio with 40 to 55 individual stocks. C) purchase the shares of an index fund. D) purchase stocks that plot above the security market line. 74) A scatter in the plot of a stock’s returns versus the returns on the market reflects the: A) high beta of the stock. B) specific risk of the stock. C) changes in market risk premium over time. D) current underpricing of the stock. 75) A project has a beta of 1.24, the risk-free rate is 3.8%, and the market rate of return is 9.2%.

What is the project's expected rate of return? A) 15.21% B) 11.41% C) 10.50% D) 14.61% 76) Which statement is correct? A) The superior performance of value stocks is exactly what the CAPM would predict. B) The CAPM predicts that investors are concerned only with the risk that cannot be

diversified away. C) Few financial managers in practice use the CAPM to estimate the cost of capital. D) The CAPM is a model of actual returns whereas the cost of capital is concerned with expected returns. 77) A project has a beta of 0.97, the risk-free rate is 4.1%, and the market risk premium is 8.1%.

What is the project's expected rate of return? A) 7.98% B) 11.96% C) 8.35% D) 11.83%

Version 1

78) Which one of the following statements is correct when Treasury bills yield 3.5% and the

market risk premium is 9.5%? A) The S&P 500 would be expected to return 4.50%. B) The S&P 500 would be expected to return 5.50%. C) The S&P 500 would be expected to return 19.68%. D) The S&P 500 would be expected to return 13.00%. 79) If a well-diversified portfolio of stocks has an expected return of 15% when the expected

return on the market portfolio is 10%, then: A) Treasury bills are offering a 7% yield. B) the portfolio beta is greater than 1.0. C) the portfolio beta equals 1.67. D) the investor's portfolio contains mostly defensive stocks. 80) The market rate of return is 12.5% and the risk-free rate is 3.1%. What will be the change in

a stock's expected rate of return if its beta increases from 1.2 to 1.4? A) 1.88% B) 2.5% C) 18.8% D) 25.0% 81) If a stock with a beta of 1.4 is expected to return 18% when Treasury bills yield 6%, what is

the expected return on the market portfolio? A) 8.67% B) 10.84% C) 12.02% D) 14.57% 82) When Treasury bills yield 3% and the expected return on the market is 12%, then the risk

premium on an asset is equal to: A) 3%. B) 12%. C) 9% times the asset's beta. D) 9% plus the risk-free rate.

Version 1

83) Calculate the risk premium on stock C given the following information: risk-free rate = 5%,

market return = 13%, stock C’s beta = 1.3. A) 8.0% B) 10.4% C) 15.4% D) 16.9% 84) If the interest rate on Treasury bills is 4% and the market risk premium is 9%, then a stock

with a beta of 1.5 would be expected to return: A) 11.0%. B) 13.0%. C) 17.5%. D) 19.5%. 85) An investor expects a return of 18% on his portfolio with a beta of 1.25. If the expected

market risk premium increases from 8% to 10%, what return should he now expect on the portfolio? A) 20.0% B) 20.5% C) 22.5% D) 26.0% 86) An investor expects a return of 14.7% on her portfolio with a beta of 1.13. If the expected

market risk premium decreases from 8% to 7%, what return should she now expect on the portfolio? A) 13.57% B) 13.89% C) 14.67% D) 15.87% 87) What rate of return should an investor expect for a stock that has a beta of 0.8 when the

market is expected to yield 14% and Treasury bills offer 6%? A) 9.2% B) 11.2% C) 12.4% D) 12.8%

Version 1

88) You believe that Alpha stock which has a beta of 1.32 will return 16.0% this coming year.

The market is expected to return 11.4% and T-bills return 3.8%. According to CAPM, which one of these statements is correct given this information? A) The stock is currently underpriced. B) The stock plots below the security market line. C) The risk premium on the stock is too low given the stock's beta. D) The stock plots to the left of the market on a security market line graph. 89) Why should stock market investors ignore specific risks when calculating required rates of

return? A) There is no method for quantifying specific risks. B) Specific risk can be diversified away. C) Specific risks are compensated by the risk-free rate. D) Beta includes a component to compensate for specific risk. 90) If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the

portfolio beta is: A) 0.70. B) 1.05. C) 1.40. D) 2.10. 91) A portfolio consists of an index mutual fund which represents the overall market and

Treasury bills. The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk premium is 7.6%. What is your best estimate of the portfolio expected rate of return? A) 8.39% B) 7.76% C) 10.80% D) 9.02% 92) What is the beta of a security with an expected return of 12% if Treasury bills yield 6% and

the market risk premium is 8%? A) 0.50 B) 0.75 C) 0.90 D) 1.50

Version 1

93) The slope of the security market line equals: A) one. B) beta. C) the market risk premium. D) the expected return on the market portfolio. 94) A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the

market rate of return is 10.6%? A) 2.825% B) 3.250% C) 3.275% D) 3.415% 95) The market portfolio has an expected return of 18% and the risk-free rate is 6%. An investor

borrows $100 at the risk-free rate and invests this and a further $100 of his own in the market portfolio. What is his expected return? A) 18.6% B) 19.6% C) 21.6% D) 30.0% 96) If Stock A has a higher expected return than Stock B, which of the following statements is

most likely? A) Stock A has more specific risk. B) Stock B plots below the security market line. C) Stock B is a cyclical stock. D) Stock A has a higher beta. 97) A stock's risk premium is equal to the: A) expected market return times beta. B) Treasury bill yield plus the expected market return. C) risk-free rate plus the expected market risk premium. D) expected market risk premium times beta. 98) Investing borrowed funds in a stock portfolio will generally: A) increase the beta of the portfolio. B) decrease the volatility of the portfolio. C) decrease the expected return on the portfolio. D) increase the market risk premium.

Version 1

99) A stock is expected to pay a year-end dividend of $8 and then to sell at a price of $109. The

risk-free interest rate is 4%, the expected market return is 12%, and the stock has a beta of 0.8. What is the stock price today? A) $102.99 B) $98.73 C) $105.98 D) $109.00 100)

Which one of these statements is correct? A) Betas can be measured exactly. B) If a stock has a very low beta, it is likely to have a high beta in the future. C) The expected future risk premium is easy to accurately determine. D) CAPM is widely used as a means of estimating expected returns.

101)

What happens to the expected portfolio return if the portfolio beta increases from 1.0 to 1.5, the risk-free rate decreases from 5 to 4%, and the market risk premium increases from 8 to 9%? A) It increases from 12.5% to 14.0%. B) It increases from 13.0% to 17.5%. C) It increases from 12.0% to 12.5%. D) It increases from 13.0% to 13.5%.

102)

What would you recommend to an investor who is considering an investment that plots below the security market line? A) Invest; the expected return is high relative to the risk. B) Don't invest; the risk is high relative to the expected return. C) Invest; all stocks revert to the SML over time. D) Don't invest; all stocks below the SML are low-growth stocks.

103)

Investment projects that plot above the security market line have: A) a positive NPV. B) a negative NPV. C) a zero NPV. D) an excessively high discount rate.

Version 1

104)

The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if: A) it results in a negative NPV for the proposal. B) the project has a different degree of risk from the company. C) the company has specific risk. D) the company expects to earn more than the risk-free rate.

105)

A proposed investment must earn at least as much as the _____________ if it is to be deemed acceptable. A) company cost of capital B) risk-free rate C) market risk premium D) project cost of capital

106)

A project with higher than average risk offers an expected return of 14%. Which statement is correct if the company's opportunity cost of capital is 12% and the project's opportunity cost of capital is 15%? A) Project NPV is positive; it should be accepted. B) Project NPV is negative; it should be rejected. C) Project NPV is positive but it should be rejected. D) Project NPV is negative but it should be accepted.

107)

The project cost of capital is: A) always equal to the company cost of capital. B) always less than the company cost of capital. C) always greater than the company cost of capital because the project has specific risk. D) not necessarily related to the company cost of capital.

108)

The minimum acceptable expected rate of return on a project is the: A) project cost of capital. B) company cost of capital. C) risk-free rate of return. D) project beta times the market risk premium.

109)

If changing discount rates from the company cost of capital to the project cost of capital changes NPV from negative to positive, then the project should use the: A) company cost of capital and be accepted. B) company cost of capital and be rejected. C) project cost of capital and be accepted. D) project cost of capital and be rejected.

Version 1

110)

Which one of the following statements best explains the fact that cyclical firms tend to have high betas? A) Their earnings are particularly sensitive to the state of the economy. B) Their stocks are overpriced. C) Their earnings are less diversifiable. D) Their profit margins are small.

111)

What type of risk is properly reflected in a project's discount rate? A) Market risk B) Specific risk C) Total risk D) Diversifiable risk

112)

Last month a stock with a beta of 1.0 lost 20% while the S&P 500 had a 10% gain. Given this, it is most likely that the: A) stock's beta has been calculated incorrectly. B) S&P 500 cannot represent the overall market. C) firm released some negative information about itself. D) market index had an exceptionally good month.

113)

The slope of the fitted line that shows the relationship between a stock's return and the market's return is the: A) market's beta. B) stock's beta. C) market risk premium. D) stock's standard deviation.

114)

Which one of the following is most likely correct for a diversified stock portfolio that exhibits a higher standard deviation than the market index? A) The portfolio contains aggressive stocks with a beta greater than 1.0. B) The portfolio plots below the security market line. C) The portfolio's beta is less than 1.0. D) The portfolio contains a significant amount of specific risk.

Version 1

115)

An investor divides her portfolio into three equal parts, with one part in Treasury bills, one part in a market index, and one part in a mutual fund with beta of 1.50. What is the beta of the investor's overall portfolio? A) 0.83 B) 1.00 C) 1.17 D) 1.25

116)

If the market portfolio is expected to return 16%, then a portfolio that is expected to return 13%: A) plots above the security market line. B) plots to the right of the market on an SML graph. C) is not diversified. D) has a beta that is less than 1.0.

117)

The basic tenet of the CAPM is that a stock's expected risk premium should be: A) greater than the expected market return. B) proportionate to the market return. C) proportionate to the stock's beta. D) greater than the risk-free rate of return.

118)

If the company cost of capital is 20% and a proposed project's cost of capital is 15%, then discounting the projects' cash flows at 20% would: A) determine where the project plots in relation to the security market line. B) make the project look more attractive than it should be. C) be correct from a theoretical perspective. D) be incorrect and could cause the project to be erroneously rejected.

119)

If a project could have a bad outcome: A) the discount rate should be increased. B) expected cash flows should be adjusted downward to reflect this possibility. C) the beta should be increased. D) the market risk premium should be revised downward.

120)

A project costs $3 million, and is expected to generate $1 million in cash flows for the next 4 years. If the opportunity cost of capital is 15%, the project’s return would plot: A) above the security market line. B) below the security market line. C) on the security market line. D) on the security market line, with a beta of 1.0.

Version 1

121)

An investor prefers to invest in companies that have high operating leverage. How can this be accomplished if the investor also requires a portfolio beta of 1.0? A) Invest 50% in cyclical stocks and 50% in firms with high operating leverage. B) Invest 50% in a market index fund and 50% in firms with high operating leverage. C) Finance part of the portfolio with borrowing. D) Invest a portion of the portfolio in U.S. Treasury securities.

122)

Which one of the following portfolios might be expected to exhibit less specific risk? A) Five random stocks; portfolio beta = 0.8 B) Three random stocks; portfolio beta = 1.2 C) Ten random stocks; portfolio beta = 1.0 D) Twelve random stocks; portfolio beta unknown

123)

If the plot of a portfolio's returns against returns on the market index produces a tight pattern, then the portfolio: A) appears to be well diversified. B) has a beta of 0. C) has very little systematic risk. D) has a risk premium lower than the market.

124)

If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury bills, then the investor should expect to receive: A) the risk-free rate plus 75% of the expected return on the market. B) the risk-free rate plus 75% of the expected market risk premium. C) 75% of the expected return on the market. D) 25% of the risk-free rate plus 75% of the expected market risk premium.

Version 1

Answer Key Test name: Ch12 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) TRUE 7) FALSE 8) FALSE 9) TRUE 10) TRUE 11) FALSE 12) TRUE 13) TRUE 14) TRUE 15) TRUE 16) FALSE 17) TRUE 18) TRUE 19) FALSE 20) TRUE 21) FALSE 22) TRUE 23) FALSE 24) TRUE 25) TRUE 26) FALSE 27) FALSE 28) FALSE 29) FALSE 30) TRUE 31) FALSE 32) C

E(R) = 3% + 1.80 × 7% = 15.60% 33) C

β = 1.69% ÷ 1.23% = 1.37

Version 1

34) B

19% = 2% + 2.00 × MRP MRP = 8.50% 35) D

36) B

37) A

38) C

E(R) = 4.65% + 1.41 × (10.05% − 4.65%) = 12.26% 39) B

E(R) = 4.1% + 0.94 × 8.1% = 11.71% 40) A

ΔE(R) = (1.8 − 1.6) × (12.5% − 3.5%) = 1.80% 41) B

42) B

E(R) = 23% + 1.30 × (10% − 8%) = 25.6% 43) C

E(R) = 6% + 0.6 × (16% − 6%) = 12.0% 44) B

45) A

Version 1

46) B

The project's IRR = 13.59%. Therefore, the return on the project will plot below the SML. 47) D 48) C 49) C 50) B 51) B 52) D 53) C 54) B 55) C

E(R) = 2% + 1.50 × 6% = 11.00% 56) A 57) D 58) B 59) C

β = 1.6% ÷ 1.2% = 1.33 60) C 61) D 62) B

14% = 2% + 1.60 × MRP MRP = 7.50% 63) C 64) B 65) A 66) A 67) A 68) D

69) D

Version 1

70) B

71) A

{MISSING IMAGE}

72) C 73) C 74) B 75) C

E(R) = 3.8% + 1.24 × (9.2% − 3.8%) = 10.50% 76) B 77) B

E(R) = 4.1% + 0.97 × 8.1% = 11.96% 78) D

E(R) = 3.5% + 1 × (9.5%) = 13% 79) B 80) A

ΔE(R) = (1.4 − 1.2) × (12.5% − 3.1%) = 1.88% 81) D

82) C 83) B

84) C

E(R) = 4% + 1.5 × (9%) = 17.5% 85) B

E(R) = 18% + 1.25 × (10% − 8%) = 20.5%

Version 1

86) A

E(R) = 14.7% + 1.13 × (7% − 8%) = 13.57% 87) C

E(R) = 6% + 0.8 × (14% − 6%) = 12.4% 88) A

E(R) = 3.8% + 1.32 × (11.4% − 3.8%) = 13.83% < 16% 89) B 90) B

91) B

92) B

E(R) = 12% = 6% + β × 8% → β = 0.75 93) C 94) C

95) D

Expected return = 6% + 2 × (18% − 6%) = 30% 96) D 97) D 98) A 99) C

r = 4% + 0.8 × (12% − 4%) = 10.4% P = ($8 + $109) ÷ 1.104 = $105.98 100) 101)

D B

Version 1

102) 103) 104) 105) 106) 107) 108) 109) 110) 111) 112) 113) 114) 115)

B A B D B D A C A A C B A A

116) 117) 118) 119) 120)

D C D B B

The project's IRR = 12.59%. Therefore, the return on the project will plot below the SML. 121) 122) 123) 124)

D D A B

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) Capital structure refers to a firm's mix of long-term debt and equity financing. ⊚ true ⊚ false 2) The company cost of capital is the expected rate of return that investors demand from the

company's assets and operations. ⊚ true ⊚ false 3) The company cost of capital is the minimum acceptable rate of return for any project the firm

undertakes. ⊚ true ⊚ false 4) The weighted-average cost of capital is the expected rate of return on a portfolio of all the

firm's securities, adjusted for the tax savings on interest payments. ⊚ true ⊚ false 5) If a project has a zero NPV when the expected cash flows are discounted at the weighted-

average cost of capital, then the project's cash flows are just sufficient to give debtholders and shareholders the return they require. ⊚ true ⊚ false 6) A firm's cost of capital should be computed using the book weights of each financing source. ⊚ true ⊚ false 7) There are two costs of debt finance. The explicit cost of debt is the rate of interest that

bondholders demand. But there is also an implicit cost, because higher levels of debt increase the required rate of return to equity. ⊚ true ⊚ false

Version 1

8) The weighted-average cost of capital is the return the company needs to earn after tax in

order to satisfy all its security holders. ⊚ true ⊚ false 9) If the firm decreases its debt ratio, both the debt and the equity will become riskier. The

debtholders and equityholders will require a higher return to compensate for the increased risk. ⊚ true ⊚ false 10) A firm's weighted-average cost of capital will generally increase if the firm lowers its debt-

equity ratio. ⊚ true ⊚ false 11) Preferred stock should be ignored when computing a firm's weighted-average cost of capital. ⊚ true ⊚ false 12) Both the capital asset pricing model and the dividend discount model can be used to

determine the cost of equity financing. ⊚ true ⊚ false 13) The cost of equity will generally increase for risky firms when the risk-free rate of return

increases. ⊚ true ⊚ false 14) Interest tax shields are available to the firm on debt and preferred stock but not on common

equity. ⊚ true ⊚ false 15) New projects should be undertaken by firms only if they have the same risk as existing

assets. ⊚ true ⊚ false

Version 1

16) Projects that have a zero NPV when the cash flows are discounted at the WACC will provide

just sufficient returns to creditors and shareholders. ⊚ true ⊚ false 17) As a firm increases its debt ratio, debtholders are likely to demand higher rates of return. ⊚ true ⊚ false 18) An increase in a firm's debt ratio will have no effect on the required rate of return for

equityholders. ⊚ true ⊚ false 19) A firm's cost of capital should be used as the discount rate for every new project the firm

considers. ⊚ true ⊚ false 20) The mix of a company's short-term financing is referred to as its capital structure. ⊚ true ⊚ false 21) To a company, the cost of interest payments on its bonds is reduced by the amount of tax

savings generated by that interest. ⊚ true ⊚ false 22) The interest tax shield generated by a project's actual equity financing is accounted for by

using the after-tax cost of equity in the WACC. ⊚ true ⊚ false 23) Assuming a project has the same risk and financing as the firm, it will have a positive NPV if

its rate of return is greater than the firm's WACC. ⊚ true ⊚ false

Version 1

24) For healthy firms, the expected return on their bonds is close to their yield to maturity. ⊚ true ⊚ false 25) One way to estimate the expected return on bonds is to find the yield to maturity on recently-

issued bonds with similar characteristics and risks. ⊚ true ⊚ false 26) The WACC is the rate of return that the firm must expect to earn on its average-risk

investments in order to provide an acceptable return to its security holders. ⊚ true ⊚ false 27) When using the WACC as a discount rate, it is often adjusted upward for riskier projects and

downward for safer projects. ⊚ true ⊚ false 28) All things being equal, a decrease in the corporate tax rate will cause the company to be

financed with more debt. ⊚ true ⊚ false 29) A change in the company's capital structure will change the amount of taxes paid but will not

change the WACC. ⊚ true ⊚ false 30) A drop in the corporate tax rate from 35% to 21% will cause the WACC for companies to go

up. ⊚ true ⊚ false

Version 1

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 31) The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 10% pre-tax cost of debt, 19% cost of equity, and a 21% tax rate is: A) 11.79%. B) 12.37%. C) 12.88%. D) 16.23%. 32) The weighted-average cost of capital for a firm with a 40/60 debt/equity split, 9% cost of

debt, 15% cost of equity, and a 21% tax rate is: A) 12.52%. B) 8.94%. C) 11.84%. D) 14.11%. 33) Company X has 3.60 million shares of common stock outstanding with a book value of $2.80

per share. The stock trades for $3.16 per share. It also has $3.60 million in face value of debt that trades at 90% of face value. What is the debt ratio that should be used to calculate WACC? A) 13.00% B) 22.17% C) 30.12% D) 26.76% 34) A firm is financed 55% by common stock, 10% by preferred stock, and 35% by debt. The

required return is 18.50% on the common, 13.50% on the preferred, and 11.50% on the debt. If the tax rate is 21%, what is the WACC? A) 13.96% B) 14.70% C) 14.94% D) 15.29% 35) How much will a firm need in cash flow before tax and interest to satisfy debtholders and

equityholders if the tax rate is 21%, there is $10 million in common stock requiring a 13.2% return, and $6 million in bonds requiring a return of 9.2%? A) $1,615,923 B) $1,712,787 C) $2,222,886 D) $2,920,000

Version 1

36) A firm has 20,000 shares of common stock outstanding with a book value of $28 per share

and a market value of $47. There are 5,000 shares of preferred stock with a book value of $30 and a market value of $42. There is a $440,000 face value bond issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the firm's WACC? A) 7.21% B) 13.70% C) 11.44% D) 15.05% 37) A firm has a debt-to-equity ratio of 1/4. The WACC is 20.2%, and the pretax cost of debt is

11.0%. What is the cost of common equity if the tax rate is 21%? A) 21.58% B) 22.58% C) 23.08% D) 24.41% 38) How much cash flow before tax and interest is necessary to support a project if $2.25 million

is used to pay interest, the tax rate is 21%, and equity investors require annual income of $4.25 million? A) $7.63 million B) $8.43 million C) $8.72 million D) $9.42 million 39) What equity proportion should be used when calculating WACC for a firm with $50.5

million in debt selling at 85% of par, $50 million in book value of equity, and $65.5 million in market value of equity? A) 50.50% B) 60.41% C) 54.12% D) 56.49% 40) XYZ Company issues common stock at a price of $25 a share. The firm expects to pay a

dividend of $4.00 a share next year. If the dividend is expected to grow at 2.5% annually, what is XYZ's cost of common equity? A) 13.5% B) 18.5% C) 20.9% D) 16.1%

Version 1

41) Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk-

free rate is 5% and the return on the market is 15.2%. A) 13.62% B) 15.16% C) 18.26% D) 20.10% 42) Plasti-tech Incorporated is financed 60% with equity and 40% with debt. Currently, its debt

has a pretax interest rate of 12%. Plasti-tech's common stock trades at $15.15 per share and its most recent dividend was $1.06. Future dividends are expected to grow by 4%. If the tax rate is 21%, what is Plasti-tech's WACC? A) 7.60% B) 9.78% C) 10.56% D) 11.41% 43) The capital structure for the CR Corporation includes bonds valued at $7,200 and common

stock valued at $12,700. If CR has an after-tax cost of debt of 6%, and a cost of common stock of 16%, what is its WACC? A) 9.04% B) 12.38% C) 13.04% D) 14.38% 44) What is the yield to maturity on Dotte Incorporated's bonds if its after-tax cost of debt is

10.35% and its tax rate is 21%? A) 6.94% B) 13.10% C) 15.82% D) 16.86% 45) Suppose an analyst estimates that free cash flow will be $2.57 million in year 5. What is the

present value of this free cash flow if the company cost of capital is 12%, the WACC is 10%, and the equity cost of capital is 15%? A) $2,199,972 B) $1,295,068 C) $1,595,768 D) $1,465,776

Version 1

46) Capital structure decisions refer to the: A) dividend yield of the firm's stock. B) blend of equity and debt used by the firm. C) capital gains available on the firm's stock. D) maturity date for the firm's securities. 47) What is the debt ratio of a firm that has an equity market value of $35 million and a debt

market value of $15 million? A) 15% B) 30% C) 35% D) 43% 48) To calculate the present value of a business, the firm's free cash flows should be discounted

at the firm's: A) weighted-average cost of capital. B) pre-tax cost of debt. C) after-tax cost of debt. D) cost of equity. 49) The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax

cost of debt, 15% cost of equity, and a 21% tax rate is: A) 9.36%. B) 9.94%. C) 10.45%. D) 13.80%. 50) The weighted-average cost of capital for a firm with a 40/60 debt/equity split, 8% cost of

debt, 15% cost of equity, and a 21% tax rate is: A) 12.20%. B) 8.63%. C) 11.53%. D) 13.80%. 51) Why is debt financing said to include a tax shield for the company? A) Taxes are reduced by the amount of the debt. B) Taxes are reduced by the amount of the interest. C) Taxable income is reduced by the amount of the debt. D) Taxable income is reduced by the amount of the interest.

Version 1

52) If the after-tax cost of debt is 10%, what is the pretax cost for a firm in the 21% tax bracket? A) 5.85% B) 10.15% C) 12.66% D) 18.71% 53) What is a firm's weighted-average cost of capital for a firm that is financed 45% by debt?

The debt has a 10% required return and the equity has a 17% required return. The tax rate is 21%. A) 13.85% B) 12.91% C) 13.50% D) 9.00% 54) What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20%

on its equity, and has a 21% tax rate? A) 9.6% B) 12.0% C) 14.7% D) 16.0% 55) Company X has 2 million shares of common stock outstanding with a book value of $2 per

share. The stock trades for $3 per share. It also has $2 million in face value of debt that trades at 90% of face value. What is the debt ratio that should be used to calculate WACC? A) 13.91% B) 23.08% C) 31.03% D) 27.67% 56) If the tax rate is 21%, what is the cost of preferred stock that sells for $10 per share and pays

a $1.20 dividend? A) 4.20% B) 7.80% C) 8.33% D) 12.00%

Version 1

57) A firm is financed 55% by common stock, 10% by preferred stock, and 35% by debt. The

required return is 15% on the common, 10% on the preferred, and 8% on the debt. If the tax rate is 21%, what is the WACC? A) 10.72% B) 11.46% C) 11.70% D) 12.05% 58) For a firm with EBIT of $10 million, paying $6 million per year in interest expense, a drop in

the corporate tax rate from 35% to 21% will have what impact on their interest tax shield? A) $0.84 million higher B) $0.84 million lower C) $0.56 million higher D) $0.56 million lower 59) A project requires an investment of $10 million and offers an annual after-tax cash flow of

$1,250,000 indefinitely. If the firm's WACC is 12.5% and the project is riskier than the firm’s average projects, should it be accepted? A) Yes, since the project's NPV is positive. B) Yes, since a zero NPV indicates marginal acceptability. C) No, since the project's NPV is zero. D) No, since the project's NPV is negative. 60) How much will a firm need in cash flow before tax and interest to satisfy debtholders and

equityholders if the tax rate is 21%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds requiring an 8% return? A) $1,392,024 B) $1,488,888 C) $1,998,987 D) $2,800,000 61) How much will a firm need in cash flow before tax and interest to satisfy debtholders and

equityholders if the tax rate is 21%, there is $15.8 million in common stock requiring a 10% return, and $6 million in bonds requiring a 6% return? A) $1,392,000 B) $1,488,000 C) $2,360,000 D) $2,480,000

Version 1

62) Which one of the following statements is incorrect? A) The equity component of WACC reflects the return expected by the company’s

shareholders. B) Market values should be used in calculating WACC. C) Preferred equity is a separate component of WACC. D) There is a tax shield on the equity dividends paid. 63) What will be the effect of using the book value of debt in WACC decisions if interest rates

have decreased substantially since a firm's long-term bonds were issued? A) The debt-to-value ratio will be overstated. B) The debt-to-value ratio will be understated. C) There will be no effect on WACC decisions. D) It cannot be determined without knowing interest rates. 64) A firm has 12,000 shares of common stock outstanding with a book value of $20 per share

and a market value of $39. There are 5,000 shares of preferred stock with a book value of $22 and a market value of $26. There is a $400,000 face value bond issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the firm's WACC? A) 7.25% B) 13.74% C) 11.48% D) 15.09% 65) What would you estimate as the cost of equity if a stock sells for $40, pays a $4.25 dividend,

and is expected to grow at a constant rate of 5%? A) 17.46% B) 14.52% C) 12.69% D) 15.63% 66) What is the expected growth rate in dividends for a firm in which shareholders require an

18% rate of return and the dividend yield is 10%? A) 1.8% B) 5.2% C) 8.0% D) 28.0%

Version 1

67) What dividend is paid on preferred stock if investors require a 9% rate of return and the stock

has a market value of $54 per share and a book value of $50 per share? A) $2.92 B) $4.50 C) $4.68 D) $4.86 68) If a firm earns the WACC on its assets, then: A) equityholders will be satisfied, but bondholders will not. B) bondholders will be satisfied, but equityholders will not. C) all investors will earn their minimum required rate of return. D) the firm is investing in only positive NPV projects. 69) As debt is added to the capital structure, the: A) WACC will continually decline. B) WACC will tend towards 0. C) cost of debt can be expected to eventually rise. D) WACC will be unaffected. 70) An implicit cost of increasing the proportion of debt in a firm's capital structure is that: A) the firm's asset beta will increase. B) shareholders will demand a higher rate of return. C) the tax shield will not apply to the added debt. D) the cost of equity will decrease. 71) A firm is considering a project that will generate perpetual cash flows of $50,000 per year

beginning next year. The project has the same risk as the firm's overall operations. If the firm's WACC is 12%, and its debt-to-equity ratio is 1.33, what is the most it could pay for the project and still earn its required rate of return? A) $313,283 B) $375,094 C) $416,667 D) $554,167 72) A firm's WACC: A) is the proper discount rate for every project the firm undertakes. B) is used to value all of the firm's existing projects. C) is a benchmark discount rate that may be adjusted for the riskiness of each project. D) is for informational value only and should never be used as a discount rate.

Version 1

73) Other things equal, which of the following will decrease the WACC of a firm that has both

debt and equity in its capital structure? A) An increase in the stock’s beta B) An increase in the expected market return C) An increase in the tax rate D) An increase in the yield on preferred stock 74) Calculate a firm's WACC given that the total value of the firm is $2 million, $600,000 of

which is debt, the pre-tax cost of debt is 10%, and the cost of equity is 15%. The firm pays no taxes. A) 9.0% B) 11.5% C) 13.5% D) 14.4% 75) A firm has a debt-to-equity ratio of 1/4. The WACC is 18.6%, and the pretax cost of debt is

9.4%. What is the cost of common equity if the tax rate is 21%? A) 19.90% B) 20.90% C) 21.39% D) 22.73% 76) For a company that pays no corporate taxes, its WACC will be equal to: A) the expected return on its assets. B) the expected return on its debt. C) the total value of its assets. D) the expected return on its equity. 77) A firm is 40% financed by debt with a yield-to-maturity of 8.5%. The equity has a beta of

1.3, the market risk premium is 8.4%, and the risk-free rate is 3.8%. What is the firm's WACC if the tax rate is 21%? A) 10.74% B) 11.52% C) 11.91% D) 12.38%

Version 1

78) If a firm has twice as much equity as debt in its capital structure, then the firm is financed

with: A) 75.0% debt. B) 66.7% equity. C) 40.0% debt. D) 33.3% equity. 79) If a firm has three times as much equity as debt in its capital structure, then the firm is

financed with: A) 25.0% debt. B) 90.0% equity. C) 40.0% debt. D) 33.3% debt. 80) If a company's WACC is less than the required return on equity, then the firm: A) is financed with more than 50% debt. B) is perceived to be safe. C) has debt in its capital structure. D) is all-equity financed. 81) The company cost of capital is the return that is expected on a portfolio of the company's: A) existing securities. B) equity securities. C) debt securities. D) proposed securities. 82) A firm has just paid its annual dividend of $5.64 a share. Thereafter the dividend is expected

to increase at a rate of 2% a year. If the firm's stock currently sells for $60 a share, what is the cost of equity? A) 11.59% B) 14.33% C) 11.40% D) 9.40% 83) What is the WACC for a firm financed with 30% debt if the debt investors require a return of

12.5% and equity investors require a 16% return? The corporate tax rate is 21%. A) 11.8% B) 13.3% C) 14.2% D) 14.8%

Version 1

84) Which one of the following changes would tend to increase the WACC for a tax-paying

firm? A) Decrease the proportion of equity financing B) Increase the market value of the debt C) Decrease the proportion of debt financing D) Decrease the market value of the equity 85) A firm is considering expanding its current operations and has estimated the internal rate of

return on that expansion to be 12.2%. The firm's WACC is 11.8%. Given this, you know that the: A) project will have a lower debt-equity ratio than the firm's current operations. B) appropriate discount rate for the project is between 11.8% and 12.2%. C) project has slightly more risk than the firm's current operations. D) expansion should be undertaken as it has a positive net present value. 86) A firm has 12,500 shares of stock outstanding that sell for $42 each. The book value of

equity is $400,000. The firm has also issued $250,000 face value of debt that is currently quoted at 101.2. What value should be used as the weight of equity when computing WACC? A) 67.48% B) 72.09% C) 61.54% D) 69.74% 87) A tax-paying firm is currently financed with 50% debt and 50% equity. The after-tax cost of

debt is 6% and the cost of equity is 12%. If the firm issues some 8% preferred stock at par, then the firm's WACC will: A) increase. B) decrease. C) either increase or decrease depending upon the amount of stock issued. D) not be affected. 88) Assume a firm's debt is selling at face value. What is the firm's cost of debt if the debt has a

coupon rate of 7.5% and the tax rate is 21%? A) 4.88% B) 4.97% C) 5.21% D) 5.93%

Version 1

89) What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt

is 7%, the tax rate is 21%, and the required return on equity is 18%? A) 54.00% B) 63.64% C) 70.26% D) 77.78% 90) What proportion of a firm is equity financed if the WACC is 14%, the before-tax cost of debt

is 10.77%, the tax rate is 21%, and the required return on equity is 18%? A) 54.00% B) 57.86% C) 70.26% D) 77.78% 91) A firm has a debt-to-value ratio of 40%, a cost of equity of 14%, and an after-tax cost of debt

of 5.5%. It plans to launch a new product that will produce cash flows of $398,000 next year and $211,000 in year 2. If this project is about as risky as the firm’s existing assets, what is the present value of the project? A) $458,008 B) $481,707 C) $500,614 D) $532,349 92) Al's Market plans to close after 3 more years. The firm expects to have free cash flows of

$148,000 next year, $128,000 in year 2, and $65,000 in year 3 after incurring the costs of closing. The firm's cost of equity is 15.5% and its after-tax cost of debt is 6.2%. What is the present value of the firm if its debt to value ratio is 30%? A) $312,020 B) $248,915 C) $277,467 D) $301,004 93) A proposed project has a positive NPV if it is financed entirely by equity. If the project can

sensibly be financed partly by debt and the firm pays tax, will the project remain acceptable? A) Yes, using debt will increase the NPV. B) No, using debt will decrease the NPV. C) The project may now become unacceptable. D) There will be no change in the project's NPV.

Version 1

94) What is the after-tax cost of preferred stock that pays a 12% dividend and sells at par if the

firm's tax rate is 21%? A) 7.8% B) 8.5% C) 12.0% D) 16.2% 95) What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if their

respective costs are 6% after tax, 12%, and 18%? The firm's tax rate is 21%. A) 9.48% B) 11.16% C) 12.00% D) 15.60% 96) What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if their

respective costs are 9.23% before tax, 12%, and 18%? The firm's tax rate is 21%. A) 9.48% B) 11.16% C) 12.52% D) 15.60% 97) A project will generate a $1 million net cash flow annually in perpetuity. If the project costs

$7 million, what is the break-even WACC? A) 13.33% B) 12.08% C) 14.29% D) 16.67% 98) Which one of the following changes offers the greatest chance of changing a project's NPV

from negative to positive? A) Substituting preferred stock for debt B) Selling the debt at less than par value C) Reducing the risk of the project D) Reducing the maturity of the debt

Version 1

99) What decision should be made on a project with above-average market risk? A) Accept if the cash flows discounted at the WACC have a positive NPV. B) Discount the cash flows at the IRR and accept if NPV is positive. C) Accept if the IRR is greater than the WACC. D) Use a higher discount rate than the WACC to reflect the project’s risk and accept if

NPV is positive at this higher discount rate. 100)

If equity investors require a 20% rate of return, what is the maximum acceptable amount of equity financing for a project with cash flows of $2 million a year in perpetuity before tax and interest? The project supports debt of $3 million with a 10% coupon, and the tax rate is 21%. A) $5.87 million B) $6.72 million C) $8.5 million D) $9.03 million

101)

For purposes of computing the WACC, if the book value of equity exceeds the market value of equity, then the: A) book value of equity should be used. B) book value of equity less retained earnings should be used. C) market value of equity should be used. D) market value of equity less retained earnings should be used.

102)

How much cash flow before tax and interest is necessary to support a project if $2 million is used to pay interest, the tax rate is 21%, and equity investors require annual income of $4 million? A) $7.06 million B) $7.86 million C) $8.15 million D) $8.85 million

103)

What equity proportion should be used when calculating WACC for a firm with $50 million in debt selling at 85% of par, $50 million in book value of equity, and $65 million in market value of equity? A) 50.00% B) 54.18% C) 56.55% D) 60.47%

Version 1

104)

According to CAPM estimates, what is the cost of equity for a firm with a beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%? A) 19.5% B) 21.0% C) 22.5% D) 24.0%

105)

What return on equity do investors expect for a firm with a $55 share price, an expected dividend of $4.60, a beta of 0.9, and a constant growth rate of 3.5%? A) 9.87% B) 12.48% C) 13.95% D) 11.86%

106)

Changing the capital structure by adding debt will: A) reduce the return that shareholders require. B) reduce default risk. C) increase debtholder risk. D) reduce the cost of debt.

107)

The company cost of capital: A) measures the return that investors require from the company. B) depends on current profits and cash flows. C) is measured using security book values. D) depends on historical profits and cash flows.

108)

XYZ Company issues common stock at a price of $25 a share. The firm expects to pay a dividend of $2.20 a share next year. If the dividend is expected to grow at 2.5% annually, what is XYZ's cost of common equity? A) 6.3% B) 11.3% C) 13.7% D) 8.9%

109)

Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk-free rate is 5% and the return on the market is 13.6%. A) 11.54% B) 13.08% C) 16.18% D) 18.02%

Version 1

110)

Plasti-tech Incorporated is financed 60% with equity and 40% with debt. Currently, its debt has a pretax interest rate of 12%. Plasti-tech's common stock trades at $15.00 per share and its most recent dividend was $1.00. Future dividends are expected to grow by 4%. If the tax rate is 21%, what is Plasti-tech's WACC? A) 7.39% B) 9.57% C) 10.35% D) 11.20%

111)

The capital structure for the CR Corporation includes bonds valued at $5,500 and common stock valued at $11,000. If CR has an after-tax cost of debt of 6%, and a cost of common stock of 16%, what is its WACC? A) 9.33% B) 12.67% C) 13.33% D) 14.67%

112)

What is the yield to maturity on Dotte Incorporated's bonds if its after-tax cost of debt is 10% and its tax rate is 21%? A) 6.50% B) 12.66% C) 15.38% D) 16.42%

113)

Increasing debt financing will do all of the following except: A) cause investors to demand a higher interest rate on debt. B) increase the risk to the firm's common stockholders. C) cause stockholders to demand a higher return. D) decrease the firm's cost of common equity.

114)

Suppose an analyst estimates that free cash flow will be $2.43 million in year 5. What is the present value of this free cash flow if the company cost of capital is 12%, the WACC is 10%, and the equity cost of capital is 15%? A) $2,113,043 B) $1,208,139 C) $1,508,839 D) $1,378,847

Version 1

115)

WACC can be used to determine the value of a firm by discounting the firm's: A) after-tax net profits. B) pretax profits. C) cash inflows. D) free cash flows.

Version 1

Answer Key Test name: Ch13 1) TRUE 2) TRUE 3) FALSE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) FALSE 12) TRUE 13) TRUE 14) FALSE 15) FALSE 16) TRUE 17) TRUE 18) FALSE 19) FALSE 20) FALSE 21) TRUE 22) FALSE 23) TRUE 24) TRUE 25) TRUE 26) TRUE 27) TRUE 28) FALSE 29) FALSE 30) TRUE 31) A

WACC = [0.65 × 0.10 × (1 − 0.21)] + (0.35 × 0.19) = 0.1179, or 11.79% 32) C

WACC = [0.40 × 0.09 × (1 − 0.21)] + (0.60 × 0.15) = 0.1184, or 11.84% 33) B

Version 1

Debt ratio = (0.90 × $3.60 million) ÷ [(3.60 million × $3.16) + (0.90 × $3.60 million)] = 0.2217, or 22.17% 34) B

WACC = (0.55 × 0.1850) + (0.1350 × 0.1) + [0.35 × 0.1150 × (1 − 0.21)] = 0.1470, or 14.70% 35) C

36) B

Weight of preferred = (5,000 × $42) ÷ [(20,000 × $47) + (5,000 × $42) + ($440,000 × 0.87)] = 0.1370, or 13.70% 37) C

38) A

39) B

40) B

41) C

42) C

re = ($1.06 × 1.04) / $15.15 + 0.04 = 0.1128, or 11.28% WACC = 0.4 × 0.12 × (1 − 0.21) + 0.6 × 0.1128 = 0.1056, or 10.56% 43) B

44) B

Version 1

45) C

PV = $2,570,000 ÷ 1.105raise to the power of 5 = $1,595,768 46) B 47) B

Debt ratio = $15 million ÷ ($15 million + 35 million) = 0.30, or 30% 48) A 49) A

WACC = [0.65 × 0.08 × (1 − 0.21)] + (0.35 × 0.15) = 0.0936, or 9.36% 50) C

WACC = [0.40 × 0.08 × (1 − 0.21)] + (0.60 × 0.15) = 0.1153, or 11.53% 51) D 52) C

After-tax cost of debt = 0.10 ÷ (1 − 0.21) = 0.1266, or 12.66% 53) B

WACC = [0.45 × 10% × (1 − 0.21)] + 0.55 × 17% = 12.91% 54) C

WACC = [0.5 × 0.12 × (1 − 0.21)] + (0.5 × 0.20) = 0.1474, or 14.74% 55) B

Debt ratio = (0.90 × $2 million) ÷ [(2 million × $3) + (0.90 × $2 million)] = 0.2308, or 23.08% 56) D

Cost of preferred = $1.20 ÷ $10.00 = 0.12, or 12% 57) B

WACC = (0.55 × 0.15) + (0.1 × 0.1) + [0.35 × 0.08 × (1 − 0.21)] = 0.1146, or 11.46% 58) D

Tax Shield Change = ($10,000,000 − $6,000,000) × (0.35 − 0.21) = $560,000 decrease 59) D

Version 1

NPV at WACC = −$10 million + $1.25 million ÷ 0.125 = $0; However, the 12.5% rate does not reflect the projects' greater risk; thus the project's NPV is negative. 60) C

61) C

62) D 63) B

Assume for example that the market value of equity is $5 million, the book value of debt is $2 million, and the value of the firm is $7 million. In the example, the debt-to-value ratio is 0.286. However, if the market value of debt is $2.5 million due to decreased interest rates, the value of the firm is $7.5 million and the debt-to-value ratio is 0.333. The key is that the numerator of the ratio changes proportionately more than the denominator. 64) B

Weight of preferred = (5,000 × $26) ÷ [(12,000 × $39) + (5,000 × $26) + ($400,000 × 0.87)] = 0.1374, or 13.74% 65) D

E(R) = $4.25 ÷ $40 + 0.05 = 0.1563, or 15.63% 66) C

g = 18% − 10% = 8% 67) D

9% = dividend ÷ $54; Dividend = $4.86 68) C 69) C 70) B 71) C

PV = $50,000 ÷ 0.12 = $416,667 72) C 73) C 74) C

Version 1

WACC = 0.10 × ($600,000 ÷ $2,000,000) + 0.15 × [($2,000,000 − 600,000) ÷ $2,000,000] = 0.135, or 13.5% 75) C

76) A 77) B

WACC = 0.40 × 0.085 × (1 - 0.21) + (1 − 0.40) × 0.1472 = 0.1152, or 11.52% 78) B 79) A 80) C 81) A 82) A

83) C

WACC = 0.3 × (0.79 × 12.5%) + (1 − 0.3) × 16% = 0.142, or 14.2% 84) C 85) D

Since the project is an expansion project, the risk level of the project is equal to the risk level of the current firm. Thus, the project NPV will be positive since the IRR exceeds the required return. 86) A

87) B

Current WACC = 0.50 × 0.06 + 0.50 × 0.12 = 0.09, or 9%; Including some preferred stock at a cost of 8% will lower the firm's WACC. 88) D

89) B

Version 1

14% = (1 − x) × 7% + x × 18%; x = 63.64% 90) B

14% = (1 − x) × 10.77% × (1 − 0.21) + x × 18% → x = 57.86% 91) D

WACC = 0.4 × 5.5% + (1 − 0.4) × 14% = 10.6% PV = $398,000 ÷ 1.106 + $211,000 ÷ 1.1062raise to the power of 2 = $532,349 92) C

WACC = 0.3 × 6.2% + (1 − 0.3) × 15.5% = 12.71% PV = $148,000 ÷ 1.1271 + $128,000 ÷ 1.12712raise to the power of 2 + $65,000 ÷ 1.12713raise to the power of 3 = $277,467 93) A 94) C

There is no adjustment for taxes on preferred stock. Therefore, after-tax cost = pretax cost. 95) C

WACC = (0.4 × 6%) + (0.2 × 12%) + (0.4 × 18%) = 12.00% 96) C

WACC = [0.4 × (1 − 0.21) × 9.23%] + (0.2 × 12%) + (0.4 × 18%) = 12.52% 97) C

$7 million = $1 million ÷ WACC; WACC = 14.29% 98) C 99) D 100) B

101) 102)

C A

103)

Version 1

104)

105)

106) 107) 108)

C A B

109)

110)

WACC = 0.4 × 0.12 × (1 − 0.21) + 0.6 × 0.1093 = 0.1035, or 10.35% 111)

112)

113) 114)

D C PV = $2,430,000 ÷ 1.105raise to the power of 5 = $1,508,839 115)

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) Only a portion of the board of directors are up for election in any given year when a firm has a classified board. ⊚ true ⊚ false 2) Shares of stock that have been issued and subsequently repurchased by the issuer are known

as treasury stock. ⊚ true ⊚ false 3) The price at which new shares are sold to investors almost always exceeds par value. The

difference is entered into the company's accounts as additional paid-in capital, or capital surplus. ⊚ true ⊚ false 4) Firms tend to issue more debt when internal funds are low. ⊚ true ⊚ false 5) In proxy contests, outsiders compete with the firm's existing management and directors for

control of the corporation. ⊚ true ⊚ false 6) Historically, internally generated cash covers less than half of the non-financial firms' capital

requirements in the U.S. ⊚ true ⊚ false 7) The gap between internally generated cash and the cash that the company needs is called the

financial deficit. ⊚ true ⊚ false

Version 1

8) Ford Motor Company and Google have issued two classes of shares with different voting

rights to allow their firms to obtain fresh capital without giving up their management's controlling rights. ⊚ true ⊚ false 9) Suppose a firm needs fresh capital, but its management does not want to give up its

controlling interest. The existing shares could be labeled Class A, and then Class B shares with limited voting rights could be issued to outside investors. ⊚ true ⊚ false 10) If an incompetent management team controls a large block of votes, it may use these votes to

stay in control. ⊚ true ⊚ false 11) Companies sometimes sell the cash flows from a bundle of loans. Such bonds are known as

asset-backed bonds. ⊚ true ⊚ false 12) Firms have the right to resell any Treasury stock they own. ⊚ true ⊚ false 13) Different classes of stock often have different voting rights. ⊚ true ⊚ false 14) If shareholders do not like the policies that management pursues, they can vote in a different

board of directors. ⊚ true ⊚ false 15) A majority of a firm's directors must be independent of the firm's management. ⊚ true ⊚ false

Version 1

16) Corporate investors are indifferent between investing in common and preferred shares. ⊚ true ⊚ false 17) If you are concerned with maintaining the market value of your preferred stock, you should

purchase floating-rate preferred shares. ⊚ true ⊚ false 18) A convertible bond generally has a higher market value than an otherwise similar non-

convertible bond. ⊚ true ⊚ false 19) A corporation cannot default on funded debt. ⊚ true ⊚ false 20) Dividends represent an important component of a firm's net book value. ⊚ true ⊚ false 21) The price at which new shares are issued is referred to as the par value of the stock. ⊚ true ⊚ false 22) A capital surplus is created when the selling price of new shares is greater than the par value. ⊚ true ⊚ false 23) Declassification of a firm's board tends to increase the market value of the firm's stock. ⊚ true ⊚ false 24) The term "senior debt" refers only to debt that was issued in the more distant past. ⊚ true ⊚ false

Version 1

25) In a bankruptcy situation, funded debt will be repaid while unfunded debt will not. ⊚ true ⊚ false 26) Holders of callable bonds know that the company will wish to buy the issue back if interest

rates fall, and therefore the price of the bond will not rise above the call price. ⊚ true ⊚ false 27) Callable bonds may be repurchased by the issuing firm before maturity at the specified call

price. ⊚ true ⊚ false 28) The call provision of callable bonds comes at the expense of bondholders, for it limits their

capital gain potential. ⊚ true ⊚ false 29) Bonds with the callable feature tend to sell at lower prices than bonds without such a feature. ⊚ true ⊚ false 30) A eurobond is defined as any bond that is denominated in euros. ⊚ true ⊚ false 31) For most firms, the majority of their funding is from external sources. ⊚ true ⊚ false 32) Privately-placed debt must be held until maturity and can never be resold. ⊚ true ⊚ false 33) When firms retain cash, they are generating funds internally thereby decreasing the amount

of external funds needed. ⊚ true ⊚ false

Version 1

34) As a group, individual investors are the largest holders of U.S. company bonds. ⊚ true ⊚ false 35) The par value of stock is determined by the stock market. ⊚ true ⊚ false 36) When faced with a financial deficit, companies will usually first turn to issuing new shares. ⊚ true ⊚ false 37) Floating-rate bonds appeal to investors who are worried about fluctuations in interest rates. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 38) How much will be recorded as a firm's additional paid-in capital if the firm issues 1 million shares that have a $5 par value for $18 per share? A) $0 B) $5 million C) $13 million D) $18 million 39) Assume a firm with 5,700 shares outstanding earns $10 per share and has a 30% plowback

ratio. In this case retained earnings will: A) increase by $17,100. B) increase by $57,000. C) decrease by $17,100. D) decrease by $57,000. 40) What is the book value per share of equity for a firm with $1.22 million in net common

equity, $50,000 in authorized share capital, 25,000 shares issued, and 20,000 shares outstanding? A) $49.00 B) $51.00 C) $58.50 D) $61.00

Version 1

41) Assume a corporation has cumulative voting and there are two directors up for election.

What is the maximum number of votes a shareholder who owns 175 shares can cast for Candidate Jones if there are a total of 5 candidates? A) 35 B) 70 C) 175 D) 350 42) If a corporation receives $52,600 in preferred stock dividends, how much tax does it pay on

these dividends? The corporate tax rate is 21%. A) $3,310 B) $5,523 C) $12,890 D) $18,410 43) Jay's Jams Incorporated was just established with an investment of $3.1 million. Jay expects

his company to generate free cash flow of $820,000 a year for the next 10 years. If Jay's cost of capital is 15%, find the market value and book value of his company. A) Market value = $8.2 million; book value = $3.0 million B) Market value = $3.1 million; book value = $4.1 million C) Market value = $4.1 million; book value = $3.1 million D) Market value = $8.2 million; book value = $4.1 million 44) Wheat's Market just issued 18,100 new shares of common stock at a price of $26 a share.

How will this transaction affect the equity accounts on the firm's balance sheet if the par value is $1 per share? A) The common stock account will increase by $470,600. B) The common stock account will decrease by $18,100. C) Paid-in surplus will increase by $452,500. D) Paid-in surplus will increase by $470,600. 45) A firm just issued 15,500 new shares of stock with a market price of $19 per share and par

value of $2 per share. Which one of these correctly states the resulting change in the equity accounts? A) Capital surplus will increase by $263,500. B) Retained earnings will decrease by $294,500. C) Common stock will increase by $15,500. D) Common stock will increase by $294,500.

Version 1

46) A shareholder owning 200 shares of stock is voting for the board of directors who are elected

by cumulative voting. How many votes will the shareholder cast for Director "A" if four directors are to be elected and the maximum number of votes are cast for "A"? A) 50 B) 200 C) 400 D) 800 47) Which one of the following statements is correct about a corporation in the 21% tax bracket

that can invest either in a bond paying 13% interest or in the preferred stock of another corporation that pays a dividend of 10%? Ignore any differences in risk. A) The preferred stock should be selected because its after-tax yield is 0.24% higher. B) The preferred stock should be selected because its after-tax yield is 1.32% higher. C) The bond should be selected because its after-tax yield is 0.24% lower. D) The bond should be selected because its after-tax yield is 1.32% higher. 48) If 104 million shares of common stock are issued with a par value of $2 and additional paid-

in capital is $800 million, the total par value of the issued shares is: A) $208 million. B) $624 million. C) $832 million. D) $1 billion. 49) A company is about to issue 1,120 new shares of stock at a market price of $33 per share. If

the par value per share is $4, the increase in capital surplus from this stock issue will be: A) $32,480. B) $36,960. C) $35,840. D) $4,480. 50) When a firm issues 52,000 shares with a par value of $5 and a market price of $22 per share,

additional paid-in capital will: A) decrease by $260,000. B) increase by $260,000. C) increase by $884,000. D) increase by $1,144,000.

Version 1

51) If the Beta Company issues $115 million worth of preferred stock, what will happen to its net

worth if book value of common equity is $515 million? A) It will increase by $430 million. B) It will decrease by $115 million. C) It will increase to $630 million. D) It will decrease to $430 million. 52) Earnings this year for Plasti-tech, Incorporated, were $228,000. It decided to plow back

$67,000 and recorded $27,000 of depreciation. Plasti-tech's internally generated funds are: A) $40,000. B) $67,000. C) $94,000. D) $161,000. 53) A stock's par value is the: A) maturity value of the stock. B) price at which each share is recorded. C) price at which an investor could sell the stock. D) price received by the firm when the stock was issued. 54) Additional paid-in capital refers to: A) a firm's retained earnings. B) a firm's treasury stock. C) the difference between the issue price and the par value. D) funds borrowed from a bank or bondholders. 55) Which one of the following equity concepts would you expect to be least important to a

financial analyst? A) Par value per share B) Additional paid-in capital C) Retained earnings D) Net common equity 56) Any capital surplus shown by a firm on its balance sheet results from: A) not paying out all net income as dividends. B) repurchasing shares for treasury stock. C) issuing stock at a price higher than par value. D) retained earnings.

Version 1

57) How much will be recorded as a firm's additional paid-in capital if the firm issues 1 million

shares that have a $5 par value for $15 per share? A) $0 B) $5 million C) $10 million D) $15 million 58) If a corporation issues 1,000 shares of $1 par value stock for $10 per share, then retained

earnings will: A) increase by $1,000. B) increase by $9,000. C) decrease by $9,000. D) remain unchanged. 59) Assume a firm with 5,000 shares outstanding earns $10 per share and has a 30% plowback

ratio. In this case retained earnings will: A) increase by $15,000. B) increase by $50,000. C) decrease by $15,000. D) decrease by $50,000. 60) What is the book value per share of equity for a firm with $1 million in net common equity,

$50,000 in authorized share capital, 25,000 shares issued, and 20,000 shares outstanding? A) $38.00 B) $40.00 C) $47.50 D) $50.00 61) Assume a corporation has cumulative voting and there are two directors up for election.

What is the maximum number of votes a shareholder who owns 100 shares can cast for Candidate Jones if there are a total of 5 candidates? A) 20 B) 40 C) 100 D) 200

Version 1

62) Assume a corporation has cumulative voting and there are two directors up for election.

What is the minimum number of votes a shareholder who owns 100 shares can cast for Candidate Jones if there are a total of 5 candidates? A) 0 B) 20 C) 40 D) 100 63) In which voting process are outsiders more likely to win seats on the board of directors? A) Cumulative voting B) Majority voting C) Minority voting D) Staggered voting 64) A proxy contest is typically one in which: A) the Board attempts to gain control from the shareholders. B) management attempts to gain control from the Directors. C) outsiders attempt to gain control from management. D) the Board attempts to gain control from the Directors. 65) A corporation's net worth is composed of the: A) book value of common equity plus par value of debt. B) par value plus additional paid-in capital. C) retained earnings less treasury stock. D) book value of common equity plus preferred stock. 66) Preferred stock dividends: A) have preference over bond interest payments. B) are guaranteed to be paid at least annually. C) are excluded from the taxable income of their recipients. D) have priority over common stock dividends. 67) If a corporation receives $50,000 in preferred stock dividends, how much tax does it pay on

these dividends? The corporate tax rate is 21%. A) $3,150 B) $5,250 C) $12,250 D) $17,500

Version 1

68) Which one of the following statements about floating-rate preferred stock is correct? A) Its dividends increase as interest rates increase. B) Its market price increases at a set rate annually. C) It is the only stock issued without a par value. D) Its dividends are deductible for tax purposes by the paying corporation. 69) Funded debt refers to those liabilities that: A) have established a sinking fund for repayment. B) are not callable at the option of the firm. C) are secured by specific collateral. D) have a maturity of more than one year remaining. 70) The purpose of a sinking fund is to: A) reduce the par value of stock over time. B) take advantage of the tax break on preferred stock. C) periodically retire debt prior to final maturity. D) allow risky corporations to avoid bankruptcy. 71) Warrants: A) allow their holder to purchase shares at the current market price. B) have a guaranteed maturity value. C) grant the option to purchase either stocks or bonds at the holders discretion. D) have an expiration date. 72) Which one of these terms applies to bundled groups of loans with the subsequent sale of the

cash flows from those loans? A) Convertible bond B) Warrants C) Asset-backed bond D) Preferred bond 73) Eurobonds are long-term, corporate liabilities that: A) are issued by European firms. B) must be held inside the U.S. by foreigners. C) are marketed in many countries. D) are repaid in U.S. dollars.

Version 1

74) Bonds that have been sold only to a limited number of institutional investors are considered: A) secured bonds. B) convertible bonds. C) private placements. D) indexed bonds. 75) Which one of these accounts represents internal funding? A) Retained earnings B) Common stock C) Bonds payable D) Preferred stock 76) A warrant grants its holder the right to do which one of these prior to a specified date? A) Convert debt into a specified number of shares B) Sell common shares at a predetermined price C) Exchange stock for bonds at a specified price D) Purchase shares at a predetermined price 77) What happens in the case of a bond selling for $1,000 that can be converted to 20 shares of

stock that are currently selling for $80 per share? A) The bondholder will lose $100. B) The stock will go down to $50 per share. C) The bond's price will go down to $900. D) The bondholder will choose to convert. 78) What happens in the case of a bond selling for $1,000 that can be converted to 20 shares of

stock that are currently selling for $45 per share? A) The bondholders will choose to convert. B) The stock will go up to $50 per share. C) The bond's price will go down to $900. D) Bondholders will not convert. 79) Convertible bonds resemble a combination of which two types of securities? A) Investment grade bonds and junk bonds B) Bonds and Treasury bills C) Bonds and warrants D) Bonds and preferred stock

Version 1

80) What is the most commonly bundled type of loan in the asset-backed bond category? A) Automobile loans B) Mortgages C) Credit card receivables D) Student loans 81) Which one of the following statements is correct? A) A convertible bondholder is forced to convert no later than a pre-specified time. B) The convertible option on a bond gives the owner the right to buy shares from a

company at a pre-determined cash price. C) The owner of a warrant has an option to convert the warrant into convertible bonds. D) The owner of a warrant will benefit if the firm's stock does well. 82) An investor might prefer floating-rate debt if she thought that: A) interest rates would rise. B) interest rates would decline. C) its bond rating might be lowered. D) its bonds were going to be converted into equity. 83) If net equity issues have been negative, A) more shares have been repurchased than newly issued. B) new shares have been sold at less than par value. C) issuing stock has been a negative NPV transaction. D) dividend payments have exceeded net income. 84) All of the following are true of retained earnings except they: A) are the difference between paid-in capital and the total dividends paid. B) represent the amount of new capital shareholders have indirectly contributed. C) are equal to the cumulative earnings less dividends. D) are the amount of earnings plowed back into the firm. 85) Jay's Jams Incorporated was just established with an investment of $3 million. Jay expects

his company to generate free cash flow of $800,000 a year for the next 10 years. If Jay's cost of capital is 15%, find the market value and book value of his company. A) Market value = $8.0 million; book value = $3.0 million B) Market value = $3.0 million; book value = $4.0 million C) Market value = $4.0 million; book value = $3.0 million D) Market value = $8.0 million; book value = $4.0 million

Version 1

86) Wheat's Market just issued 17,500 new shares of common stock at a price of $20 a share.

How will this transaction affect the equity accounts on the firm's balance sheet if the par value is $1 per share? A) The common stock account will increase by $350,000. B) The common stock account will decrease by $17,500. C) Paid-in surplus will increase by $332,500. D) Paid-in surplus will increase by $350,000. 87) When new shares of stock are sold at a price greater than par value, the excess over par is

recorded as: A) capital surplus. B) retained earnings. C) treasury stock. D) authorized capital. 88) A firm just issued 15,000 new shares of stock with a market price of $14 per share and par

value of $2 per share. Which one of these correctly states the resulting change in the equity accounts? A) Capital surplus will increase by $180,000. B) Retained earnings will decrease by $210,000. C) Common stock will increase by $15,000. D) Common stock will increase by $150,000. 89) Corporations generally need shareholder approval to do which one of the following? A) Select a new CEO B) Increase the number of authorized shares C) Purchase Treasury stock D) Pay a regular dividend 90) Which statement correctly describes the company’s dividend decision? A) The dividend payment is set by shareholders at the annual general meeting. B) The dividend payment is the sole responsibility of the company’s management. C) The dividend payment must be approved by the board of directors. D) The dividend payment is set by the company’s bondholders together with the

shareholders.

Version 1

91) The value of retained earnings on the corporate balance sheet represents the amount of

earnings: A) not paid out in dividends this period. B) that are being held in cash. C) over and above corporate income taxes. D) reinvested in the firm since its inception. 92) Which one of the following statements is typically correct for a going-concern firm? A) Book value of equity exceeds market value of equity. B) Market value of equity exceeds book value of equity. C) Book value of equity equals market value of equity. D) No typical relationship exists between book and market values of equity. 93) A company's board of directors is primarily an agent of the company's: A) management. B) employees. C) shareholders. D) management and employees. 94) The system of electing a board of directors where each director is voted on separately is

known as: A) majority voting. B) supermajority voting. C) cumulative voting. D) proxy voting. 95) A shareholder owning 100 shares of stock is voting for the board of directors who are elected

by cumulative voting. How many votes will the shareholder cast for Director "A" if four directors are to be elected and the maximum number of votes are cast for "A"? A) 25 B) 100 C) 200 D) 400 96) One way in which control of a corporation can be removed from the current board of

directors is to: A) take away the directors' stock. B) give voting power to management. C) remove the Board's voting power. D) fight a proxy contest.

Version 1

97) One common reason for issuing two distinct classes of common stock is to: A) sell different classes to increase profits. B) allow one stock to increase in price while the other class declines. C) restrict voting privileges from some shareholders. D) conserve cash by offering dividends to only one class of stockholders. 98) Which one of the following statements is correct? A) Common stock dividends cannot be paid if preferred stock dividends are in arrears. B) Preferred stock dividends cannot be paid if common stock dividends are in arrears. C) Common and preferred dividends must be paid simultaneously. D) No dividends on the common stock can be paid without specific shareholder

approval. 99) What is the after-tax cost to a corporation in the 21% tax bracket of paying $50,000 in

preferred stock dividends? A) $17,500 B) $32,500 C) $50,000 D) $76,923 100)

Which one of the following statements is correct about a corporation in the 21% tax bracket that can invest either in a bond paying 8% interest or in the preferred stock of another corporation that pays a 6% dividend? Ignore any differences in risk. A) The preferred stock should be selected because its after-tax yield is 0.17% higher. B) The preferred stock should be selected because its after-tax yield is 0.95% higher. C) The bond should be selected because its after-tax yield is 0.17% lower. D) The bond should be selected because its after-tax yield is 0.95% higher.

101)

What is the rationale for saying that the federal government provides a tax subsidy to corporate debtors? A) Interest and principal payments are tax deductible. B) Interest payments are tax deductible. C) Principal payments are tax deductible. D) Seventy percent of interest payments are tax deductible.

Version 1

102)

Which one of the following statements is correct about a floating interest rate loan if the interest rate is defined as "Prime plus 1 percent"? The interest rate: A) is set to vary at a rate equal to the prime rate plus 1 percent. B) can fluctuate up to a maximum of 1 percent above the current prime rate over the life of the loan. C) will be fixed at the current prime rate plus 1 percent. D) will vary with the prime rate but changes will only occur in 1 percent intervals.

103)

Corporations that annually retire a set portion of their long-term debt are said to be using: A) indexed bonds. B) sinking funds. C) convertible debt. D) secured debt.

104)

An independent outside director: A) is defined as a company employee who has no management responsibilities outside of the board. B) cannot serve as the board chairman. C) is prohibited from owning shares of the firm. D) can be a shareholder as long as he/she holds no management position in the firm outside of the board.

105)

If a corporation has more shares issued than outstanding, then: A) the Board of Directors is holding shares. B) there are preferred shares outstanding. C) the corporation has treasury stock. D) unexercised stock warrants exist.

106)

Which one of the following statements is true with respect to financial and product markets? A) In product markets, companies rarely find investments that yield a positive NPV. B) Financial markets face fast-moving competition. C) Competition in financial markets is not as thorough as in product markets. D) Competition in product markets is more intense than in financial markets.

Version 1

107)

A warrant has an exercise price of $40, and the current stock price is $38. An investor holding this option will purchase the stock only if the: A) dividend yield on the stock exceeds 10%. B) stock price falls below $38. C) stock price rises above $40. D) stock price falls to $20 or below.

108)

Which one of these statements describes U.S. firms during recent years? A) Firms have rarely relied on debt financing. B) Internal funds have provided less than half of the firms financing needs. C) Firms have repurchased more equity than they have sold. D) Debt is used to fund approximately half of the firms financing needs.

109)

A firm's internally generated funds are calculated by: A) subtracting depreciation from net income. B) adding depreciation to net income. C) adding dividends to net income. D) subtracting dividends from net income plus depreciation.

110)

If 100 million shares of common stock are issued with a par value of $2 and additional paid-in capital is $800 million, the total par value of the issued shares is: A) $200 million. B) $600 million. C) $800 million. D) $1 billion.

111)

A company is about to issue 1,000 new shares of stock at a market price of $33 per share. If the par value per share is $4, the increase in capital surplus from this stock issue will be: A) $33,000. B) $4,000. C) $29,000. D) $32,000.

112)

One way that investors contribute capital to the firm is by: A) the company plowing back part of its earnings. B) paying less than par value for the stock. C) letting their warrants expire unexercised. D) increasing the amount of treasury stock.

Version 1

113)

When a firm issues 50,000 shares with a par value of $5 and a market price of $22 per share, additional paid-in capital will: A) decrease by $250,000. B) increase by $250,000. C) increase by $850,000. D) increase by $1,100,000.

114)

If the Beta Company issues $100 million worth of preferred stock, what will happen to its net worth if book value of common equity is $500 million? A) It will increase by $400 million. B) It will decrease by $100 million. C) It will increase to $600 million. D) It will decrease to $400 million.

115)

Preferred stockholders generally: A) have full voting rights. B) receive a fixed dividend. C) have priority over debtholders if the company goes bankrupt. D) convert to bondholders.

116)

All of the following are types of innovative bonds except: A) preferred stock. B) asset-backed bonds. C) collateralized debt obligations (CDOs). D) mortality bonds.

117)

The majority of an established firm's capital is generated: A) internally. B) externally. C) through issuance of new shares. D) through funded debt.

118)

Earnings this year for Plasti-tech, Incorporated, were $200,000. It decided to plow back $60,000 and recorded $20,000 of depreciation. Plasti-tech's internally generated funds are: A) $40,000. B) $60,000. C) $80,000. D) $140,000.

Version 1

119)

With respect to bonds, when interest rates increase typically: A) the coupon rate on existing bonds also increases. B) the coupon rate on existing bonds remains unchanged. C) bond prices also increase. D) bond prices remain constant.

120)

How does competition in financial markets compare to the competition that can be found in product markets? A) Financial markets are more competitive. B) Financial markets are less competitive. C) Both markets are similar in competition. D) Financial markets are not competitive, due to regulation.

121)

To state that financing at current market terms is a zero-NPV transaction indicates that: A) firms should avoid these methods of financing. B) there is no cost involved in the financing. C) the market has not set financing terms correctly. D) there are no "bargains" when financing at current terms.

122)

An efficient capital market is one in which: A) all securities that investors desire are offered. B) all transactions are closed within 2 business days. C) current prices reflect all current information. D) the lowest interest rates are offered.

123)

Which one of the following is least likely to contribute to the positive-NPV investments found in product markets? A) Patented-production processes B) Financing strategies C) Brand-name product recognition D) Lack of competition

124)

If financial markets were not efficient, it would be easier for firms to: A) finance investments in a zero-NPV transaction. B) finance investments in a positive NPV transaction. C) totally avoid the need for external financing. D) finance investments in a negative NPV transaction.

Version 1

125)

The true value of a security is the: A) value of that security at some future date. B) sum of all future income from that security. C) amount of funds invested to date in the security. D) price that incorporates all currently available information.

Version 1

Answer Key Test name: Ch14 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) TRUE 9) TRUE 10) TRUE 11) TRUE 12) TRUE 13) TRUE 14) TRUE 15) TRUE 16) FALSE 17) TRUE 18) TRUE 19) FALSE 20) FALSE 21) FALSE 22) TRUE 23) TRUE 24) FALSE 25) FALSE 26) TRUE 27) TRUE 28) TRUE 29) TRUE 30) FALSE 31) FALSE 32) FALSE 33) TRUE 34) FALSE 35) FALSE 36) FALSE 37) TRUE

Version 1

38) C

Additional paid-in capital = 1,000,000 × ($18 − 5) = $13,000,000 39) A

Change in retained earnings = 5,700 × $10 × 0.30 = $17,100 40) D

Book value per share = $1,220,000 ÷ 20,000 = $61 41) D

Maximum votes = 175 × 2 = 350 votes 42) B

Tax liability = $52,600 × 0.50 × 0.21 = $5,523 43) C

44) C

Increase in common stock account = 18,100 × $1 = $18,100 Increase in paid-in surplus = 18,100 × ($26 − $1) = $452,500 45) A

Increase in common stock = 15,500 × $2 = $31,000 Increase in capital surplus = 15,500 × ($19 − 2) = $263,500 46) D

Maximum votes with cumulative voting = 4 × 200 = 800 47) D

Bond after-tax yield = 13% × (1 − 0.21) = 10.27% Preferred stock after-tax yield = 10% − (10% × 0.50 × 0.21) = 8.95% Difference = 8.95% − 10.27% = −1.32%; the bond is the better investment. 48) A

Total par value = 104,000,000 × $2 = $208,000,000 49) A

Increase in capital surplus = 1,120 × ($33 − 4) = $32,480

Version 1

50) C

Increase in paid-in capital = 52,000 × ($22 − 5) = $884,000 51) C

Book value = $115,000,000 + 515,000,000 = $630,000,000 52) C

Internally generated funds = $67,000 + 27,000 = $94,000 53) B 54) C 55) A 56) C 57) C

Additional paid-in capital = 1,000,000 × ($15 − $5) = $10,000,000 58) D

Issuing new shares does not affect retained earnings. 59) A

Change in retained earnings = 5,000 × $10 × 0.30 = $15,000 60) D

Book value per share = $1,000,000 ÷ 20,000 = $50 61) D

Maximum votes = 100 × 2 = 200 votes 62) A

Minimum votes = 0 63) A 64) C 65) D 66) D 67) B

Tax liability = $50,000 × 0.50 × 0.21 = $5,250 68) A 69) D

Version 1

70) C 71) D 72) C 73) C 74) C 75) A 76) D 77) D

Conversion value = 20 × $80 = $1,600 > $1,000 → Bondholders will convert. 78) D

Conversion value = 20 × $45 = $900 < $1,000 → Bondholders will not convert. 79) C 80) B 81) D 82) A 83) A 84) A 85) C

86) C

Increase in common stock account = 17,500 × $1 = $17,500 Increase in paid-in surplus = 17,500 × ($20 − $1) = $332,500 87) A 88) A

Increase in common stock = 15,000 × $2 = $30,000 Increase in capital surplus = 15,000 × ($14 − 2) = $180,000 89) B 90) C 91) D 92) B 93) C 94) A 95) D

Maximum votes with cumulative voting = 4 × 100 = 400

Version 1

96) D 97) C 98) A 99) C

Dividends are paid out of after-tax income. 100)

D Bond after-tax yield = 8% × (1 − 0.21) = 6.32% Preferred stock after-tax yield = 6% − (6% × 0.50 × 0.21) = 5.37% Difference = 5.37% − 6.32% = −0.95%; the bond is the better investment. 101) 102) 103) 104) 105) 106) 107) 108) 109) 110)

B A B D C B C C D A Total par value = 100,000,000 × $2 = $200,000,000 111)

C Increase in capital surplus = 1,000 × ($33 − 4) = $29,000 112) 113)

A C Increase in paid-in capital = 50,000 × ($22 − 5) = $850,000 114)

C Book value = $100,000,000 + 500,000,000 = $600,000,000 115) 116) 117) 118)

B A A C Internally generated funds = $60,000 + 20,000 = $80,000 119)

Version 1

120) 121) 122) 123) 124) 125)

A D C B B D

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) Equity capital in young businesses is known as venture capital and it is provided by venture capital firms, wealthy individuals, and investment institutions such as pension funds. ⊚ true ⊚ false 2) Venture capitalists generally provide sufficient up-front funding in one lump sum to take a

new firm to the point where it can go public. ⊚ true ⊚ false 3) In many countries it is common even for large businesses to remain privately owned. ⊚ true ⊚ false 4) Underwriters usually play a triple role—first providing the company with procedural and

financial advice, then buying the stock, and finally reselling it to the public. ⊚ true ⊚ false 5) Some successful corporations will provide venture capital to new firms with innovative

ideas. ⊚ true ⊚ false 6) A consequence of the Sarbanes-Oxley Act has been a decreased reporting burden on small

public companies and a decrease in the number of companies reverting to private ownership. ⊚ true ⊚ false 7) When a public company makes a general cash offer of debt or equity, it follows a similar

procedure used when it first went public. ⊚ true ⊚ false

Version 1

8) Shelf registration is a procedure that allows firms to file several registration statements for

one issue of the security. ⊚ true ⊚ false 9) The bookbuilding method used by almost all IPOs in the United States is like an auction,

since potential buyers indicate how many shares they are prepared to buy at given prices. ⊚ true ⊚ false 10) The SEC requires the sale of a private placement to be limited to a small number of

knowledgeable investors. ⊚ true ⊚ false 11) The advantage of the bookbuilding method is that it allows underwriters to give preference to

those investors whose bids are most helpful in setting the issue price and to offer them a reward in the form of underpricing. ⊚ true ⊚ false 12) When securities are issued under a firm commitment, the underwriter bears the risk of low

demand from investors. ⊚ true ⊚ false 13) The SEC reviews the registration statement and determines whether or not an investment in

the firm is advisable. ⊚ true ⊚ false 14) Like a general cash offering, a rights issue is an offer to buy shares made to existing and

potential shareholders. ⊚ true ⊚ false

Version 1

15) In a rights offering, the shares are priced at a substantial discount to current market value,

which ensures that the shareholders will either exercise the rights themselves or sell them to other investors. ⊚ true ⊚ false 16) Shelf registration is used more frequently for equity financing than for debt financing. ⊚ true ⊚ false 17) An average-sized firm should expect the underwriting and administrative costs of going

public to be around 7% to 8% of the IPO proceeds. ⊚ true ⊚ false 18) Issue costs for debt are considerably lower than issue costs for equity securities. ⊚ true ⊚ false 19) The evidence indicates that industrial stock prices in the U.S. decrease by approximately 3%,

on average, when new equity issues are announced. ⊚ true ⊚ false 20) Firms are attracted to the private placement of debt because of the lower average interest

rates. ⊚ true ⊚ false 21) The contract between the underwriter and the issuing company is known as the new issue

prospectus. ⊚ true ⊚ false 22) IPOs are generally overpriced in order to raise large amounts of cash. ⊚ true ⊚ false

Version 1

23) The winner's curse theory assumes that the informed investor receives more of the

underpriced IPOs. ⊚ true ⊚ false 24) Privately placed securities may be difficult to resell. ⊚ true ⊚ false 25) A rights issue is one in which a public company offers shares only to existing shareholders in

order to raise additional cash. ⊚ true ⊚ false 26) Crowdfunding is primarily used as a means for a publicly-traded company to raise additional

capital. ⊚ true ⊚ false 27) A general cash offer is necessary when issuing a private placement. ⊚ true ⊚ false 28) Private placement contracts may be custom tailored for firms with special needs or unique

opportunities. ⊚ true ⊚ false 29) One advantage to private placements is the low cost. ⊚ true ⊚ false 30) Private placements tend to be made by smaller firms that usually incur the highest costs when

issuing public securities. ⊚ true ⊚ false

Version 1

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 31) An investor exercises the right to buy one additional share at $28 for every five shares held. How much should each share be worth after the rights issue if they previously sold for $58 each? A) $43.00 B) $49.67 C) $53.00 D) $54.00 32) How much will a firm receive in net funding from a firm commitment underwriting of

250,000 shares priced to the public at $50 if a 10% underwriting spread has been added to the price paid by the underwriter? Additionally, the firm pays $1,100,000 in legal fees. A) $10,150,000 B) $10,208,650 C) $10,263,636 D) $10,295,455 33) An IPO was offered to the public at $19.70 a share with the issuing firm receiving $18.20 of

that amount. The issuer incurred $767,000 in legal and administrative costs. At the end of the first trading day, the stock was priced at $24.10 a share. What was the total dollar cost, including both direct and indirect costs, of issuing the securities if 242,000 shares were offered? A) $1,725,750 B) $1,574,908 C) $2,194,800 D) $1,112,150 34) What was the market price of a share of stock before a rights issue, if one share of new stock

could be purchased at $109 for every four shares that were previously owned? The stock price after the successful rights issue was $4. A) $229 B) $234 C) $249 D) $259

Version 1

35) What direct expense percentage is required to market stock if the issuer incurs $1 million in

other expenses to sell 3 million shares at $50 each to an underwriter and the underwriter sells the shares at $53 each? A) 5.52% B) 5.73% C) 6.29% D) 6.87% 36) Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $76 each to

an underwriter and the underwriter sells the shares at $61 each. By the end of the first day's trading, the issuing company's stock price had risen to $88. What is the total cost of issuing the securities? A) $27 million B) $37 million C) $47 million D) $57 million 37) Assume an issuer incurs $1 million in other expenses to sell 3 million shares at $46 each to

an underwriter and the underwriter sells the shares at $49 each. By the end of the first day's trading, the issuing company's stock price had risen to $76. In percentage terms, how much of the day's closing market value was absorbed by the total costs associated with the issue? A) 9.91% B) 19.91% C) 29.91% D) 39.91% 38) A rights issue offers the firm's shareholders one new share of stock at $52 for every three

shares of stock they currently own. What should be the stock price after the rights issue if the stock sells for $92 per share before the issue? A) $66.27 B) $72.00 C) $82.00 D) $83.33

Version 1

39) An IPO was priced to sell at $37 a share and closed at $36 a share at the end of the first day

of trading. The underwriting spread was 7% of the offer price and the legal, accounting, and administrative costs were $188,000. What was the total percentage cost of the issue as a percentage of the market value at the end of the first day if 250,000 shares were offered? A) 4.46% B) 6.51% C) 4.83% D) 4.18% 40) Plasti-tech Incorporated has decided to go public and has sold 2 million of its shares to its

underwriter for $34 per share. The underwriter then sold them to the public for $36 each. Plasti-tech also encountered $0.1 million in administrative fees. Soon after the issue, the stock price rose to $41. Find Plasti-tech Incorporated's total cost of this issue including any underpricing. A) $4.1 million B) $13.1 million C) $14.1 million D) $18.1 million 41) Currently, M & S Incorporated has 2 million shares outstanding selling at $76 a share. A

rights issue will be made that allows 1 share to be purchased for every 5 shares currently held by stockholders for $46 each. Which one of the following is true? A) The number of shares outstanding will fall to 1.6 million. B) The firm will raise $15.73 million. C) The stock price will fall to $71. D) The total value of the firm will equal $134 million. 42) An underwriter agrees to purchase the shares directly from the issuing firm for $60 million.

The underwriter ends up selling all 3 million shares for $24.80 each. What is the implied underwriting spread? A) The underwriter's spread was 22.60%. B) The underwriter’s spread was 19.35%. C) The underwriter's spread was 16.81%. D) The underwriter’s spread was 14.99%.

Version 1

43) What direct expense is required to market stock if the issuer incurs $1 million in other

expenses to sell 3 million shares at $31 each to an underwriter and the underwriter sells the shares at $33 each? A) 7.07% B) 7.66% C) 8.43% D) 8.80% 44) Assume the issuer incurs $2 million in other expenses to sell 3 million shares at $67 each to

an underwriter and the underwriter sells the shares at $71 each. By the end of the first day's trading, the issuing company's stock price had risen to $92. What is the cost of underpricing? A) $35 million B) $60 million C) $63 million D) $66 million 45) A company offers investors the right to buy one additional share at $21 for every four shares

currently held. How much should each share be worth after the rights issue if they previously sold for $26 each? A) $21 B) $24 C) $25 D) $26 46) Money that is offered to finance a new business is known as: A) a general cash offer. B) venture capital. C) a private placement. D) a rights issue. 47) An investor exercises the right to buy one additional share at $20 for every five shares held.

How much should each share be worth after the rights issue if they previously sold for $50 each? A) $35.00 B) $41.67 C) $45.00 D) $46.00

Version 1

48) A firm's first offering of stock to the general public is known as: A) first-stage financing. B) an IPO. C) a general cash offer. D) a seasoned offering. 49) A secondary offering IPO occurs when: A) new shares are sold to provide the company with additional funds. B) the second public issue of equity becomes available. C) the company's founders or venture capitalists market a portion of their shares. D) not all of the shares in a primary IPO were sold. 50) The most important function of an underwriter is to: A) assess the firm's capital needs. B) approve the prospectus before distribution to the public. C) provide private placement of the firm's debt. D) buy the securities issue from the firm and resell the securities to the public. 51) When underwriters issue securities on a best efforts basis, they: A) sell as much of the stock as possible, but with no guarantee. B) submit a bid for purchase, which the issuer compares to other bids. C) buy the entire issue from the firm. D) guarantee that the issuer will be charged the minimum spread. 52) If an underwriter charges the public $40 per share for a new issue after having promised the

issuer $38 per share, the spread per share is: A) $1. B) $2. C) $38. D) $40. 53) When underwriters are unsure of the demand for a new offering, they: A) reduce their spread. B) undertake the issue on a firm commitment basis. C) undertake the issue on a best efforts basis. D) provide shelf registration for the issue.

Version 1

54) A major purpose of the prospectus is to: A) inform investors of the security's rate of return. B) advise investors of the security's potential risks. C) distribute stock warrants to prospective investors. D) list the security's dividend payment dates. 55) Studies have shown that, on average, new security issues are: A) subject to flotation costs of approximately 32%. B) overpriced by the amount of the spread. C) underpriced. D) overpriced to reward venture capitalists. 56) One reason that underpricing of new issues occurs more frequently than overpricing is that: A) underwriters want to reduce the risk of a firm commitment. B) the demand for a new issue is typically too high. C) underwriters earn low rates of return. D) issuing firms demand that equity be underpriced. 57) How much will a firm receive in net funding from a firm commitment underwriting of

250,000 shares priced to the public at $40 if a 10% underwriting spread has been added to the price paid by the underwriter? Additionally, the firm pays $600,000 in legal fees. A) $8,400,000 B) $8,460,025 C) $8,490,909 D) $8,545,455 58) One reason for an underwriters' syndication is to: A) monitor the actions of the different underwriters. B) reduce the risk of selling a large issue. C) increase the size of the spread. D) avoid the scrutiny of the Securities and Exchange Commission. 59) Who bears the bulk of the cost of underpricing an IPO? A) The underwriters B) The investors who purchase IPO shares C) All of the after-IPO shareholders D) The pre-IPO shareholders

Version 1

60) An IPO was offered to the public at $18 a share with the issuing firm receiving $16.50 of that

amount. The issuer incurred $750,000 in legal and administrative costs. At the end of the first trading day, the stock was priced at $22.40 a share. What was the total dollar cost, including both direct and indirect costs, of issuing the securities if 225,000 shares were offered? A) $1,687,500 B) $1,540,000 C) $2,077,500 D) $1,087,500 61) The consent of a corporation's stockholders must be received prior to any: A) issue of new securities. B) selection of an underwriter. C) increase in authorized capital. D) private placement of securities. 62) When securities are issued under a rights issue: A) existing shareholders have the opportunity to expand their holdings. B) shares are offered to the public at a discount. C) the existing shares will increase in price. D) current shareholders have the right to resell their stock to the issuer. 63) What would you expect to be the market price of stock after a sold-out rights issue, if each

existing shareholder purchases one new share at $60 for each three that he or she currently holds, and the current share price is $100? A) $75 B) $80 C) $85 D) $90 64) What was the market price of a share of stock before a rights issue, if one share of new stock

could be purchased at $100 for every four shares that were previously owned? The stock price after the successful rights issue was $200. A) $220 B) $225 C) $240 D) $250

Version 1

65) Which one of these terms applies to a public company offering new shares to the general

public? A) Rights offer B) Initial public offering C) Venture capital offer D) General cash offer 66) Shelf registration was enacted to allow: A) the Department of Justice to prosecute those guilty of insider trading. B) the prospectus to be distributed after the sale of securities begins. C) underwriters to join together in syndication. D) a joint filing for multiple issues of a single security. 67) Which one of the following would not be included among the benefits of shelf registration? A) Reduction of lead time for security issuance B) No additional registration necessary for 5 years C) Issuer can take advantage of favorable conditions D) Issuer can search for best underwriting terms 68) The enactment of shelf registration is likely to have increased: A) the cost of issuing new securities. B) the interests of venture capitalists. C) competition among underwriters. D) the underpricing of securities. 69) If a corporation's management, with its superior knowledge of proposed investments,

considers a security issue to be underpriced, it may react by: A) forgoing the security issuance and investment. B) lowering the price of the existing shares to equal the new shares. C) increasing the number of shares to be sold. D) adopting shelf registration, which automatically raises the issue price. 70) If a new stock offering were overpriced and could be sold, then the: A) existing shareholders would benefit. B) new investors would gain at the expense of the existing shareholders. C) firm could avoid the underwriting spread. D) firm could avoid the SEC filing.

Version 1

71) Issue costs for equity are higher than those for debt for all of the following reasons except: A) equity issues have higher administrative costs. B) underwriting stock is riskier than underwriting bonds. C) equity issues involve significantly more time to sell. D) equity issues have no economies of scale. 72) A firm has just issued $250 million of equity which caused its stock price to drop by 3%.

Calculate the loss in value of the firm's equity given that its market value of equity was $1 billion before the new issue. A) $7.5 million B) $30.0 million C) $33.3 million D) $37.5 million 73) Companies offering smaller security issues may prefer to issue them through a: A) private placement because lower rates of return can be offered. B) private placement because it is cheaper than a public issue. C) public issue because it is cheaper than a private placement. D) public issue because more exposure will be achieved. 74) Which one of the following statements is incorrect concerning private placements? A) Terms of the financing can be custom-tailored. B) The securities are not made available to the public. C) The securities are often less marketable. D) Only a small amount of corporate debt is financed in this manner. 75) Private placement of debt securities occurs more frequently in: A) smaller-sized firms. B) larger-sized firms. C) firms that are using venture capitalists. D) combination with convertible bonds. 76) In return for providing funds, venture capitalists generally require: A) collateral equal in value to the funds provided. B) first right to all of the firm's assets. C) an equity position in the firm. D) ownership of the entire firm.

Version 1

77) Which one of the following is least likely to explain why entrepreneurs contribute their

personal funds to start-up projects? Their contribution: A) acts as a signal to venture capitalists. B) repays debt held by the venture capitalist. C) retains a portion of the firm's equity. D) provides incentive to expend effort. 78) What is the market value placed on a firm in which an entrepreneur invests $1 million and a

venture capitalist invests $3 million in first-stage financing for a 50% interest in the firm? A) $4 million B) $6 million C) $7 million D) $8 million 79) Second-stage financing occurs: A) prior to the initial public offering. B) when company founders sell a portion of their shares. C) after the best efforts of the underwriters. D) when the IPO does not raise sufficient cash. 80) One of the primary reasons for disbursing venture capital funds in installments is to: A) avoid tax liability. B) identify and cut losses early. C) increase the importance of the venture capitalist. D) take advantage of the time value of money. 81) Roadshows: A) give companies an opportunity to thank investors who have bought the new issue. B) describe the meetings that managers have with investment bankers to select the

underwriter to an issue. C) provide underwriters and the company’s management an opportunity to meet potential investors. D) describe the meetings that management has with the SEC to finalize the issue prospectus. 82) Stock underwriters are: A) investors seeking low prices. B) regulatory agencies that evaluate equity offerings. C) the firm's founders who guarantee a stock's performance. D) investment banking firms that manage security offerings.

Version 1

83) When underwriters offer a firm commitment on a stock issue, they: A) employ their best efforts in selling the stock. B) guarantee the net proceeds to the issuing firm. C) agree to purchase the venture capitalists' shares. D) assure purchasers that the stock will appreciate. 84) Which one of the following is correct for stock issued under a firm commitment where the

underwriter is to receive a spread of 8%? A) The underwriter's profits are guaranteed to be 8%. B) The underwriter must sell at least 92% of the shares. C) The underwriter receives 8% of all shares. D) The underwriter may suffer a loss on the issue. 85) An underwriter enters into a firm commitment to sell 1 million shares at $20 each, including

a $2 spread. How much does the issuing firm receive if only 500,000 shares are sold? A) $9 million B) $10 million C) $18 million D) $20 million 86) An underwriter sells 2 million shares of stock to the public at $40 per share. The issuing firm

receives $73 million before non-underwriting costs. Which of the following is true? A) The underwriter's spread was 2.14%. B) The underwriter’s spread was $40. C) The underwriter’s spread was 8.75%. D) The underwriter’s spread was 9.59%. 87) Blue-sky laws exist in order to: A) protect stock underwriters from fraudulent firms. B) restrict the amount of profit from IPOs. C) control the amount of stock owned by one investor. D) protect investors from deceptive firms. 88) The Securities and Exchange Commission will not permit securities to be sold: A) if they have been overpriced. B) prior to approval of the registration statement. C) unless the issuer guarantees their value. D) until a shelf registration exists.

Version 1

89) Prospective investors are advised of a stock's potential risks by the: A) underwriter. B) underpricing laws. C) prospectus. D) initial public offering. 90) One way to reduce the risk of marketing a stock is for the underwriter to: A) offer a firm commitment on the issue. B) set the initial stock price below its true value. C) sell the securities in foreign countries. D) offer price rebates on the stock purchases. 91) The "winner's curse" is a reminder that: A) successful bidders may often overpay for an object. B) underwriters charge excessive fees. C) stocks are much riskier than bonds. D) underpricing an issue is a cost to existing owners. 92) The direct expense of a stock issue includes the: A) cost of underpricing the stock. B) underwriting spread and other expenses. C) underwriting spread, other expenses, and cost of underpricing. D) underwriting spread. 93) What direct expense percentage is required to market stock if the issuer incurs $1 million in

other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each? A) 6.98% B) 7.19% C) 7.75% D) 8.33% 94) Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to

an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the cost of underpricing? A) $81 million B) $91 million C) $101 million D) $111 million

Version 1

95) Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to

an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the total cost of issuing the securities? A) $81 million B) $91 million C) $101 million D) $111 million 96) Assume an issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to

an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. In percentage terms, how much of the day's closing market value was absorbed by the total costs associated with the issue? A) 13.33% B) 23.33% C) 33.33% D) 43.33% 97) Stock that is sold through a rights issue: A) is offered for cash to the general investing public. B) will not affect the market price of the shares. C) is limited to sales to existing shareholders. D) must be sold on a firm commitment basis. 98) What is the primary reason for a reduction in share value after a successful rights issue? The

new shares: A) have higher underwriting expenses. B) are offered at attractive prices. C) reduce the firm's return on equity. D) do not include voting rights. 99) A rights issue offers the firm's shareholders one new share of stock at $40 for every three

shares of stock they currently own. What should be the stock price after the rights issue if the stock sells for $80 per share before the issue? A) $56.67 B) $60.00 C) $70.00 D) $71.33

Version 1

100)

Shelf registration allows firms to: A) purchase securities for up to 2 years without registration. B) incur only short time delays in selling securities. C) wait for 2 years before paying for securities. D) offer rights issues to the general public.

101)

Which one of the following statements is generally true concerning the costs of issuing securities? A) Underpricing is rarely a significant cost. B) Legal and other administrative costs generally average less than $1 million. C) Debt is cheaper to issue than equity. D) There are no economies of scale in security issuance.

102)

Some investors believe that the decision by management to issue equity as opposed to issuing debt is a signal that: A) the stock is currently undervalued. B) the stock is currently overvalued. C) the firm will avoid dilution of stock value. D) a shelf registration of securities will occur.

103)

Which one of these types of financing commonly provides investors with only sample products? A) Seasoned offering B) Rights offer C) IPO D) Crowdfunding

104)

A private placement avoids which one of the following costs? A) Depression in the stock price B) Administration costs C) Registration with the SEC D) Legal costs

105)

A private placement of securities involves: A) selling only to the firm's current investors. B) nondisclosure of the issuing firm's name until after the sale. C) the exchange of convertible bonds for equity. D) a nonpublic sale of securities to a limited number of investors.

Version 1

106)

Which one of the following methods may be particularly cost-effective to smaller issuers of securities? A) Seasoned offerings B) Private placement C) General cash offer D) Best efforts underwriting

107)

When a new issue goes wrong and the stock price immediately crashes once trading commences, the IPO investors may: A) sue the SEC for recommending the issue. B) convert their shares into bonds. C) sue the company executives who are still shareholders. D) sue the underwriters for overhyping the issue.

108)

An investor can earn 20% on underpriced IPOs, but will lose 10% on overpriced IPOs. If he is awarded $2,000 worth of shares in an overpriced IPO, how much of the underpriced issue must he be awarded in order to gain $500 total? A) $1,500 B) $2,500 C) $3,500 D) $10,000

109)

An IPO was priced to sell at $23 a share and closed at $22 a share at the end of the first day of trading. The underwriting spread was 7% of the offer price and the legal, accounting, and administrative costs were $160,000. What was the total percentage cost of the issue as a percentage of the market value at the end of the first day if 250,000 shares were offered? A) 3.89% B) 5.68% C) 4.21% D) 3.64%

110)

Which one of the following is not an advantage of shelf registration? A) The issuing firm can avoid competition from underwriters. B) Securities can be issued with short notice. C) Securities can be issued in small amounts without excessive costs. D) The firm can take advantage of market conditions.

Version 1

111)

Second-stage financing: A) involves a substantial increase in leverage. B) immediately follows first-stage financing for every new business. C) may involve issuing additional shares of stock. D) occurs when the company is in danger of bankruptcy.

112)

Firms go public primarily to: A) raise additional capital. B) diversify public debtholders' risk. C) maintain ownership control. D) increase their financial leverage.

113)

In a firm commitment, the underwriter: A) encounters virtually no risk because the spread is fixed. B) is allowed to sell the shares at any price they choose. C) is protected against being stuck with unsold shares. D) is allowed to sell the shares at a price slightly higher than the price it paid to the company.

114)

Those subject to the winner's curse are: A) underwriters. B) uninformed investors. C) firms issuing IPOs. D) venture capitalists.

115)

Plasti-tech, Incorporated, has decided to go public and has sold 2 million of its shares to its underwriter for $20 per share. The underwriter then sold them to the public for $22 each. Plasti-tech also encountered $0.5 million in administrative fees. Soon after the issue, the stock price rose to $25. Find Plasti-tech Incorporated's total cost of this issue including any underpricing. A) $4.5 million B) $9.5 million C) $10.5 million D) $14.5 million

116)

Economists have found that the announcement of a new issue of common stock: A) results in a decline in the stock price. B) causes the stock price to rise. C) has no effect on the stock price. D) increases the market value of the stock but only temporarily.

Version 1

117)

Currently, M & S, Incorporated, has 2 million shares outstanding selling at $70 a share. A rights issue will be made that allows 1 share to be purchased for every 5 shares currently held by stockholders for $40 each. Which one of the following is true? A) The number of shares outstanding will fall to 1.6 million. B) The firm will raise $13.33 million. C) The stock price will fall to $65. D) The total value of the firm will equal $124 million.

118)

An underwriter agrees to purchase the shares directly from the issuing firm for $60 million. The underwriter ends up selling all 3 million shares for $23.50 each. What is the implied underwriting spread? A) The underwriter's spread was 18.14%. B) The underwriter’s spread was 14.89%. C) The underwriter's spread was 12.35%. D) The underwriter’s spread was 10.53%.

119)

What direct expense is required to market stock if the issuer incurs $1 million in other expenses to sell 3 million shares at $30 each to an underwriter and the underwriter sells the shares at $32 each? A) 7.29% B) 7.88% C) 8.65% D) 9.02%

120)

Assume the issuer incurs $2 million in other expenses to sell 4 million shares at $55 each to an underwriter and the underwriter sells the shares at $59 each. By the end of the first day's trading, the issuing company's stock price had risen to $68. What is the cost of underpricing? A) $20 million B) $32 million C) $36 million D) $40 million

Version 1

121)

A company offers investors the right to buy one additional share at $15 for every four shares currently held. How much should each share be worth after the rights issue if they previously sold for $20 each? A) $15 B) $18 C) $19 D) $20

Version 1

Answer Key Test name: Ch15 1) TRUE 2) FALSE 3) TRUE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) FALSE 9) TRUE 10) TRUE 11) TRUE 12) TRUE 13) FALSE 14) FALSE 15) TRUE 16) FALSE 17) TRUE 18) TRUE 19) TRUE 20) FALSE 21) FALSE 22) FALSE 23) TRUE 24) TRUE 25) TRUE 26) FALSE 27) FALSE 28) TRUE 29) TRUE 30) TRUE 31) C

New price = ($28 + 5 × $58) ÷ (1 + 5) = $53.00 32) C

Net proceeds = [($50 ÷ 1.10) × 250,000] − $1,100,000 = $10,263,636 33) C

Version 1

Total cost = [($24.10 − 18.20) × 242,000] + $767,000 = $2,194,800 34) B

35) C

Direct expense % = {$1 million + [($53 − 50) × 3 million]} ÷ ($53 × 3 million) = 0.0629, or 6.29% 36) B

Total cost = [($88 − 76) × 3,000,000] + $1,000,000 = $37,000,000 37) D

38) C

New price = [$52 + ($92 × 3)] ÷ (1 + 3) = $82 39) B

40) C

Total cost = [($41 − 34) × 2 million] + $0.1 million = $14.1 million 41) C

Number of shares issued: (2 million ÷ 5) = 400,000 Number of shares outstanding: 2 million + 0.4 million = 2.4 million Firm will raise: $46 × 400,000 = $18.4 million Total value of firm will increase from $152 million to $170.4 million Stock price will fall to: ($170.4 million ÷ 2.4 million) = $71 42) B

Spread = ($74.4 − 60) ÷ $74.4 = 0.1935, or 19.35% 43) A

Version 1

44) C

Cost of underpricing = ($92 − 71) × 3,000,000 = $63 million 45) C

New price = ($21 + 4 × $26) ÷ (1 + 4) = $25.00 46) B 47) C

New price = ($20 + 5 × $50) ÷ (1 + 5) = $45.00 48) B 49) C 50) D 51) A 52) B

Spread = $40 − 38 = $2 53) C 54) B 55) C 56) A 57) C

Net proceeds = [($40 ÷ 1.10) × 250,000] − $600,000 = $8,490,909 58) B 59) D 60) C

Total cost = [($22.40 − 16.50) × 225,000] + $750,000 = $2,077,500 61) C 62) A 63) D

New price = ($60 + 3 × $100) ÷ (1 + 3) = $90 64) B

65) D 66) D

Version 1

67) B 68) C 69) A 70) A 71) D 72) B

Loss in value = 0.03 × $1 billion = $30 million 73) B 74) D 75) A 76) C 77) B 78) B

Firm value = $3 million ÷ 0.5 = $6 million 79) A 80) B 81) C 82) D 83) B 84) D 85) C

Proceeds to firm = ($20 − 2) × 1 million = $18 million 86) C

Spread = ($80 − 73) ÷ $80 = 0.0875, or 8.75% 87) D 88) B 89) C 90) B 91) A 92) B 93) C

Direct expense % = {$1 million + [($43 − 40) × 3 million]} ÷ ($43 × 3 million) = 0.0775, or 7.75% 94) A

Version 1

Cost of underpricing = ($70 − 43) × 3 million = $81 million 95) B

Total cost = [($70 − 40) × 3,000,000] + $1,000,000 = $91,000,000 96) D

97) C 98) B 99) C

New price = [$40 + ($80 × 3)] ÷ (1 + 3) = $70 100) 101) 102) 103) 104) 105) 106) 107) 108)

B C B D C D B D C $500 = (0.20 × value of shares) − (0.10 × $2,000) → value of shares = $3,500 109)

110) 111) 112) 113) 114) 115)

A C A D B C Total cost = [($25 − 20) × 2 million] + $0.5 million = $10.5 million 116) 117)

A C

Version 1

Number of shares issued: (2 million ÷ 5) = 400,000 Number of shares outstanding: 2 million + 0.4 million = 2.4 million Firm will raise: $40 × 400,000 = $16 million Total value of firm will increase from $140 million to $156 million Stock price will fall to: ($156 million ÷ 2.4 million) = $65 118)

B Spread = ($70.5 − 60) ÷ $70.5 = 0.1489, or 14.89% 119)

120)

C Cost of underpricing = ($68 − 59) × 4,000,000 = $36 million 121)

C New price = ($15 + 4 × $20) ÷ (1 + 4) = $19.00

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. ⊚ true ⊚ false 2) When asked about key factors of debt policy, financial managers commonly mention the tax

advantage of debt and the importance of maintaining their credit rating. ⊚ true ⊚ false 3) Loan covenants can ensure that companies will accept all positive-NPV investments and

reject negative ones. ⊚ true ⊚ false 4) Debt finance does not affect the operating risk but it does add financial risk. ⊚ true ⊚ false 5) Debt financing affects neither the business risk nor the financial risk of the firm. ⊚ true ⊚ false 6) As long as investors can borrow or lend on their own account on the same terms as the firm,

they will not pay extra for firm leverage. ⊚ true ⊚ false 7) Once you recognize the fact that debt also increases financial risk and causes shareholders to

demand a higher return on their investment, debt can be no cheaper than equity. ⊚ true ⊚ false 8) At moderate debt levels the probability of financial distress is trivial and therefore the tax

advantages of debt dominate. ⊚ true ⊚ false

Version 1

9) Debt financing affects neither the operating risk nor the business risk of the firm. ⊚ true ⊚ false 10) Financial leverage describes debt financing's amplification of the effects of changes in

operating income on the returns to stockholders. ⊚ true ⊚ false 11) Financial risk is the risk to shareholders that results from debt financing. ⊚ true ⊚ false 12) MM's proposition I, or the debt-irrelevance proposition, states that the value of a firm is

unaffected by its capital structure. ⊚ true ⊚ false 13) According to MM, debt restructuring will not change the firm’s overall value. ⊚ true ⊚ false 14) According to MM’s proposition II the expected return on equity is equal to the expected

return on assets for a levered firm. ⊚ true ⊚ false 15) MM's proposition II states that the expected return on assets increases as the debt-equity ratio

increases. ⊚ true ⊚ false 16) MM's proposition II states that the required return on equity increases as the firm's debt-

equity ratio increases. ⊚ true ⊚ false 17) The benefit of an interest tax shield is captured by the equityholders. ⊚ true ⊚ false

Version 1

18) The risk of tax shields can be reasonably assumed to be the same as that of the interest

payments generating them. ⊚ true ⊚ false 19) Even after relaxing the MM assumption of no taxes, restructuring should not affect the value

of the firm. ⊚ true ⊚ false 20) Costs of financial distress are costs arising from bankruptcy or distorted business decisions

before bankruptcy. ⊚ true ⊚ false 21) The "trade-off theory" of capital structure suggests that firms have an optimal level of debt. ⊚ true ⊚ false 22) At some debt-equity ratio, the costs of financial distress are expected to overcome the value

of the extra interest tax shield for a firm. ⊚ true ⊚ false 23) Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude. ⊚ true ⊚ false 24) The pecking-order theory of capital structure states that firms prefer internal financing to

avoid sending out adverse signals that may lower the stock price. ⊚ true ⊚ false 25) Management's perceived signals to investors form an important component of pecking-order

theory. ⊚ true ⊚ false

Version 1

26) Financial slack means having ready access to cash or debt financing. ⊚ true ⊚ false 27) When additional borrowing causes the probability of financial distress to increase rapidly, the

potential costs of distress begin to take a substantial bite out of firm value. ⊚ true ⊚ false 28) A necessary assumption in the MM's proposition I, or the debt-irrelevance proposition, is that

the company and individual borrowing rates are the same. ⊚ true ⊚ false MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 29) A firm is expected to generate $1.5 million in operating income and pay $268,000 in interest. Ignoring taxes, this will generate EPS of $12.32. What will happen to EPS if operating income increases by 33.0% to $2.0 million? A) EPS increases by 25% to $15.41. B) EPS increases by 33.0% to $16.44. C) EPS increases by 40% to $17.27. D) EPS increases by 60% to $19.77. 30) A firm issues 100,000 shares of common stock with a total market value of $3,900,000 and

an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $195,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $1,950,000 of shares and substitutes an equal amount of additional debt? A) EPS decreases by 21.50% to $10.55. B) EPS decreases by 12.60% to $12.22. C) EPS increases by 17.05% to $15.55. D) EPS increases by 68.20% to $21.95.

Version 1

31) A firm issues 100,000 shares of common stock with a total market value of $4,900,000 and

an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $245,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $3,675,000 of shares and substitutes an equal amount of debt? A) EPS decreases by 33.41% to $10.05. B) EPS stays at $12.55. C) EPS increases by 138.73% to $29.96. D) EPS increases by 238.73% to $42.51. 32) If MM's proposition II without taxes is true, what is the return to investors who invest $20 in

a stock, borrow another $20 to buy a share of stock, and pay 6% on the borrowed money if the EPS is $2.40? A) 15.0% B) 18.0% C) 21.0% D) 24.0% 33) What is the proportion of debt financing for a firm that expects a 32% return on equity, a

16% return on assets, and a 12% return on debt? Ignore taxes. A) 67.3% B) 73.3% C) 80.0% D) 88.3% 34) Assume a firm is financed with 30% debt on which it pays interest of 9%. What is the

expected return on equity if the expected return on assets is 22%? Ignore taxes. A) 27.57% B) 29.29% C) 26.35% D) 26.93% 35) What is the amount of the annual interest tax shield for a firm with $3.4 million in debt that

pays 12% interest if the firm is in the 21% tax bracket? A) $85,680 B) $265,200 C) $294,667 D) $623,333

Version 1

36) Assume an unlevered firm changes its capital structure to include $2.1 million in permanent

debt at a 7% interest rate. The tax rate is 21%. According to MM I with taxes, the value of the firm will increase by _________blank due to this change in its capital structure. A) $68,000 B) $136,000 C) $441,000 D) $1,470,000 37) Calculate the WACC for a firm that pays 10% on its debt, requires a rate of return of 24% on

its equity, finances 50% of the market value of its assets with debt, and has a tax rate of 21%. A) 15.95% B) 16.49% C) 16.89% D) 20.69% 38) What is the after-tax cost of debt for a firm in the 21% tax bracket that pays 12% on its debt? A) 6.88% B) 9.48% C) 9.80% D) 11.88% 39) A firm has an expected return on equity of 28% and an after-tax cost of debt of 11.2%. What

debt-equity ratio produces a WACC of 22.4%? A) 0.50 B) 0.75 C) 0.67 D) 0.33 40) An all-equity firm has 1 million shares outstanding with a market value of $10 million. It

does not pay tax and has an operating income of $1.63 million. If $2 million of 10% debt is issued and the proceeds are used to repurchase shares of stock, then the firm's EPS: A) increases by 20% to $1.96. B) decreases by 40% to $1.10. C) decreases by 20% to $1.36. D) increases by 9.7% to $1.79.

Version 1

41) A firm currently has operating income of $4.4 million, interest expense of $2 million, and

EPS of $2.40. How low can operating income drop before EPS are reduced by half, to $1.2? Ignore taxes. A) $3.7 million B) $3.2 million C) $2.7 million D) $2.2 million 42) A firm has a WACC of 16%, an expected return on equity of 33%, and a debt-to-asset ratio

of 80%. If the firm does not pay tax, what is the interest rate on the debt? A) 7.58% B) 10.98% C) 11.75% D) 12.22% 43) What is the expected rate of return to equity holders if the firm has a tax rate of 21%, the

interest rate on debt is 18%, WACC is 23%, and the debt-asset ratio is 60%? A) 20.50% B) 31.77% C) 33.02% D) 36.17% 44) A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.

Ignoring taxes, this will generate EPS of $12.50. What will happen to EPS if operating income increases by 33.3% to $2.0 million? A) EPS increases by 25% to $15.63. B) EPS increases by 33.3% to $16.67. C) EPS increases by 40% to $17.50. D) EPS increases by 60% to $20.00. 45) A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and

Version 1

46) A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and

an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $3,750,000 of shares and substitutes an equal amount of debt? A) EPS decreases by 33.3% to $10.00. B) EPS stays at $12.50. C) EPS increases by 140% to $30.00. D) EPS increases by 240% to $42.50. 47) Which one of these is not an underlying assumption of MM Proposition I? A) Capital markets function well. B) Investors can borrow or lend on the same terms as firms. C) Taxes remain at their current non-zero levels. D) Securities are fairly priced. 48) Fluctuations in a firm's operating income represent: A) financial leverage. B) the weighted-average cost of capital. C) capital structure. D) business risk. 49) An increase in a firm's financial leverage will: A) increase the variability in earnings per share. B) always reduce the operating risk of the firm. C) increase the value of the firm in an MM world. D) increase the WACC. 50) Financial risk refers to the: A) risk of owning equity securities. B) risk faced by equity holders of firms with debt. C) general business risk of the firm. D) possibility that interest rates will increase. 51) If MM's proposition II without taxes is true, what is the return to investors who invest $20 in

a stock, borrow another $20 to buy a share of stock, and pay 6% on the borrowed money if the EPS is $1.50? A) 6.0% B) 9.0% C) 12.0% D) 15.0%

Version 1

52) What is the proportion of debt financing for a firm that expects a 24% return on equity, a

16% return on assets, and a 12% return on debt? Ignore taxes. A) 54.0% B) 60.0% C) 66.7% D) 75.0% 53) Assume a firm is financed with 30% debt on which it pays interest of 9%. What is the

expected return on equity if the expected return on assets is 14%? Ignore taxes. A) 16.14% B) 17.86% C) 14.92% D) 15.50% 54) Assume a firm is financed with 60% debt on which it pays interest of 7%. What is the

expected return on equity if the expected return on assets is 12%? Ignore taxes. A) 16.14% B) 20.30% C) 19.50% D) 21.67% 55) According to MM Proposition II, as a firm's debt-equity ratio decreases: A) its financial risk increases. B) its operating risk increases. C) the required rate of return on equity increases. D) the required rate of return on equity decreases. 56) An implicit cost of adding debt to the capital structure is that it: A) adds interest expense to the operating statement. B) increases the required return on equity. C) reduces the expected return on assets. D) decreases the firm's beta. 57) When debt is risky: A) bondholders shift some of the firm risk to equityholders. B) equityholders shift some of the firm risk to bondholders. C) the value of the interest tax shield is at its highest. D) there is more overall risk in the firm.

Version 1

58) What is the amount of the annual interest tax shield for a firm with $3 million in debt that

pays 12% interest if the firm is in the 21% tax bracket? A) $75,600 B) $234,000 C) $260,000 D) $550,000 59) A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value

of the interest tax shield if the tax rate is 21%? A) $245,000 B) $700,000 C) $2,100,000 D) $10,000,000 60) If MM's proposition II without taxes is true and no bankruptcy risk exists, how much debt

will a company prefer if their cost of debt is 6%, cost of equity is 10%, and the corporate tax rate is 21%? A) Close to 0% B) 21% C) Exactly 50% D) Close to 100% 61) When taxes are considered, the value of a levered firm equals the value of the: A) unlevered firm. B) unlevered firm plus the value of the debt. C) unlevered firm plus the present value of the tax shield. D) unlevered firm plus the value of the debt plus the value of the tax shield. 62) Assume an unlevered firm changes its capital structure to include $1 million in permanent

debt at a 7% interest rate. The tax rate is 21%. According to MM I with taxes, the value of the firm will increase by _________ due to this change in its capital structure. A) $35,000 B) $70,000 C) $210,000 D) $700,000

Version 1

63) In a world with corporate taxes but no possibility of financial distress, the value of the firm is

maximized when the: A) firm uses no debt in its capital structure. B) firm uses the maximum amount of debt in its capital structure. C) firm uses a debt-equity ratio of 1.0. D) corporate tax rate approaches 100%. 64) Calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on

its equity, finances 45% of the market value of its assets with debt, and has a tax rate of 21%. A) 13.46% B) 14.00% C) 14.40% D) 18.20% 65) What is the after-tax cost of debt for a firm in the 21% tax bracket that pays 15% on its debt? A) 9.25% B) 11.85% C) 12.17% D) 14.25% 66) A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What

debt-equity ratio produces a WACC of 12%? A) 0.50 B) 0.75 C) 0.67 D) 0.33 67) Which of the following items will NOT change due to the cost of financial distress? A) Cost of debt B) Cost of equity C) Cost of goods sold D) Cost of legal fees 68) If the present value of the interest tax shield on debt equals the present value of the costs of

financial distress, then the trade-off theory implies that the: A) firm is using the optimal level of debt. B) firm is paying too high an interest rate. C) firm's market value equals its book value. D) firm should increase its use of debt.

Version 1

69) The present value of the costs of financial distress increases as the debt ratio increases

because the: A) expected return on assets increases. B) present value of the interest tax shield is greater. C) equity tax shield is depleted. D) probability of default is greater. 70) When financial disaster is looming, management may borrow to invest in projects having a

negative expected NPV because: A) the firm's beta is now negative. B) taxes are no longer a concern. C) the interest tax shield will cover the loan costs. D) the lender bears most of the risk. 71) Firms facing financial distress may pass up positive NPV projects rather than commit new

equity because: A) they prefer to finance with debt. B) the benefits are shared with the bondholders. C) no cash is available for dividends. D) there is no interest tax shield associated with equity. 72) The trade-off theory of capital structure suggests that firms: A) add leverage whenever interest rates are low. B) with higher risk should use less debt. C) should use 50% debt and 50% equity. D) should use debt to overcome high par values of stock. 73) The trade-off theory of capital structure describes the optimal capital structure for any firm as

being the level of debt that: A) minimizes the financial distress costs. B) maximizes the present value of the interest tax shield. C) equates the present values of the incremental interest tax shield and the incremental financial distress costs. D) maximizes the after-tax cash flows that are internally generated. 74) Firms are more likely to restrict borrowing if the: A) return on the financed project is too high. B) firm's asset base is largely intangible. C) firm's asset beta is zero. D) increased debt decreases the firm's WACC.

Version 1

75) According to the pecking-order theory, managers will often choose to finance with: A) new equity rather than debt, due to bankruptcy costs. B) debt rather than new equity, to avoid a fall in the share price. C) debt rather than retained earnings, to lower the WACC. D) new equity rather than debt, to strengthen EPS. 76) A firm's capital structure is represented by its mix of: A) assets. B) liabilities and equity. C) assets and liabilities. D) assets, liabilities, and equity. 77) Restructuring a firm involves changing the: A) mix of liabilities and equity. B) dividend payout policy. C) managerial personnel. D) types of production equipment utilized. 78) MM Proposition I without taxes states that: A) firms should be all-equity financed to maximize shareholder value. B) shareholders are unaffected by the debt policy of the firm. C) shareholders are indifferent to a firm's value. D) shareholders prefer to invest in all-equity firms. 79) What is the return on equity for a firm with a return on assets of 15%, a return on debt of

10%, and a 0.75 debt-equity ratio? A) 18.75% B) 20.00% C) 23.75% D) 26.25% 80) An all-equity firm has 1 million shares outstanding with a market value of $10 million. It

does not pay tax and has an operating income of $1.5 million. If $2 million of 10% debt is issued and the proceeds are used to repurchase shares of stock, then the firm's EPS: A) increases by 20% to $1.80. B) decreases by 40% to $0.9. C) decreases by 20% to $1.20. D) increases by 8.3% to $1.63.

Version 1

81) A firm currently has operating income of $4 million, interest expense of $2 million, and EPS

of $2. How low can operating income drop before EPS are reduced by half, to $1? Ignore taxes. A) $3.5 million B) $3.0 million C) $2.5 million D) $2.0 million 82) A firm increases its debt ratio from 50% to 60%. In the absence of taxes, an investor can

offset the change in capital structure by: A) selling part of her holding and buying debt. B) borrowing money and investing it in the firm’s equity. C) holding a diversified portfolio. D) switching her investment to convertible bonds. 83) MM proposition I states that a firm's value is unaffected by its: A) required rate of return on equity. B) operating income, in the absence of taxes. C) interest rate paid on debt. D) mixture of debt and equity. 84) A firm's business risk depends upon: A) its use of debt in the capital structure. B) the risk of the firm's assets and operations. C) the types of debt financing utilized. D) the costs of financial distress. 85) The reason that financial leverage increases shareholder risk is that there is: A) more debt which increases the operating risk. B) less equity to absorb the operating risk. C) less business risk to be spread around. D) more financial risk due to reduced business risk. 86) According to MM, leverage may increase expected earnings per share but still leave the share

price unchanged because the: A) firm's operating risk decreases. B) number of shares is decreased. C) required return on equity increases. D) firm is less risky.

Version 1

87) A firm has a WACC of 14%, an expected return on equity of 19%, and a debt-to-asset ratio

of 60%. If the firm does not pay tax, what is the interest rate on the debt? A) 6.50% B) 9.90% C) 10.67% D) 11.14% 88) In the absence of taxes, which one of the following would not be expected to change with

changes in the firm's capital structure? A) Weighted-average cost of capital B) Expected return on equity C) Expected return on assets D) Expected earnings per share 89) If a firm's expected return on equity equals its expected return on assets, then the: A) expected return on debt exceeds the expected return on assets. B) likelihood of financial distress is high. C) firm has too much debt. D) firm has no debt in its capital structure. 90) MM's proposition II without taxes states that the: A) expected return on equity increases as financial leverage increases. B) expected return on assets decreases as expected return on debt decreases. C) firm's capital structure is irrelevant to the firm's overall value. D) greater the proportion of equity, the higher the expected return on debt. 91) As a firm's debt-equity ratio approaches zero, the firm's expected return on equity

approaches: A) the expected return on debt. B) the expected return on assets. C) its maximum. D) zero. 92) With risky debt and MM’s Proposition II, the expected return on assets _________ as the

debt-equity ratio _________. A) increases; increases B) decreases; increases C) increases; decreases D) remains constant; increases

Version 1

93) When a firm pays tax, MM’s Proposition I no longer holds, and the capital structure of the

firm can be important due to the: A) lower tax rates on dividends than on debt. B) higher tax rates on retained earnings than on debt. C) interest tax shield. D) higher operating income from lower dividends. 94) The interest tax shield is equal to the: A) difference between the interest expense and income taxes. B) amount of interest paid in a given year. C) product of the interest expense and the tax rate. D) product of the debt principal and the interest rate on debt. 95) Any financial benefit derived from the interest tax shield accrues to the: A) bondholders. B) shareholders. C) bondholders and shareholders equally. D) shareholders and the federal government. 96) The present value of a perpetual tax shield increases as the firm's tax rate _________ and as

the amount of the debt _________. A) increases; increases B) increases; decreases C) decreases; decreases D) decreases; increases 97) How much debt is outstanding if the present value of a perpetual tax shield is $300,000, the

tax rate is 21%, and the interest rate on the debt is 10%? A) $300,000 B) $1,428,571 C) $3,000,000 D) $3,750,000 98) What is the expected rate of return to equity holders if the firm has a tax rate of 21%, the

interest rate on debt is 10%, WACC is 15%, and the debt-asset ratio is 60%? A) 12.50% B) 21.25% C) 22.50% D) 25.65%

Version 1

99) When corporate taxes and the cost of financial distress are taken into consideration, the

market value of a firm is equal to the value of the all-equity firm _________ the PV of the tax shield _________ the costs of financial distress. A) plus; plus B) minus; plus C) plus; minus D) minus; minus 100)

According to the trade-off theory, if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs, then the: A) tax shield has been calculated incorrectly. B) firm is too heavily levered. C) firm has reached its optimal debt level. D) firm appears to have a low risk of financial distress.

101)

Which ranking of financing from most preferred to least preferred is predicted by the pecking-order theory? A) Debt issue, stock issue, internally generated funds B) Internally generated funds, debt issue, stock issue C) Stock issue, internally generated funds, debt issue D) Internally generated funds, stock issue, debt issue

102)

Debt may be the preferred form of external financing for many firms because: A) most firms already have too much equity. B) tax rates on equity are lower. C) debt will not adversely affect the firm's financial ratios. D) equity issuance is considered by investors to be a negative signal.

103)

Which one of the following statements is false according to MM's proposition I? A) Firm value is unaffected by the firm's capital structure. B) Proposition I is also called the debt-irrelevance proposition. C) Shareholders should care about the firm's debt policy. D) After restructuring, the firm's value should be the same as it was prior to restructuring.

104)

Debt usage will have an effect on: A) business risk. B) financial risk. C) operating risk. D) asset risk.

Version 1

105)

Leverage will ________ shareholders' expected return and ________ their risk. A) increase; decrease B) decrease; increase C) increase; increase D) increase; do nothing to

106)

Calculate the firm's expected return on its assets if its expected return on debt is 10%, its expected return on equity is 20%, and the company cost of capital is 14%. A) 14% B) 15% C) 16% D) 17%

107)

A firm with a debt-equity ratio of 0.5, a return on assets of 14%, and a return on debt of 8%, will have a return on equity of: A) 15.25%. B) 16.00%. C) 17.00%. D) 17.33%.

108)

As the debt-equity ratio decreases when debt is not risk free: A) debtholders require a higher expected return. B) debtholders require a lower expected return. C) the expected return on equity increases. D) the expected return on assets increases.

109)

One advantage of debt financing over equity financing is the: A) tax-deductible dividends. B) tax-deductible interest. C) tax-deductible principal repayment. D) tax-free interest income.

110)

Those who benefit from the interest tax shield are: A) debtholders. B) equityholders. C) both debtholders and equityholders. D) only the firm's customers.

Version 1

111)

When a corporation issues permanent debt, its value: A) increases by the present value of the tax shield. B) decreases by the present value of the tax shield. C) increases by the annual interest tax shield. D) decreases by the annual interest tax shield.

112)

When corporate taxes are considered, how does leverage affect the WACC? A) An increase in leverage will be offset by a decrease in equity financing, thus leaving WACC unchanged. B) Changes in leverage will affect the WACC only if the interest rate on debt changes. C) Increased leverage will increase the WACC. D) Increased leverage will decrease the WACC.

113)

According to the trade-off theory, optimal capital structure occurs when: A) additional borrowing results in lower financial distress costs. B) additional borrowing is offset by the interest tax shield. C) the tax savings from additional leverage are just offset by the increased costs of distress. D) the present value of the tax shield exceeds the value of the all-equity-financed firm.

114)

The possibility of bankruptcy will do all of the following except: A) increase financial distress costs. B) reduce the current market value of the firm. C) reduce the interest rate on debt. D) reduce the possible payoff to stockholders.

115)

Costs of financial distress are greater when a firm increases its: A) intangible assets as a percentage of total assets. B) tangible assets as a percentage of total assets. C) net working capital. D) retained earnings.

116)

Which one of the following statements is true regarding the trade-off theory? A) Highly profitable firms should have low debt ratios. B) All firms should have the same target debt-equity ratio. C) Riskier firms should have high target debt ratios. D) Less risky firms ought to have a greater amount of debt financing.

Version 1

117)

According to the trade-off theory, capital structure is a trade-off between: A) tangible and intangible asset risk. B) high and low target debt ratios. C) tax savings and financial distress costs. D) tax shields and equity financing.

118)

The pecking-order theory suggests that less profitable firms borrow more because: A) equity issues are more expensive. B) leverage is preferred over raising funds internally. C) debt issues are good omens. D) they have insufficient internal funds.

119)

Financial slack: A) is associated with high leverage. B) allows firms to take advantage of good investment opportunities. C) solves any agency costs when managers want to empire-build. D) is a term that describes a lazy CFO.

120)

Which one of these statements corresponds to MM proposition I without taxes? A) Debt interest has no effect on either equity income or firm value. B) Debt interest reduces equity income and increases firm value. C) Debt interest reduces equity income but does not affect firm value. D) The value of a firm increases as its debt-equity ratio increases.

121)

Which one of these statements correctly applies to an unlevered firm that pays no taxes? A) The return on equity exceeds the WACC. B) The return on assets equals the return on equity and also equals WACC. C) The return on assets equals the return on equity and exceeds WACC. D) The return on equity equals WACC and exceeds the return on assets.

122)

Which one of these is a disadvantage to tax-paying individual investors? A) Receiving interest income rather than dividends B) Receiving capital gains rather than dividends C) Receiving capital gains rather than interest income D) Receiving dividends rather than interest income

Version 1

123)

An increase in a corporation's tax rate will cause: A) an increase in an unlevered firm's return on assets. B) a decrease in a levered firm's WACC. C) an increase in a levered firm's cost of debt. D) a decrease in an unlevered firm's cost of equity.

124)

Leverage will _________ shareholders' expected return and _________ their risk. A) increase; decrease B) decrease; increase C) increase; increase D) increase; do nothing to

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question. 125) Which of the following pair of firms do you think should be more highly levered: A retailing firm with prime downtown real estate, or a social media company whose major assets are its unique software and client loyalty?

126)

Which of the following pair of firms do you think should be more highly levered: A biotech firm which may need a large cash injection if its drug trials are successful, or a company with a well-established market and large cash reserves?

127)

Which of the following pair of firms do you think should be more highly levered: A taxpaying company, or a company with large tax loss carry-forwards?

Version 1

128)

Which of the following pair of firms do you think should be more highly levered: A risky company, or a safe company?

Version 1

Answer Key Test name: Ch16 1) TRUE 2) TRUE 3) FALSE 4) TRUE 5) FALSE 6) TRUE 7) TRUE 8) TRUE 9) TRUE 10) TRUE 11) TRUE 12) TRUE 13) TRUE 14) FALSE 15) FALSE 16) TRUE 17) TRUE 18) TRUE 19) FALSE 20) TRUE 21) TRUE 22) TRUE 23) TRUE 24) TRUE 25) TRUE 26) TRUE 27) TRUE 28) TRUE 29) C

30) D

Version 1

31) D

32) B

Return = [($2.40 × 2) − ($20 × 0.06)] ÷ $20 = 0.18, or 18.0% 33) C

0.32 = 0.16 + (D ÷ E)(0.16 − 0.12) D ÷ E = 4.00 Debt financing % = 4.00 ÷ (4.00 + 1) = 0.8000, or 80.00% 34) A

35) A

Annual interest tax shield = 0.12 × $3,400,000 × 0.21 = $85,680 36) C

PV of interest tax shield = 0.21 × $2,100,000 = $441,000 37) A

WACC = (1 − 0.50) × 0.24 + 0.50 × 0.10 × (1 − 0.21) = 0.1595, or 15.95% 38) B

Version 1

After-tax cost of debt = 0.12 × (1 − 0.21) = 0.0948, or 9.48% 39) A

0.22 = 0.28 × (1 − x) + 0.112 × x x = ⅓ D / E = (⅓) ÷ (1 − ⅓) = ½, or 0.50 40) D

Issue $2,000,000 Debt (@10% Interest):

41) B

42) C

43) D

44) C

45) D

46) D

Version 1

47) C 48) D 49) A 50) B 51) B

Return = [($1.50 × 2) − ($20 × 0.06)] ÷ $20 = 0.09, or 9.0% 52) C

0.24 = 0.16 + (D ÷ E)(0.16 − 0.12) D ÷ E = 2 Debt financing % = 2 ÷ (2 + 1) = 0.667, or 66.7% 53) A

54) C

55) D 56) B 57) B 58) A

Annual interest tax shield = 0.12 × $3,000,000 × 0.21 = $75,600 59) C

PV tax shield = (0.07 × $10,000,000 × 0.21) ÷ 0.07 = $2,100,000 60) D 61) C 62) C

Version 1

PV of interest tax shield = 0.21 × $1,000,000 = $210,000 63) B 64) A

WACC = (1 − 0.45) × 0.18 + 0.45 × 0.10 × (1 − 0.21) = 0.1346, or 13.46% 65) B

After-tax cost of debt = 0.15 × (1 − 0.21) = 0.1185, or 11.85% 66) A

0.12 = 0.15 × (1 − x) + 0.06 × x x = ⅓ D / E = (⅓) / (1 − ⅓) = ½, or 0.50 67) C 68) A 69) D 70) D 71) B 72) B 73) C 74) B 75) B 76) B 77) A 78) B 79) A

80) D

Issue $2,000,000 Debt (@10% Interest):

81) B

Version 1

82) A 83) D 84) B 85) B 86) C 87) C

88) C 89) D 90) A 91) B 92) D 93) C 94) C 95) B 96) A 97) B

$300,000 = D × 0.21

D = $1,428,571

98) D

99) C 100) 101) 102) 103) 104) 105) 106)

C B D C B C A Company cost of capital = expected return on assets = 14% 107)

Version 1

108) 109) 110) 111) 112) 113) 114) 115) 116) 117) 118) 119) 120) 121) 122) 123) 124) 125)

B B B A D C C A D C D B C B A B C Short Answer The retailing firm with readily saleable assets. 126)

Short Answer The company with a well-established market and large cash reserves. 127)

Short Answer The taxpaying company with income to shield. 128)

Short Answer The safe company.

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) Stocks that are purchased on the record date are not entitled to the dividend. ⊚ true ⊚ false 2) Anyone holding a stock before its ex-dividend date is entitled to the dividend. ⊚ true ⊚ false 3) Companies can pay out cash to their shareholders in two ways. They can pay a dividend or

they can buy back some of their outstanding shares. ⊚ true ⊚ false 4) In recent years more than 40% of U.S. corporations did not pay a dividend nor did they

repurchase shares. ⊚ true ⊚ false 5) Over the past 30 years stock repurchases have become an increasingly popular way of paying

out cash. ⊚ true ⊚ false 6) In a three-for-two stock split, each investor would receive one additional share for each two

shares already held. ⊚ true ⊚ false 7) Many companies offer their shareholders an automatic dividend reinvestment plan. This

means that the shareholders automatically receive the dividend on the payment date. ⊚ true ⊚ false 8) Dividends are paid to all shareholders who are recorded in its books on the payment date. ⊚ true ⊚ false

Version 1

9) Dividends are paid to all shareholders who are recorded in its books on the record date. ⊚ true ⊚ false 10) A two-for-one stock split is like a 33% stock dividend. ⊚ true ⊚ false 11) Investors often interpret a stock split announcement as a signal of management's confidence

in the future. ⊚ true ⊚ false 12) A stock split will affect the stock's price, while a stock dividend will not. ⊚ true ⊚ false 13) Stock repurchases are more volatile than dividends. ⊚ true ⊚ false 14) The share price declines when a stock repurchase occurs. ⊚ true ⊚ false 15) Dividends are likely to shift up and down as earnings fluctuate so that managers can maintain

a stable payout ratio. ⊚ true ⊚ false 16) Corporate dividends are less volatile than corporate earnings. ⊚ true ⊚ false 17) MM's dividend irrelevance proposition assumes an efficient market with no taxes or issue

costs. ⊚ true ⊚ false

Version 1

18) According to the MM dividend irrelevance proposition, since investors do not need dividends

to convert their shares to cash, they will not pay higher prices for firms with higher dividend payouts. ⊚ true ⊚ false 19) The most common way that companies buy back their stock is to buy it in the market just like

any other investor. ⊚ true ⊚ false 20) The information content of dividends says that dividend increases send good news about cash

flow and earnings, while dividend cuts send bad news. ⊚ true ⊚ false 21) The longer an investor waits to take capital gains, the lower is the present value of the tax

liability. ⊚ true ⊚ false 22) Firms can increase their stock price by increasing their dividends to a level that appeals to the

clientele group that prefers high-dividend stocks. ⊚ true ⊚ false 23) A tender offer includes a variable price at which the shares may be repurchased. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 24) You currently own 400 shares of stock valued at $16 per share. If the firm declares a 1-for-4 reverse stock dividend you will own _____________blank shares valued at _____________blank per share. A) 1,600; $16 B) 1,600; $4.00 C) 100; $16 D) 100; $64

Version 1

25) ABC Corporation stock is selling for $34 per share when a 10% stock dividend is declared. If

you own 140 shares of ABC Corporation then you will receive: A) shares valued at $3.4 each. B) $3 times 140 shares = $340 cash. C) $340 plus 14 shares of ABC Corporation. D) 14 shares of ABC Corporation. 26) A firm has current assets of $2.8 million, fixed assets of $5.2 million, and debt of $3.8

million. There are 282,000 shares of stock outstanding. What will be the book value of equity if the firm repurchases 10% of its outstanding shares for $12.00 a share? A) $4,115,200 B) $4,200,000 C) $3,861,600 D) $4,140,400 27) What is the new share price for a corporation with a current share price of $36 that employs a

3-for-4 reverse split? A) $108 B) $324 C) $144 D) $48 28) An investor buys a stock today for $28, receives a dividend of $2 at the end of the year and

then sells the stock for $32. If the dividend is taxed at 37%, and the capital gain at 20%, what is her return after tax? A) 21.86% B) 15.93% C) 8.01% D) 29.92% 29) What is the difference in the one-year after-tax returns on the following two stocks, assuming

a 37% tax rate on dividends and a 20% tax rate on capital gains? Stock A is purchased for $61, pays a $2.5 dividend at the end of the year, and is then sold for $67; stock B is purchased for $71, pays no dividend, but is sold after one year for $81. A) Stock B's after-tax return is higher by 0.82%. B) Stock B's after-tax return is higher by 0.49%. C) Stock A's after-tax return is higher by 0.51%. D) Stock A's after-tax return is higher by 1.04%.

Version 1

30) Compare the after-tax returns for a corporation that invests in preferred stock with a 13%

dividend yield versus a common stock with no dividend but a capital gain of 23%. The corporation's tax rate is 21%. The: A) common stock returns 7.24% less than the preferred. B) preferred stock returns 6.54% less than the common. C) common stock returns 6.96% less than the preferred. D) returns are equal on an after-tax basis. 31) Firm X will pay a dividend of $10 next year and its stock is expected to sell at $105 after the

payment. Firm Y pays no dividend but its stock is expected to sell at $115. Dividends are taxed at 37% and capital gains are untaxed. If both stocks offer an after-tax return of 8%, what is the price of the two stocks? A) Price of X = $106.48; price of Y = $106.48 B) Price of X = $103.06; price of Y = $106.48 C) Price of X = $105.00; price of Y = $106.48 D) Price of X = $103.06; price of Y = $105.00 32) An investor owns 354 shares of stock currently selling for $79 per share. After a 3-for-2

stock split, the investor will have: A) 531 shares selling for $52.67 each. B) 531 shares selling for $105.10 each. C) 236.00 shares selling for $118.50 each. D) 236.00 shares selling for $105.10 each. 33) Which one of the following is correct for a firm with $495,900 in net earnings, 51,300 shares,

and a 30% payout ratio? A) Retained earnings will increase by $148,770. B) Each share will receive a $1.45 dividend. C) $148,770 will be spent on new investments. D) The dividend per share will be $2.90. 34) An unlevered firm expects to generate and pay out free cash flows of $122,000 annually in

the form of dividends and share repurchases starting next year. The discount rate is 13% and there are 126,000 shares outstanding. What is the current value per share? A) $0.97 B) $7.45 C) $1.09 D) $6.94

Version 1

35) A stock is currently priced at $73 per share and will pay a $4 dividend in one year. What

must the stock sell for in one year to meet investors' expectations of a 15% after-tax return if dividends are taxed at 37% and there are no capital gains taxes? A) $79.95 B) $81.43 C) $82.83 D) $85.20 36) Stock A has a dividend yield of 10.25% but no capital gain. Stock B offers a capital gain but

no dividend. If a corporate investor in the 21% tax bracket earns the same after-tax return from the two stocks, what capital gain does B offer? A) 8.55% B) 10.62% C) 11.61% D) 13.86% 37) With respect to the proposition that dividend policy does not matter, in order to raise an

additional $5,700 in cash by issuing stock, the stock sold must be worth: A) more than $5,700. B) $2,850. C) $5,700. D) less than $5,700. 38) The Beta Corporation has 1,000 shares outstanding and a market value of $110,000. What

will be the market value per share after the firm distributes a $5 per share dividend? Ignore taxes and market imperfections. A) $110 B) $105 C) $100 D) $107.50 39) A dividend will be paid to shareholders on Friday, May 9. To receive this dividend you must

purchase the stock no later than the: A) payment date. B) with-dividend date. C) record date. D) ex-dividend date.

Version 1

40) You currently own 200 shares of stock valued at $6 per share. If the firm declares a 1-for-4

reverse stock dividend you will own _____________ shares valued at _____________ per share. A) 800; $6 B) 800; $1.50 C) 50; $6 D) 50; $24 41) Which method of share repurchase requires investors to submit bids and the companies to

take the lowest ones, in sequence? A) Tender offer B) Auction repurchase C) Direct negotiation D) Open-market repurchase 42) A stock goes ex-dividend: A) one business day prior to the record date. B) two business days after the declaration date. C) three business days after the record date. D) three business days prior to the payment date. 43) What would you expect to happen to the price of a share of stock on the day it goes ex-

dividend if you ignore taxes? The price should: A) increase by the amount of the dividend. B) decrease by the amount of the dividend. C) decrease by one-half the amount of the dividend. D) remain constant. 44) Which one of these is the most common method of share repurchase? A) Tender offer B) Auction repurchase C) Direct negotiation D) Open-market repurchase 45) Boards of directors may be legally restricted in their declaration of dividends if: A) cash must be borrowed for the dividend payment. B) dividends have increased substantially over a short period of time. C) the dividend would create a situation of insolvency. D) the stock is selling at a low relative price.

Version 1

46) ABC Corporation stock is selling for $30 per share when a 10% stock dividend is declared. If

you own 100 shares of ABC Corporation then you will receive: A) shares valued at $3 each. B) $3 times 100 shares = $300 cash. C) $300 plus 10 shares of ABC Corporation. D) 10 shares of ABC Corporation. 47) Which statement is correct? A) Stock that has been repurchased must be put in the firm’s treasury and cannot be

resold. B) Most repurchases are mandatory. Investors are obliged to sell part of their holding back to the company. C) Corporations are much more willing to cut repurchases than dividends. D) Companies like to smooth repurchases. 48) Which of the following is not a way to repurchase stock? A) Open-market repurchase B) Repurchase a block of shares from a major shareholder C) Make a rights issue D) Tender offer 49) An investor owns 5,000 shares, which is 1% of a corporation's outstanding stock before a

stock repurchase. The investor did not sell any of his stock during the 25,000 share repurchase. Which one of the following statements is correct? A) The investor still owns 1% of the corporation. B) The stock's price is likely to drop by 5%. C) The investor owns more than 1% of the corporation. D) The investor now has 5,250 shares. 50) Which one of these statements is correct? A) Dividends tend to fluctuate in direct relation to changes in annual earnings. B) Managers are less concerned with the change in the dividend than with the actual

amount of the dividend. C) Managers tend to avoid smooth dividends as they don't signal the firm's most recent successes. D) Managers tend to only increase dividends when they believe the increased amount can be sustained.

Version 1

51) Stock repurchases may be interpreted by investors as a signal that: A) future repurchases will be forthcoming. B) the firm's shares are underpriced. C) the firm has an increasing number of positive-NPV opportunities. D) stock repurchases will gradually replace the stock dividends. 52) A company recently announced a dividend of $2 per share. The stock is currently priced at

$38 per share. All things being equal, what is the likely stock price to be on the date of record? A) $36 B) $38 C) $40 D) $42 53) A firm has current assets of $1.2 million, fixed assets of $3.6 million, and debt of $2.2

million. There are 250,000 shares of stock outstanding. What will be the book value of equity if the firm repurchases 10% of its outstanding shares for $10.40 a share? A) $2,552,000 B) $2,600,000 C) $2,340,000 D) $2,574,000 54) A policy of dividend "smoothing" refers to: A) maintaining a constant dividend payout ratio. B) keeping the regular dividend at the same level indefinitely. C) maintaining a steady progression of dividend increases over time. D) alternating cash dividends with stock dividends. 55) How are investors most apt to interpret a reduction in a firm's regular dividend payment? A) Earnings are expected to decline. B) New investments are expected to increase. C) Stock repurchases are expected to increase. D) Share price is expected to increase. 56) What is the new share price for a corporation with a current share price of $4 that employs a

2-for-9 reverse split? A) $8 B) $16 C) $36 D) $18

Version 1

57) If investors are expecting a dividend cut, then the announcement of the decreased dividend

payment will: A) cause the stock price to decline by more than the dividend amount. B) not affect the stock price as long as the announcement was in line with expectations. C) cause the stock price to increase if the cut was greater than anticipated. D) signal that the next dividend will be cut even further. 58) MM's proposition of dividend irrelevance depends upon: A) firms maintaining a constant dividend payout. B) dividends being taxed the same as capital gains. C) the existence of a dividend clientele. D) the efficiency of capital markets. 59) A firm has $250,000 to spend on either a one-time special dividend or on a share repurchase

program. If the share repurchase is selected, then the firm's: A) value will decrease just as if the dividend option had been selected. B) balance sheet will be unaffected and the share price will remain constant. C) equity balance will be reduced by less than it would have been under the dividend option. D) shareholders will receive less value than under the dividend option. 60) Based on the dividend growth model, a lower current payout will not affect the stock price,

provided that the: A) required return on the stock is proportionately increased. B) growth rate in dividends remains constant. C) reduction is offset by an increase in the growth rate. D) growth rate is decreased by the percent decrease in the dividend. 61) Why are dividend changes rather than the absolute level of dividends perceived to be more

important to managers and shareholders? A) Managers change dividends only under threatening conditions. B) Dividend changes are thought to signal future expectations. C) MM's argument states that the absolute level of dividends is irrelevant. D) Dividend changes determine whether borrowing must occur. 62) Which one of the following signals is most likely to elicit a decrease in share price? A) A repurchase of 5% of the firm's stock B) An increase in the regular quarterly dividend C) A decrease in the regular quarterly dividend D) Borrowing funds in order to pay a cash dividend

Version 1

63) If a firm does not have adequate profits or cash to pay an expected dividend, what concept is

most likely to cause a firm to consider borrowing money to ensure payment of the dividend? A) Clientele effect B) Expectations theory C) Residual dividend theory D) Signaling hypothesis 64) An increase in share price following an increase in dividends is logical if the: A) firm borrows to obtain cash for the dividend. B) increased dividend signals higher future earnings. C) dividend is believed to be temporary. D) clientele effect is not important. 65) Which one of these parties is most likely to prefer a stock with a high-dividend payout

policy? A) Financial institutions B) Retired individuals C) Growth-seeking investors D) Endowment funds 66) An investor buys a stock today for $26, receives a dividend of $2 at the end of the year, and

then sells the stock for $30. If the dividend is taxed at 37% and the capital gain at 20%, what is her return after tax? A) 23.08% B) 17.15% C) 9.23% D) 31.15% 67) What is the difference in the one-year after-tax returns on the following two stocks, assuming

a 37% tax rate on dividends and a 20% tax rate on capital gains? Stock A is purchased for $50, pays a $2.5 dividend at the end of the year, and is then sold for $56; stock B is purchased for $60, pays no dividend, but is sold after one year for $70. A) Stock A's after-tax return is higher by 1.27%. B) Stock B's after-tax return is higher by 0.58%. C) Stock A's after-tax return is higher by 0.27%. D) Stock B's after-tax return is higher by 0.73%.

Version 1

68) A company is more likely to repurchase stock rather than pay out dividends when the firm: A) wants to distribute excess cash by making a regular commitment to its investors. B) wants to conserve current cash. C) wants to avoid a commitment for future distributions. D) foresees excess cash as a common long-term occurrence. 69) Capital gains may be preferred by investors over dividends even if dividends and capital

gains are taxed at the same rate because: A) taxes on dividends are withheld immediately. B) taxes on capital gains are paid annually. C) taxes on capital gains can be deferred. D) after-tax dividends are less certain than capital gains. 70) Compare the after-tax returns for a corporation that invests in preferred stock with a 12%

dividend yield versus a common stock with no dividend but a 16% capital gain. The corporation's tax rate is 21%. The: A) common stock returns 2.60% less than the preferred. B) preferred stock returns 1.90% less than the common. C) common stock returns 2.32% less than the preferred. D) returns are equal on an after-tax basis. 71) Why may a large increase in earnings not translate into a large increase in dividends? A) The earnings will be taxed. B) Some investors may prefer capital gains. C) Managers wish to assess the earning's persistence. D) The earnings may already be a part of retained earnings. 72) You purchased a stock today. What should you expect if the stock goes ex-dividend

tomorrow? A) A dividend will be declared tomorrow. B) A dividend will be paid tomorrow. C) The stock price should decline tomorrow. D) The stock price has already adjusted for the next dividend payment. 73) With respect to the dividend-payment process, the price of a share of stock can logically be

expected to drop on: A) the payment date. B) the date of record. C) the ex-dividend date. D) the declaration date.

Version 1

74) Automatic dividend reinvestment plans allow firms to: A) pay dividends on a more frequent schedule. B) reduce their cash outflow to shareholders. C) transform regular dividends into stock dividends. D) avoid the ex-dividend date reduction in stock price. 75) Evenglade Corporation has 1,000 shares outstanding priced at $10 a share. The company is

unsure whether to pay out $1 a share as a dividend or to use the money to repurchase stock. If it pays a dividend, what happens to the stock price? If it repurchases, how many shares will remain and at what price? A) After the dividend payment stock price falls to $9. If Evenglade repurchases, 900 shares remain and the share price falls to $9. B) After the dividend payment stock price falls to $9. If Evenglade repurchases, 800 shares remain and the share price stays at $10. C) After the dividend payment stock price falls to $9. If Evenglade repurchases, 900 shares remain and the share price stays at $10. D) After the dividend payment stock price stays at $10. If Evenglade repurchases, 900 shares remain and the share price rises to $11.11. 76) Firm X will pay a dividend of $10 next year and its stock is expected to sell at $100 after the

payment. Firm Y pays no dividend but its stock is expected to sell at $110. Dividends are taxed at 37% and capital gains are untaxed. If both stocks offer an after-tax return of 8%, what is the price of the two stocks? A) Price of X = $101.85; price of Y = $101.85 B) Price of X = $98.43; price of Y = $101.85 C) Price of X = $100; price of Y = $101.85 D) Price of X = $98.43; price of Y = $100 77) What effect does a stock dividend have on the book and market values of the firm? A) Both the book and market values increase B) Book value increases; market value decreases C) Book value decreases; market value increases D) Both the book and market values remain constant 78) An investor owns 300 shares of stock currently selling for $70 per share. After a 3-for-2

stock split, the investor will have: A) 200 shares selling for $93.10 each. B) 200 shares selling for $105.00 each. C) 450 shares selling for $46.67 each. D) 450 shares selling for $93.10 each.

Version 1

79) When a corporation engages in a 10% stock repurchase, it: A) offers shareholders 110 shares for every 100 they currently own. B) purchases for cash 10% of the outstanding shares. C) sells treasury stock at a 10% discount to investors. D) issues 10% more stock but holds the shares as treasury shares. 80) A share repurchase is said to be equivalent to the payment of a cash dividend because each

strategy: A) causes share price to decline. B) causes share price to remain constant. C) creates the same tax liability for the investor. D) reduces the assets of the firm by the same amount. 81) Assuming no market imperfections, which one of the following will not be affected by a

repurchase of shares? A) Assets of the firm B) Equity of the firm C) Shares outstanding D) Price per share 82) Assuming no market imperfections, which one of the following would not be expected to

have an effect on share price? A) Dividend declaration and payment B) Stock repurchase C) Stock dividend D) Stock split 83) Which one of the following is correct for a firm with $400,000 in net earnings, 50,000 shares,

and a 30% payout ratio? A) Retained earnings will increase by $120,000. B) Each share will receive a $1.20 dividend. C) $120,000 will be spent on new investments. D) The dividend per share will be $2.40. 84) A firm is said to be "smoothing" dividends if dividends: A) are paid through an automatic dividend reinvestment plan. B) change more gradually than changes in earnings. C) increase by the same dollar amount each year. D) are paid only in even dollar amounts.

Version 1

85) Managers have been characterized as reluctant to increase dividends if: A) dividends were increased in the preceding year. B) earnings have permanently increased. C) the dividend increase cannot be sustained. D) the dividend payout ratio exceeds 20%. 86) Dividend changes are typically viewed by investors as signals of future changes in: A) investment. B) the firm's WACC. C) earnings. D) the clientele effect. 87) An unlevered firm expects to generate and pay out free cash flows of $120,000 annually in

the form of dividends and share repurchases starting next year. The discount rate is 13% and there are 125,000 shares outstanding. What is the current value per share? A) $7.38 B) $0.96 C) $1.08 D) $6.87 88) B Corporation has announced four dates (payment date, ex-dividend date, announcement

date, and record date) associated with its forthcoming dividend. The dates are August 1, October 1, August 31 and August 28. Which one of these dates is the record date and which is the ex-dividend date? A) Record date = October 1, ex-dividend date = August 31. B) Record date = August 28, ex-dividend date = August 31. C) Record date = August 1, ex-dividend date = August 28. D) Record date = August 31, ex-dividend date = August 28. 89) MM's proposition concerning dividends contends that shareholders will: A) offer higher prices for higher dividend payouts. B) not offer higher prices for higher dividend payouts. C) offer higher prices for lower dividend payouts. D) purchase only stocks that have high dividend payouts.

Version 1

90) MM's assertion that dividend policy will not affect the value of the firm requires that

dividend policy does not: A) alter the retained earnings of the firm. B) affect investment and borrowing policies. C) allow the payout ratio to change. D) alter the number of outstanding shares. 91) The manager of XYZ Corporation feels that a dividend increase will increase the stock price

because many investors value stock with a dividend-discount model. Why might MM disagree with this assertion? A) The increased dividend makes the firm much riskier. B) If investment policy remains unchanged, the company must replace the cash with a stock issue. C) Investors prefer capital gains over dividends. D) Dividend increases will increase the book value but not the market value of the firm. 92) Market imperfections may make the choice between dividends and repurchases relevant.

Which of the following is not one of these imperfections? A) Institutional restrictions on stock holdings B) Differences in dividend-payout ratios C) Taxes on dividends and capital gains D) Differences among investors in marginal tax rates 93) A stock is currently priced at $65 per share and will pay a $4 dividend in one year. What

must the stock sell for in one year to meet investors' expectations of a 15% after-tax return if dividends are taxed at 37% and there are no capital gains taxes? A) $70.75 B) $72.23 C) $73.63 D) $76.00 94) Corporations may have a legitimate preference for dividends over capital gains because: A) capital gains have a 70% tax rate. B) dividends received by corporations are not taxable. C) 30% of dividends received by corporations are exempt from taxation. D) 50% of dividends received by corporations are exempt from taxation.

Version 1

95) Stock A has a dividend yield of 8% but no capital gain. Stock B offers a capital gain but no

dividend. If a corporate investor in the 21% tax bracket earns the same after-tax return from the two stocks, what capital gain does B offer? A) 6.00% B) 8.29% C) 9.06% D) 11.31% 96) The date on which actual dividends are sent to shareholders is the: A) declaration date. B) payment date. C) ex-dividend date. D) record date. 97) An investor who owns stock on the company's _____________ date will receive the

dividends declared. A) ex-dividend B) record C) payment D) declaration 98) Which one of the following is the order in which key dividend dates occur? A) Declaration, record, ex-dividend, payment B) Declaration, ex-dividend, record, payment C) Record, declaration, payment, ex-dividend D) Ex-dividend, record, declaration, payment 99) A corporation that has an automatic reinvestment plan: A) forces shareholders to automatically reinvest dividends in the company. B) never physically pays out declared dividends. C) gives shareholders the option of purchasing either debt or equity shares. D) gives shareholders the option to re-invest the dividend in additional shares. 100)

The primary purpose of laws prohibiting a firm from paying dividends that include its legal capital is to: A) reduce investors' tax liability. B) ensure that the balance sheet balances. C) prevent managers from paying out a substantial proportion of the firm's assets. D) prevent managers from paying large dividends.

Version 1

101)

Kappa Corporation has just raised its dividend from $2.50 to $5 per share. (It plans to reduce its repurchases by a similar amount.) Caterina Chekov, who owns 100 shares of Kappa does not need the extra cash. What can she do to offset the change in dividend policy? A) Reinvest the extra dividend in Kappa stock. B) Sell $250 of Kappa stock each year. C) Borrow $250 and invest it in Kappa stock. D) Nothing. She should sell out and invest elsewhere.

102)

Kappa Corporation and Lambda Corporation are identical except that Kappa pays a dividend of $5 per share, while Lambda pays no dividend and uses the cash to repurchase stock. Peter Berngarten owns 100 shares of Kappa. How could he raise the same amount of spending money if instead he owned 100 shares of Lambda? A) He could sell $500 worth of shares of Lambda each year. B) He could not; he could not be sure of the price at which he could sell Lambda stock. C) He could sell 5 shares of Lambda each year. D) He could borrow against his holding of Lambda stock.

103)

Zeta Corporation has 1,000 shares outstanding. Its stock is priced at $100 a share and shareholders expect Zeta to pay dividends of $10 a year in perpetuity. Now the president suddenly announces that it will keep the total payout the same but will pay only a quarter of the total amount as dividends and use the remaining cash to buy back stock. What will happen to the share price now and how much will the share price grow each year? A) The value of the shares will be unchanged by the announcement and will not grow. B) The share price will be unchanged by the announcement. Subsequently the share price will grow by 7.5% each year. C) The share price will halve and then grow by 7.5% a year. D) The share price will be unchanged by the announcement and will decline by 10% a year.

104)

Which one of the following statements regarding stock dividends and stock splits is true? A) A two-for-one stock split is equivalent to a 50% stock dividend. B) A three-for-one stock split is equivalent to a 66% stock dividend. C) A three-for-two stock split is equivalent to a 100% stock dividend. D) A three-for-two stock split is equivalent to a 50% stock dividend.

105)

Stock repurchases: A) decrease the number of authorized shares. B) affect every shareholder. C) are optional to the shareholders. D) always increase shareholder value.

Version 1

106)

Research has shown all of the following to be true of the way corporations determine dividends except: A) Firms have short-run target payout ratios. B) Firms have long-run target payout ratios. C) The focus is more on dividend changes rather than absolute dividends. D) Managers try to avoid dividend changes that may need to be reversed.

107)

Which of the following statements is false? A) Most mature companies pay dividends. B) Many companies pay dividends and repurchase stock. C) Repurchases fluctuate more than dividends. D) Stock repurchases have become less common over the past 30 years.

108)

Given a set investment policy and capital structure, then payout policy is a trade-off between _____________ and _____________. A) retained earnings; borrowing B) capital budgeting; cash dividends C) cash dividends; stock issues and repurchases D) stock splits; stock dividends

109)

Which statement is correct? A) The dividend discount model is no longer applicable when there are stock repurchases. B) When valuing free cash flow per share it is important to include both dividends per share and the cash received from repurchases. C) Shareholders like dividends because it is the only way that they can get their hands on cash. D) If capital investment and capital structure are held constant, smaller dividends mean larger repurchases.

110)

With respect to the proposition that dividend policy does not matter, in order to raise an additional $5,600 in cash by issuing stock, the stock sold must be worth: A) more than $5,600. B) $2,800. C) $5,600. D) less than $5,600.

Version 1

111)

The Beta Corporation has 1,000 shares outstanding and a market value of $90,000. What will be the market value per share after the firm distributes a $5 per share dividend? Ignore taxes and market imperfections. A) $90 B) $85 C) $80 D) $87.50

112)

Q Corporation has decided to pay out an extra $1 million to shareholder, while keeping investment policy and capital structure constant. Which statement is false? A) Q Corporation must issue $1 million of stock to replace the lost cash. B) The new shareholders will demand to receive shares worth $1 million. C) The old shareholders will have reduced their stake in the firm by $1 million. D) The reduced stake that old shareholders have in the firm will more than offset the benefit of the higher dividend.

113)

A dividend increase may be used as _____________ of a firm's _____________. A) an indicator; high capital gains B) an indicator; tax liability C) a signal; poor prospects D) a signal; good prospects

114)

Which party receives the greatest tax benefit from receiving dividends rather than capital gains? A) Individual investors B) Corporations C) Financial institutions D) Foundations

115)

Which of the following statements is correct? A) Investors rightly prefer repurchases because the reduced number of shares increases earnings per share. B) Companies with large repurchase programs usually finance them by a cut in dividends. C) Companies pay out as dividends whatever is left over after making needed capital investments. D) A stock repurchase does not increase stock price but it does avoid the fall in price that would occur on the ex-dividend date.

Version 1

116)

In MM's analysis, which one of these is not fixed? A) Debt payments B) Investment policy C) Capital structure D) Payout decisions

117)

Three of the following considerations may suggest that the firm should start paying out cash to its shareholders. Which one is not a relevant consideration? A) Is the company generating positive free cash flow? B) The company is earning a high profit margin? C) Does the company have sufficient cash for emergencies and unexpected investment opportunities? D) Is the debt ratio prudent?

118)

Which one of these firms would you most expect to have the highest payout percentage? A) New technology firm B) Mature firm in a declining industry C) Mature firm with limited growth opportunities D) Rapidly expanding firm in a growth industry

119)

Under which conditions are shareholders most likely to be concerned about agency conflicts? A) Growth firm with financing needs that use most of the firm's available cash flows B) Young firm with negative free cash flows C) Large free cash flows generated by a mature firm D) Mature firm with a low retention ratio and frequent stock repurchases

Version 1

Answer Key Test name: Ch17 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) TRUE 7) FALSE 8) FALSE 9) FALSE 10) FALSE 11) TRUE 12) FALSE 13) TRUE 14) FALSE 15) FALSE 16) TRUE 17) TRUE 18) TRUE 19) TRUE 20) TRUE 21) TRUE 22) FALSE 23) FALSE 24) D

Number of shares = 400 ÷ 4 = 100→Price = $16 × 4 = $64 25) D

Shares received = 0.10 × 140 = 14 shares 26) C

Equity = $2,800,000 + 5,200,000 − 3,800,000 − (0.10 × 282,000 × $12.00) = $3,861,600 27) D

New price = 4 ÷ 3 × $36 = $48 28) B

Version 1

29) A

Difference = 11.27% − 10.45% = 0.82% 30) B

After-tax returns: Difference = 11.64% − 18.17% = −6.54% 31) B

Price X = ($105 + (1 − 0.37) × $10) ÷ 1.08 = $103.06; Price of Y = $115 ÷ 1.08 = $106.48 32) A

New shares = 354 × 3 ÷ 2 = 531 shares New price = $79 × 2 ÷ 3 = $52.67 33) D

DPS = (0.30 × $495,900) ÷ 51,300 = $2.90 34) B

Share price = ($122,000 ÷ 0.13) ÷ 126,000 = $7.45 35) B

36) C

37) C 38) B

New share price = ($110,000 ÷ 1,000) − $5 = $105 39) B

Version 1

40) D

Number of shares = 200 ÷ 4 = 50→Price = $6 × 4 = $24 41) B 42) A 43) B 44) D 45) C 46) D

Shares received = 0.10 × 100 = 10 shares 47) C 48) C 49) C 50) D 51) B 52) B 53) C

Equity = $1,200,000 + 3,600,000 − 2,200,000 − (0.10 × 250,000 × $10.40) = $2,340,000 54) C 55) A 56) D

New price = 9 ÷ 2 × $4 = $18 57) B 58) D 59) A 60) C 61) B 62) C 63) A 64) B 65) B 66) B

67) B

Version 1

Difference = 13.33% − 12.75% = 0.58% 68) C 69) C 70) B

After-tax returns: Difference = 10.74% − 12.64% = −1.90% 71) C 72) C 73) C 74) B 75) C 76) B

Price X = ($100 + (1 − 0.37) × $10) ÷ 1.08 = $98.43; Price of Y = $110 ÷ 1.08 = $101.85 77) D 78) C

New shares = 300 × 3 ÷ 2 = 450 shares New price = $70 × 2 ÷ 3 = $46.67 79) B 80) D 81) D 82) B 83) D

DPS = (0.30 × $400,000) ÷ 50,000 = $2.40 84) B 85) C 86) C 87) A

Share price = ($120,000 ÷ 0.13) ÷ 125,000 = $7.38 88) D

Version 1

89) B 90) B 91) B 92) B 93) B

94) D 95) C

96) B 97) B 98) B 99) D 100) 101) 102) 103)

C A A B The share price will be unchanged. Repurchases will cause the number of shares and dividend per share to rise by 7.5% a year. PV = $2.5 ÷ (0.10 − 0.075) = $100. 104) 105) 106) 107) 108) 109) 110) 111)

D C A D C D C B New share price = ($90,000 ÷ 1,000) − $5 = $85 112) 113) 114) 115) 116) 117)

D D B D D B

Version 1

118) 119)

C C

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) A planning horizon refers to the amount of time necessary to develop the financial plan. ⊚ true ⊚ false 2) A common, long-term corporate financial planning horizon would stretch for at least 15 to 20

years. ⊚ true ⊚ false 3) Financial plans will rarely succeed unless the forecasts are perfect. ⊚ true ⊚ false 4) Financial planning focuses on the big picture. ⊚ true ⊚ false 5) Financial planning may incorporate scenario analysis as part of the planning process. ⊚ true ⊚ false 6) The primary aim of financial planning is to obtain better forecasts of future cash flows and

earnings. ⊚ true ⊚ false 7) Financial planning is concerned with possible surprises as well as the most likely outcomes. ⊚ true ⊚ false 8) Financial planning should attempt to minimize risk. ⊚ true ⊚ false 9) Financial planning is necessary because financing and investment decisions interact and

should not be made independently. ⊚ true ⊚ false

Version 1

10) A typical horizon for long-term planning is 5 years. ⊚ true ⊚ false 11) Individual capital investment projects are not considered in a financial plan unless they are

very large. ⊚ true ⊚ false 12) Financial planning requires careful and consistent forecasting. ⊚ true ⊚ false 13) Financial planning models must include as much detail as possible. ⊚ true ⊚ false 14) The sustainable growth rate is the rate at which the firm can grow without changing its

leverage ratio. ⊚ true ⊚ false 15) Financial planning just means formulating the company's response to the most likely events. ⊚ true ⊚ false 16) Adaptability is not a desirable feature in financial plans. ⊚ true ⊚ false 17) Pro formas are projected or forecasted financial statements. ⊚ true ⊚ false 18) Percentage of sales models are planning models in which the sales forecasts are the driving

variables and most other variables are proportional to sales. ⊚ true ⊚ false

Version 1

19) The balancing items in a financial planning model are variables that adjust to maintain the

consistency of the model. They are also known as plugs. ⊚ true ⊚ false 20) Debt can be used as a plug item in financial planning. ⊚ true ⊚ false 21) Financial models identify the best financing plan. ⊚ true ⊚ false 22) The decision to acquire fixed assets is unrelated to the current level of excess capacity. ⊚ true ⊚ false 23) Financial planning models routinely adjust for present value and risk. ⊚ true ⊚ false 24) If factories are operating below full capacity, sales can increase without investment in fixed

assets. However, beyond some sales level, new capacity must be added and additional investment in fixed assets must be made. ⊚ true ⊚ false MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 25) Calculate the rate at which a firm can grow without changing its leverage if its payout ratio is 70%, equity outstanding at the beginning of the year is $976,000, and its net income for the year is $198,000. A) 6.09% B) 12.59% C) 14.92% D) 17.59%

Version 1

26) If the pro forma balance sheet shows that total assets must increase by $402,500 while

retaining a debt-equity ratio of 0.75 then: A) debt must increase by $301,875. B) equity must increase by the full $402,500. C) debt must increase by $172,500. D) equity must increase by $939,167. 27) A firm has $4 million in total assets and $2.2 million in equity. How much of its $504,000

capital budget should be debt-financed to retain the same debt-equity ratio? A) $453,600 B) $50,400 C) $226,800 D) $277,200 E) $453,600 28) If a firm uses external financing as a plug item, has a new capital budget of $2.9 million, a

net income of $3.9 million, and a plowback ratio of 40%, how much should be raised in external funds? A) $1,340,000 B) $290,000 C) $1,740,000 D) $870,000 29) A firm currently has sales of $399,000 and net working capital of $47,540. Assume net

working capital changes in direct proportion to sales. What will be the increase in net working capital if sales increase by 8%? A) $1,268 B) $2,914 C) $3,206 D) $3,803 30) If a firm with an asset base of $3,000,000 recently added $204,000 to retained earnings after

a dividend payment of $136,000, then its internal growth rate is: A) 3.47%. B) 5.13%. C) 6.80%. D) 10.15%.

Version 1

31) A firm plans to grow at 6.24% a year without increasing financial leverage. It expects to earn

a return on equity of 10.40%. What proportion of earnings should it plan to pay out? A) 0.40 B) 0.65 C) 0.72 D) 0.00 32) A firm has an ROE of 10% and a debt-equity ratio of 34%. If it wishes to grow by 6% a year

without external financing, what is the maximum proportion of earnings that it can pay out? A) 9.60% B) 15.60% C) 16.20% D) 19.60% 33) What is the internal growth rate for a firm with an ROE of 20.60%, a dividend payout ratio of

40%, and an equity-to-debt ratio of 60%? A) 4.64% B) 5.55% C) 8.24% D) 12.36% 34) A percentage of sales model projects sales to increase by 5% annually over the next 4 years.

If costs are forecast at a constant 80% of sales, and this year's income is $1,310, the forecast income in the fourth year will be: A) $1,516.46. B) $1,913.81. C) $1,671.93. D) $1,592.31. 35) A firm has projected sales of $343,000, costs of goods sold equal to 68% of sales, interest of

$26,000, a tax rate of 21%, and a dividend payout ratio of 60%. What will be the addition to retained earnings? A) $35,522 B) $26,468 C) $23,252 D) $18,921

Version 1

36) Assume a firm wants to hold its current long-term debt-to-equity ratio constant at 0.55 and its

payout ratio constant at 35%. The firm neither issues nor repurchases shares. If the firm generates $346,000 of net income, what is the maximum amount that the firm can increase its long-term debt? A) $123,695 B) $101,205 C) $130,138 D) $0 37) A firm's net assets equal 55% of sales. The firm expects sales to increase to $82,000 next

year and to generate $8,500 of retained earnings. What is the external financing need? A) $53,600 B) $16,720 C) $26,400 D) $36,600 38) A firm has projected net income of $25.20 million and the company will need new assets of

$15.20 million. If external financing is fixed at $2.20 million, what will be the company’s dividend? A) $2.20 million B) $12.20 million C) $15.20 million D) $25.20 million 39) A company requires $18.30 million in new assets to sustain its current level of growth. The

firm forecasts $26.30 million of net income and investors expect a $13.30 million dividend. Since the company does not want any new equity, how much new debt must the company issue to meet its objectives? A) $5.30 million B) $7.30 million C) $10.60 million D) $15.90 million 40) A financial planning model will generally include all of the following except the: A) listing of the firm's goals. B) required increase in fixed assets. C) projected sales. D) forecast increase in retained earnings.

Version 1

41) Planners often recommend entering a market for "strategic" reasons because the: A) company is facing too much competition in its original market. B) company may have valuable follow-on investments in the new market. C) immediate investment has a positive net present value. D) manager has a personal interest in a particular market. 42) Which one of the following is not typically included among the three major components of a

financial planning model? A) Inputs: current financial statements, forecasts of key variables B) Planning model: equations specifying key relationships C) Outputs: pro formas, financial ratios, sources and uses of cash D) Shareholders’ risk preferences 43) Which one of the following is not a reason for compiling financial plans? A) Considering options B) Contingency planning C) Calculating the optimal plan D) Forcing consistency 44) Calculate the rate at which a firm can grow without changing its leverage if its payout ratio is

70%, equity outstanding at the beginning of the year is $940,000, and its net income for the year is $162,000. A) 5.17% B) 11.67% C) 14.00% D) 16.67% 45) The firm's current financial statements would be included in: A) the inputs of a financial plan. B) the planning model for the financial plan. C) the outputs of the financial plan. D) no part of the financial plan. 46) The implications of the forecasts from a financial plan are determined by the: A) plan inputs. B) balancing item. C) planning model. D) plowback ratio.

Version 1

47) Pro formas refer to: A) plans developed by a certified financial planner. B) the inputs in the financial planning process. C) projected financial statements. D) deviations in results from previous financial plans. 48) Outputs from a financial plan would include such items as: A) sales growth forecasts. B) a percentage of sales planning model. C) a pro forma statement of sources and uses of cash. D) the firm's current financial statements. 49) When most of the elements of a financial plan are related to sales levels, the plan is: A) less likely to be effective. B) using sales as a plug figure. C) a percentage of sales model. D) not adjusted for inflation. 50) A planner's percentage of sales model forecasts that sales will grow by 20% next year. If

costs of goods sold are proportionate at 70% of sales, then costs of goods sold will: A) grow to 90% of sales. B) grow in dollars by 70%. C) not change in dollar amount. D) increase by 20% in dollar terms. 51) When a firm has no spare capacity, it: A) has no need for new employees. B) currently has no inventory available for sale. C) must issue new equity to grow. D) must usually increase fixed assets to increase sales. 52) If the pro forma balance sheet shows that total assets must increase by $400,000 while

retaining a debt-equity ratio of 0.75 then: A) debt must increase by $300,000. B) equity must increase by the full $400,000. C) debt must increase by $171,429. D) equity must increase by $933,333.

Version 1

53) If sales growth for XYZ Corporation exceeds 6%, XYZ will need to seek external financing.

This means that 6% is the: A) external growth rate. B) internal growth rate. C) optimal growth rate. D) sustainable growth rate. 54) If a firm's dividend payout ratio is determined after achieving a specific capital structure,

then: A) dividends are an input to the financial plan. B) the capital budget should be revised. C) dividends are being used as a plug item. D) dividend forecasts become crucial to planning. 55) A firm has $4 million in total assets and $2.2 million in equity. How much of its $500,000

capital budget should be debt-financed to retain the same debt-equity ratio? A) $50,000 B) $225,000 C) $275,000 D) $450,000 56) If a firm uses external financing as a plug item, has a new capital budget of $2 million, a net

income of $3 million, and a plowback ratio of 40%, how much should be raised in external funds? A) $200,000 B) $600,000 C) $800,000 D) $1,200,000 57) A potential downside to using dividends as the plug item is that: A) changes in dividends may send shareholders mixed signals. B) the plan may suggest negative dividends. C) the firm may have to borrow cash to pay dividends. D) shareholders may receive an excessive return.

Version 1

58) A firm that wants to increase its sustainable growth rate can do so by _____________ the

_____________ ratio or by _____________ the _____________, or both. A) increasing; payout; increasing; ROE B) increasing; plowback; increasing; ROE C) decreasing; plowback; increasing; ROE D) decreasing; payout; decreasing; ROE 59) Alternative "what if?" scenarios can be easily accommodated in financial planning by use of: A) sustainable growth models. B) planning outputs. C) spreadsheet programs. D) bond covenants. 60) A firm currently has sales of $382,000 and net working capital of $45,840. Assume net

working capital changes in direct proportion to sales. What will be the increase in net working capital if sales increase by 8%? A) $1,222 B) $2,809 C) $3,091 D) $3,667 61) The observation that additions to fixed assets are lumpier than additions to current assets

indicates that: A) fixed assets depreciate over time. B) fixed assets can be acquired only through external funding. C) current assets can be acquired in smaller increments. D) dollar for dollar, fixed assets are more expensive than current assets. 62) A firm can achieve a higher growth rate without raising external capital if it has a: A) high dividend payout ratio. B) low ROE. C) low debt-to-asset ratio. D) low profit margin. 63) Other things equal, a firm can grow more rapidly without raising new capital if it: A) has a low ROE. B) has a high ratio of debt to assets. C) has a low profit margin. D) pays out a small proportion of earnings.

Version 1

64) If a firm with an asset base of $3,000,000 recently added $150,000 to retained earnings after

a dividend payment of $100,000, then its internal growth rate is: A) 1.67%. B) 3.33%. C) 5.00%. D) 8.33%. 65) What is the maximum internal growth rate for a firm reporting net income of $500,000, a

dividend payout ratio of 40%, and total assets of $10 million? A) 2% B) 3% C) 5% D) 6% 66) A firm plans to grow at 6% a year without increasing financial leverage. It expects to earn a

10% return on equity. What proportion of earnings should it plan to pay out? A) 0.40 B) 0.60 C) 0.67 D) 0.00 67) A firm has an ROE of 15% and a debt-equity ratio of 40%. If it wishes to grow by 9% a year

without external financing, what is the maximum proportion of earnings that it can pay out? A) 1% B) 10% C) 12% D) 16% 68) Which one of the following will reduce the internal growth rate, other things equal? A) A higher plowback ratio B) A higher debt-to-asset ratio C) A higher return on equity D) A higher return on assets 69) What is the sustainable growth rate for a firm with net income of $2.5 million, cash dividends

of $1.5 million, and return on equity of 18%? A) 3.0% B) 5.4% C) 7.2% D) 10.8%

Version 1

70) The sustainable rate of growth assumes that the: A) debt-equity ratio is held constant. B) market to book ratio increases. C) dividend payout ratio decreases. D) external debt remains constant. 71) A firm has a policy of not issuing debt and paying out 40% of its earnings. Its asset turnover

is 2.0 and its profit margin is 10%. What is its sustainable growth rate? A) 20.0% B) 8.0% C) 3.0% D) 12.0% 72) A firm has sales of $1.2 million, a profit margin of 5%, and a dividend payout ratio of 25%.

How much will be added to retained earnings next year if sales increase by 6%? A) $15,900 B) $21,600 C) $47,700 D) $42,000 73) Short-term financial planning rarely looks beyond: A) 1 year. B) 1 month. C) 1 week. D) 1 day. 74) If the projected growth rate is less than the firm's sustainable growth rate: A) it should increase its projected growth rate. B) the firm will be required to decrease its plowback ratio. C) its debt-equity ratio will decrease. D) the firm will be required to increase borrowing. 75) Contingency planning is: A) forecasting the most likely outcomes. B) working through the implications of the most likely outcomes. C) working through the consequences of the plan under different scenarios. D) formulating responses to inevitable surprises.

Version 1

76) A major difference between financial planning and forecasting is that financial planning: A) is forward-looking. B) relies on the preferences of management. C) determines the rate of profitability. D) is equally concerned with less likely outcomes. 77) A firm has current sales of $2.4 million and fixed assets of $1.65 million. The firm is

currently operating at 88% of capacity. How high can the firm's sales go without requiring any additional fixed assets? A) $2.423 million B) $2.509 million C) $2.727 million D) $2.836 million 78) The flexibility of financial plans is evident in the extent that: A) actual profits will deviate from projected profits. B) the plans can be adapted when conditions change. C) use of the plans can be extended. D) planning output is the same regardless of economic conditions. 79) Dawson Metals is currently operating at 94% of its capacity and has sales of $3.1 million and

fixed assets of $2.5 million. How much should the firm budget for fixed asset purchases if sales are projected to increase by 9% next year? A) $0 B) $61,500 C) $43,616 D) $98,407 80) The outputs of a financial planning model often include: A) the firm's current financial statements. B) a range of macroeconomic forecasts. C) the number of employees required. D) projected financial statements of the firm.

Version 1

81) Planners have determined that sales will increase by 20% next year, and the profit margin

will remain at 10% of sales. Which one of the following statements is correct if the payout ratio remains at 30%? A) Net income will increase by 10% next year. B) The addition to retained earnings will increase by 20% next year. C) The dividend will increase by 6% next year. D) The addition to retained earnings will equal 6% of the sales increase next year. 82) A percentage-of-sales model forecasts that cost of goods sold will remain at 80% of sales. If

sales revenues are expected to grow by 20% next year, cost of goods sold: A) will grow by 16%. B) will grow by 20%. C) could grow either faster or slower than sales. D) will remain constant. 83) A firm's goal is to maintain a 75% debt-equity ratio. How much equity would be required if

the results of a financial planning model indicate that the firm's assets will grow to $4 million? A) $1.001 million B) $1.712 million C) $2.286 million D) $3.001 million 84) If a firm commits to a dividend payment and the amount of debt that it is prepared to issue,

what must be the balancing item? A) The profit margin B) New equity issues C) Cost of goods sold D) Return on equity 85) The final variable to have its value determined in a financial plan is often referred to as the: A) net income. B) balancing item. C) retained earnings plowback. D) growth forecast.

Version 1

86) Which one of the following is most apt to occur if a financial plan shows sources of funds to

be $100,000 and uses of funds to be $90,000? A) External debt of $10,000 will need to be raised. B) Dividend payments will be decreased by $10,000. C) Cash balances will be increased by $10,000. D) The capital budget will be decreased by $10,000. 87) Increased needs for net working capital are: A) recognized in pro forma balance sheets. B) totally absorbed by retained earnings. C) typically financed with short-term debt. D) ignored due to their great variability. 88) How much is required in external financing if first-stage pro forma statements indicate $1

million in net income, $300,000 in dividends, and a $900,000 increase in total assets? A) $200,000 B) $500,000 C) $600,000 D) No external financing is required. 89) If a firm's pro forma statements project a net income of $5,000, dividends of $2,000, and an

external financing requirement of $2,000, then: A) the firm must issue new equity. B) the profit margin has declined. C) total assets need to grow by $5,000. D) the internal growth rate is 15%. 90) The first step in constructing a financial planning model is to: A) determine the mix of securities that the company will need to issue. B) determine the amount of external financing that is needed. C) determine what additional fixed assets the company will need. D) project future cash flows from operations. 91) The rate at which the assets of a firm can grow without the requirement of any external

sources of financing is the: A) internal growth rate. B) sustainable growth rate. C) pro forma growth rate. D) plowback rate.

Version 1

92) Which one of the following statements is correct concerning the internal growth rate? A) It is maximized when the payout ratio equals zero. B) It is maximized when the plowback ratio equals zero. C) It cannot be less than the sustainable growth rate. D) It decreases as total assets decrease. 93) Which one of the following changes will decrease a firm's internal growth rate? A) A decrease in dividends with a given net income B) An increase in net income with a given dividend payout ratio C) A decrease in the plowback ratio D) A decrease in assets with a set dividend payout ratio 94) Under which one of the following capital structures will a firm's internal growth rate exceed

its sustainable growth rate? A) Total debt-to-asset ratio equals 35%. B) Equity-to-debt ratio equals 60%. C) Equity-to-debt ratio equals 125%. D) None of the options. 95) What would help a firm boost its internal growth rate? A) Plowing back a low proportion of its earnings B) Achieving a high return on equity C) Decreasing reinvested earnings D) Maintaining a low sales-to-total assets ratio 96) The sustainable growth rate is the maximum growth rate that the firm can achieve: A) without external financing. B) while maintaining its debt ratio. C) without investing in additional fixed assets. D) without excessive strains on management. 97) The sustainable growth rate: A) increases as ROE decreases. B) increases as the payout ratio decreases. C) is maximized when the plowback ratio equals zero. D) cannot be greater than the internal growth rate.

Version 1

98) What is the sustainable growth rate for a firm with $250,000 in net income, $100,000 in

common stock dividends, and equity of $1 million? A) 8% B) 10% C) 15% D) 17% 99) What is the internal growth rate for a firm with an ROE of 20%, a dividend payout ratio of

40%, and an equity-to-debt ratio of 60%? A) 4.50% B) 5.39% C) 8.00% D) 12.00% 100)

Which one of the following would increase the sustainable growth rate? A) Reduce the ROE. B) Increase the asset beta. C) Reduce the payout ratio. D) Reduce the operating leverage.

101)

All of the following are part of the financial planning process except: A) deciding which risks are worth taking. B) analyzing investment and financing options. C) projecting the future. D) minimizing risk.

102)

Which one of these is least likely to change proportionally with sales? A) Depreciation B) Investment in receivables C) Cost of goods sold D) EBIT

103)

A firm's internal growth rate is all of the following except the: A) rate below which external financing is needed. B) ratio of reinvested earnings to assets. C) maximum growth rate without requiring external sources of new capital. D) product of the plowback ratio, ROE, and the ratio of equity to assets.

Version 1

104)

A financial plan: A) is generally considered to be a useless exercise due to unforeseen events. B) should include all possible contingencies. C) provides a basis for evaluating future performance. D) should always be based on the worst-case scenario.

105)

In the percentage of sales model, which one of these is most likely to increase in uneven increments as sales increase? A) Cost of raw materials B) Accounts receivable C) Accounts payable D) Fixed assets

106)

Which one of these best describes the relationship between net working capital (NWC) and sales? A) NWC will change by the same percentage as sales. B) NWC is unaffected by changes in the sales level. C) NWC changes by a greater percentage than the change in sales, but the change is linear in nature. D) NWC changes in direct relation to sales, but the change may be less than proportional with sales.

107)

A percentage of sales model projects sales to increase by 5% annually over the next 4 years. If costs are forecast at a constant 80% of sales, and this year's income is $1,250, the forecast income in the fourth year will be: A) $1,447.03. B) $1,826.15. C) $1,595.35. D) $1,519.38.

108)

If a firm's sales increase by 12%, and it has no spare capacity, it must increase fixed assets by at least: A) 0%. B) 6%. C) 9%. D) 12%.

Version 1

109)

If book equity increases by $2,000, the firm does not issue new equity, and its net income is $2,500, then: A) the firm paid a dividend of $500. B) the firm plowed $500 back into the company. C) $500 went into retained earnings. D) debt increased by $2,000.

110)

Sources and uses of funds are made equal through: A) a balancing item. B) pro forma financial statements. C) borrowed cash. D) additions to retained earnings.

111)

Which one of the following statements regarding financial planning models is false? A) The models should include as much detail as possible. B) The results of a model are pro forma financial statements. C) The plug variable maintains consistency. D) Financial analysis is not used in financial planning.

112)

Which one of the following is not an output of a financial plan? A) Financial ratios B) Pro forma statements C) Sources and uses of cash statement D) Sales forecasts

113)

If a firm does not want to use either dividends or debt as the plug, then the obvious plug

is: A) inventory. B) cash. C) new issue of equity. D) fixed assets. 114)

A firm has projected sales of $328,000, costs of goods sold equal to 68% of sales, interest of $18,500, a tax rate of 21%, and a dividend payout ratio of 60%. What will be the addition to retained earnings? A) $36,667 B) $27,321 C) $24,002 D) $19,531

Version 1

115)

Assume a firm wants to hold its current long-term debt-to-equity ratio constant at 0.55 and its payout ratio constant at 35%. The firm neither issues nor repurchases shares. If the firm generates $326,000 of net income, what is the maximum amount that the firm can increase its long-term debt? A) $116,545 B) $95,355 C) $122,615 D) $0

116)

A firm's net assets equal 55% of sales. The firm expects sales to increase to $78,000 next year and to generate $6,500 of retained earnings. What is the external financing need? A) $49,400 B) $21,200 C) $28,600 D) $36,400

117)

A firm has projected net income of $25 million and the company will need new assets of $15 million. If external financing is fixed at $2 million, what will be the company’s dividend? A) $2 million B) $12 million C) $15 million D) $25 million

118)

A firm wants to limit its new debt issue to $10 million and has no interest in adding new equity. Net income is forecasted at $30 million and new assets of $22 million will be needed to sustain the growth of the company. What dividend will the company pay to maintain its objectives? A) $10 million B) $14 million C) $18 million D) $24 million

Version 1

119)

A company requires $17 million in new assets to sustain its current level of growth. The firm forecasts $25 million of net income and investors expect a $12 million dividend. Since the company does not want any new equity, how much new debt must the company issue to meet its objectives? A) $4 million B) $6 million C) $8 million D) $12 million

120)

If a growing company has a fixed dividend policy and does not want new shareholders, what must be the balancing item in a long-term financial plan? A) New equity B) New debt C) Retained earnings D) Dividend

Version 1

Answer Key Test name: Ch18 1) FALSE 2) FALSE 3) FALSE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) FALSE 9) TRUE 10) TRUE 11) TRUE 12) TRUE 13) FALSE 14) TRUE 15) FALSE 16) FALSE 17) TRUE 18) TRUE 19) TRUE 20) TRUE 21) FALSE 22) FALSE 23) FALSE 24) TRUE 25) A

Sustainable growth rate = (1 − 0.70) × ($198,000 ÷ $976,000) = 0.0609, or 6.09% 26) C

Increase in debt = $402,500 × 0.75 ÷ (0.75 + 1) = $172,500 27) C

28) A

External Funds = $2,900,000 − $3,900,000 × 0.40 = $1,340,000

Version 1

29) D

ΔNWC = 0.08 × $47,540 = $3,803 30) C

IG = $204,000 ÷ $3,000,000 = 0.0680, or 6.80% 31) A

Sustainable Growth Rate = 0.0624 = 0.1040 × (1 − payout ratio) => payout = 0.40 32) D

=> payout = 0.1960, or 19.60% 33) A

34) D

35) B

Added to Retained Earnings = ({[$343,000(1 − 0.68)] − $26,000} × (1 − 0.21)) × (1 − 0.60) = $26,468 36) A

Maximum debt increase = $346,000 × (1 − 0.35) × 0.55 = $123,695 37) D

EFN = 0.55 × $82,000 − $8,500 = $36,600 38) B

Dividend = $25,200,000 − ($15,200,000 − $2,200,000) = $12,200,000 39) A

New debt = $18,300,000 − ($26,300,000 − $13,300,000) = $5,300,000 40) A 41) B

Version 1

42) D 43) C 44) A

Sustainable growth rate = (1 − 0.70) × ($162,000 ÷ $940,000) = 0.0517, or 5.17% 45) A 46) C 47) C 48) C 49) C 50) D 51) D 52) C

Increase in debt = $400,000 × 0.75 ÷ (0.75 + 1) = $171,429 53) B 54) C 55) B

56) C

External Funds = $2,000,000 − $3,000,000 × 0.40 = $800,000 57) A 58) B 59) C 60) D

ΔNWC = 0.08 × $45,840 = $3,667 61) C 62) C 63) D 64) C

IG = $150,000 ÷ $3,000,000 = 0.05, or 5% 65) B

66) A

Version 1

Sustainable Growth Rate = 0.06 = 0.10 × (1 − payout ratio) => payout = 0.40 67) D

=> payout = 0.1600, or 16.00% 68) B 69) C

70) A 71) D

SG = (1 − 0.4) × 2.0 × 0.10 = 0.1200, or 12.00% 72) C

Add to retained earnings = ($1,200,000 × 1.06) × 0.05 × (1 − 0.25) = $47,700 73) A 74) C 75) D 76) D 77) C

Max sales = $2,400,000 ÷ 0.88 = $2,727,273 78) B 79) B

Sales from current capacity = $3,100,000 ÷ 0.94 = $3,297,872 Sales forecast = $3,100,000 × 1.09 = $3,379,000 Fixed assets needed = ($3,379,000 ÷ 3,297,872) × $2,500,000 = $2,561,500 $2,561,500 − $2,500,000 = $61,500 80) D 81) B 82) B 83) C

Version 1

Equity = [1 ÷ (1 + 0.75)] × $4,000,000 = $2,285,714 84) B 85) B 86) C

Increase in cash = $100,000 − 90,000 = $10,000 87) A 88) A

External financing need = $900,000 − ($1,000,000 − 300,000) = $200,000 89) C 90) D 91) A 92) A 93) C 94) D 95) B 96) B 97) B 98) C

99) A

100) 101) 102) 103) 104) 105) 106) 107)

C D A A C D D D

108) 109) 110) 111)

D A A A

Version 1

112) 113) 114)

D C B Added to Retained Earnings = ({[$328,000(1 − 0.68)] − $18,500} × (1 − 0.21)) × (1 − 0.60) = $27,321 115)

A Maximum debt increase = $326,000 × (1 − 0.35) × 0.55 = $116,545 116)

D EFN = 0.55 × $78,000 − $6,500 = $36,400 117)

B Dividend = $25,000,000 − ($15,000,000 − $2,000,000) = $12,000,000 118)

C Dividend = $30,000,000 − ($22,000,000 − $10,000,000) = $18,000,000 119)

A New debt = $17,000,000 − ($25,000,000 − $12,000,000) = $4,000,000 120)

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) When financial managers are asked the key reason for choosing short-term rather than longterm debt, they often say that they try to match the maturities of the firm's assets and liabilities. ⊚ true ⊚ false 2) Biotech firms require large amounts of cash if their drugs succeed in gaining regulatory

approval. Therefore, these firms often have substantial cash holdings to fund their possible investment needs. ⊚ true ⊚ false 3) Unlike long-term planners, short-term planners are concerned only with the most likely

outcomes. ⊚ true ⊚ false 4) Companies with unusually high cash reserves often hold the cash in tax havens. ⊚ true ⊚ false 5) A company that sells goods to a customer on credit will see no immediate change in its cash

position. ⊚ true ⊚ false 6) A company that pays $5,000 previously owed to one of its suppliers will see a $5,000

decrease in cash. ⊚ true ⊚ false 7) Most firms have a permanent investment in working capital. ⊚ true ⊚ false

Version 1

8) A company that borrows $1 million short term and invests the proceeds in inventory will see

its cash position unchanged. ⊚ true ⊚ false 9) Firms with a permanent investment in working capital finance that investment with short-

term debt. ⊚ true ⊚ false 10) The term "tax inversion" refers to the negative tax shield that is created when a firm invests

in securities. ⊚ true ⊚ false 11) Evidence suggests that investors place a particularly high value on liquidity in the case of

companies with growth opportunities. ⊚ true ⊚ false 12) A company that sells $5 million of marketable securities will see a $5 million increase in

cash. ⊚ true ⊚ false 13) The largest inflows of cash usually come from payments by the firm’s customers. ⊚ true ⊚ false 14) Unless customers pay cash on delivery, cash flow comes from collections on receivables. ⊚ true ⊚ false 15) The primary aim of cash budgeting models is to obtain better forecasts of earnings. ⊚ true ⊚ false

Version 1

16) If a firm reduces its accounts payable period, other things equal, it increases its cash

holdings. ⊚ true ⊚ false 17) Firms with surplus cash can use it to increase dividends or buy back securities. ⊚ true ⊚ false 18) Short-term financing plans are usually developed by trial and error. ⊚ true ⊚ false 19) A reduction in inventory levels would be a source of cash. ⊚ true ⊚ false 20) Cash holdings decline when a firm buys raw materials on credit. ⊚ true ⊚ false 21) If a firm’s customers on average take two weeks to pay their bills, then about half of each

month’s bills will not be paid until the following month. ⊚ true ⊚ false 22) A firm that sells marketable securities will see an increase in its working capital but no

change in its holdings of cash. ⊚ true ⊚ false 23) Many high tech firms hold large amounts of marketable securities. ⊚ true ⊚ false 24) Holdings of marketable securities are at worst zero-NPV investments for taxpaying firms. ⊚ true ⊚ false

Version 1

25) An increase in current liabilities is a source of cash for the firm. ⊚ true ⊚ false 26) The short-term financial plan sets out a strategy for investing any cash surpluses or financing

any deficit. ⊚ true ⊚ false 27) For firms facing financial distress a dollar of cash within the firm is often worth less than a

dollar to shareholders. ⊚ true ⊚ false 28) Managers with a large surplus of cash are often tempted to run a less tight ship. ⊚ true ⊚ false 29) If the firm repurchases its own stock, its cash holdings are unaffected. ⊚ true ⊚ false 30) Investments in marketable securities are generally a positive NPV investment for tax-paying

firms. ⊚ true ⊚ false 31) An increase in long-term assets is a source of cash for the firm. ⊚ true ⊚ false 32) An increase in accounts payable is a source of cash. ⊚ true ⊚ false 33) A company stretches payables whenever it offers more generous payment terms to its

customers. ⊚ true ⊚ false

Version 1

34) Firms with large holdings of current assets generally enjoy greater liquidity. ⊚ true ⊚ false 35) Inventory is generally more liquid than receivables. ⊚ true ⊚ false 36) A company that matches maturities will generally try to finance its receivables with long-

term debt. ⊚ true ⊚ false 37) The planning horizon for cash budgeting is usually at least five years. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 38) Brad Corporation expects to make sales of $83 million in January. In February forecast sales are $91 million, and in March they are $69 million. On average 50% of sales are paid for in the current month, 30% are paid for in the next month, and the remainder in the following month. What is the expected cash flow from operations in March? A) $22.0 million B) $44.0 million C) $78.4 million D) $82.1 million 39) A firm purchases $38 million of materials from suppliers in January, $34 million in February,

and $31 million in March. Forty percent are supplied cash on delivery. The remainder needs to be paid for in the following month. What is the cash outflow in February? A) $32.2 million B) $35.6 million C) $36.4 million D) $38.0 million

Version 1

40) Splitterfield Foods forecasts the following sales and expenses: June

July

August

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

170 100 58

180 105 60

140 90 50

Seventy percent of sales are paid for in the same month and the remainder with a delay of one month. All raw materials are paid for with a delay of one month, other expenses are paid with no delay. What is the expected cash flow from operations in July? A) $9.5 million B) $12.0 million C) $13.0 million D) $40.0 million 41) Avatar Corporation solves its cash shortage by paying its bills a week late but loses a 1.20%

discount by doing so. This is equivalent to borrowing at an annual interest rate of: A) 87.34%. B) 70.74%. C) 17.49%. D) 1.20%. 42) A firm starts with $5,200 of accounts receivables and ends the period with $4,200 of

receivables. If it collected $20,500 of receivables during the period, what was the amount of sales? A) $19,500 B) $20,500 C) $21,500 D) $24,700 43) A firm had $3,100 cash at the beginning of the period. During the period, the firm collected

$1,750 in receivables, paid $2,000 to supplier, had credit sales of $4,350, and incurred cash expenses of $2,450. What was the cash balance at the end of the period? A) $4,750 B) $400 C) $3,600 D) $2,000

Version 1

44) A firm starts the week with payables of $186,000. It pays $94,000 of outstanding bills, and

purchases $58,000 of raw materials on one month’s credit. What is the level of payables at the end of the week? A) $150,000 B) $222,000 C) $112,800 D) $244,000 45) A firm that stretches its payables gains an extra 2-month cushion before it needs to pay for its

purchases of raw materials but it loses a 1.50% discount for prompt payment. This is like borrowing at an effective annual interest rate of: A) 11.85%. B) 16.45%. C) 18.98%. D) 19.89%. 46) Clopton Incorporated forecasts cash sales of $21 million in January, $26 million in February,

and $28 million in March. Credit sales in these three months are forecast at $83 million, $113 million, and $148 million, respectively. On average, 50% of credit sales are paid for in the current month, 30% in the next month, and the remainder in the following month. What is the expected cash inflow in March? A) $124.50 million B) $108.00 million C) $130.00 million D) $152.50 million 47) For a recent period, a firm collected $40,100 on accounts receivable, paid $21,600 to

suppliers on trade credit, paid $13,900 in cash expenses, purchased for cash a $61,000 piece of equipment that will be depreciated straight-line to zero over 4 years, and had $97,000 of sales of which 15% were cash sales. The firm also paid $15,400 in taxes and interest. The beginning cash balance was $20,800. How much did the firm need to borrow in order to maintain a minimum cash balance of $10,000? A) $46,450 B) $45,350 C) $13,050 D) $31,900

Version 1

48) The Boat Works started the month with $1.16 million in accounts receivable. Sales for the

month were $5.8 million. The firm collects 35% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A) $3.77 million B) $2.87 million C) $4.93 million D) $4.27 million 49) The Boat Works started the month with $3.32 million in accounts receivable. Sales for the

month were $7.95 million. The firm collects 18% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A) $4,649,470 B) $6,519,000 C) $9,261,200 D) $1,332,000 50) A firm has $51 million and $61 million credit sales during the first two quarters of the year,

respectively. Eighty percent of the receivables are collected in the same quarter and the balance in the next quarter. What will be the total collection for the firm in the second quarter? A) $56 million B) $59 million C) $89 million D) $99 million 51) Stretching payables costs a company 1.60% per month. This is equivalent to borrowing at

what annual interest rate? A) 19.53% B) 20.27% C) 20.98% D) 21.32% 52) A mattress store had monthly sales of $24,000, $22,000 and $19,000 in the months of

December, January, and February, respectively. Collections are usually 50% in cash, 30% in one month, and the balance at the end of two months. Assuming no bad debt, how much cash will the store collect in February? A) $20,600 B) $20,700 C) $20,800 D) $20,900

Version 1

53) Which of the following statements is not true of short-term financial planning? A) The plan should consider possible shortfalls in sales or a delay in collections. B) The plan seeks to ensure that the company will be able to meet its cash needs. C) The planning period is typically five years. D) The plan needs to be based on the best forecasts available. 54) Which of these events reduces cash holdings? A) The firm changes its terms of sale and gives customers less time to pay for their

purchases. B) The firm sells a parcel of land at a profit. C) The firm pays more promptly for its raw materials. D) The firm sells a parcel of land at a loss. 55) Which of these assets is likely to be the least liquid? A) Receivables B) Marketable securities C) Inventories of work in progress D) Inventories of finished goods 56) Brad Corporation expects to make sales of $80 million in January. In February forecast sales

are $90 million, and in March they are $60 million. On average 50% of sales are paid for in the current month, 30% are paid for in the next month, and the remainder in the following month. What is the expected cash flow from operations in March? A) $30 million B) $60 million C) $73 million D) $76.7 million 57) Which of the following transactions would not be a source of cash? A) The firm issues $1 million of short-term debt and invests the proceeds in inventory. B) A customer pays an outstanding bill. C) The firm sells $10 million of marketable securities. D) The firm receives $10 million from an insurance company to compensate for flood

damage earlier that month.

Version 1

58) A firm purchases $32 million of materials from suppliers in January, $28 million in February,

and $25 million in March. Forty percent are supplied cash on delivery. The remainder needs to be paid for in the following month. What is the cash outflow in February? A) $26.2 million B) $29.6 million C) $30.4 million D) $32.0 million 59) Splitterfield Foods forecasts the following sales and expenses: June

July

August

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

150 80 38

160 85 40

120 70 30

Seventy percent of sales are paid for in the same month and the remainder with a delay of one month. All raw materials are paid for with a delay of one month, other expenses are paid with no delay. What is the expected cash flow from operations in July? A) $29.5 million B) $32 million C) $33 million D) $20 million 60) A toy store does not pay for its purchases of toys from manufacturers until one month later.

Suppose that in October it starts to stock up in anticipation of a surge in toy sales in December, when is it most likely to have a negative operating cash flow? A) It should never have a negative operating cash flow as long as its business is profitable. B) In October, because this is when it starts to stock up. C) In November, because this is when it will need to pay for the increased inventory. D) In December, because this is when the toys will start to move off the shelves. 61) Which one of the following statements best describes the total capital requirement for most

profitable firms? A) The general trend in the total capital requirement is downward sloping. B) The total capital requirement tends to be constant over long periods of time. C) There are seasonal fluctuations around the total capital requirement trend. D) The total capital requirement must be funded with short-term debt.

Version 1

62) When a firm finances long-term assets with short-term sources of funding, it: A) reduces the risk of cash shortage. B) will generally have lower interest expense. C) improves the leverage ratio. D) violates the principle of matched maturities. 63) The principle of matched maturities in finance refers to: A) finding sources of funds with the longest maturity, in order to avoid liquidity crises. B) funding long-term assets with long-term sources and short-term assets with short-term

financing. C) using as much short-term financing as possible due to the lower cost of interest. D) buying marketable securities when demand is high and borrowing short-term when demand is low. 64) Which one of the following is more likely for a firm practicing the relaxed strategy of long-

versus short-term borrowing at the height of sales demand? A) It will borrow heavily on a short-term basis. B) At the height of demand, it will invest heavily in marketable securities. C) It will borrow on both a long-term and a short-term basis. D) Its long-term financing will approximately equal its total capital requirements. 65) When internally generated cash is temporarily insufficient to meet a firm’s cash need, the

firm following a middle-of-the-road policy for long- versus short-term financing will: A) borrow short term. B) borrow long term. C) hold marketable securities. D) pay off all debts. 66) A firm's permanent working capital refers to the: A) difference between fixed assets and current assets. B) maximum difference between current assets and current liabilities. C) portion of net working capital that is financed from long-term sources. D) amounts that must be held to meet debt covenants. 67) Firms that continually invest in nontrivial amounts of marketable securities may be guilty of: A) excessive short-term borrowing. B) not matching their sources and uses of cash. C) holding excessive current liabilities. D) incurring extra taxes.

Version 1

68) What happens to a firm whose uses of cash exceed its sources of cash during an accounting

period? A) It has a loss of net working capital. B) It declares a net loss on the income statement. C) It experiences a decrease in sales. D) It experiences a decrease in its cash balance. 69) Which one of the following would not be considered a use of cash? A) Dividends B) Decreased accounts payable C) Depreciation D) Increased accounts receivable 70) Avatar Corporation solves its cash shortage by paying its bills a week late but loses a 1%

discount by doing so. This is equivalent to borrowing at an annual interest rate of: A) 52.0%. B) 12.8%. C) 68.64%. D) 1.0%. 71) A firm starts with $5,000 of accounts receivables and ends the period with $4,000 of

receivables. If it collected $20,000 of receivables during the period, what was the amount of sales? A) $19,000 B) $20,000 C) $21,000 D) $24,000 72) A firm had $2,800 cash at the beginning of the period. During the period, the firm collected

$1,600 in receivables, paid $1,850 to supplier, had credit sales of $4,200, and incurred cash expenses of $2,300. What was the cash balance at the end of the period? A) $4,450 B) $250 C) $2,850 D) $1,250

Version 1

73) Which one of the following is least likely to be correct for a firm that repeatedly stretches its

payables? A) The firm may receive more favorable status from suppliers. B) The firm may reduce its explicit short-term interest expense. C) The cost of forgone discounts may exceed the cost of bank credit. D) The firm may be labeled as a credit risk. 74) A firm must decide between borrowing from a bank at 12% interest or stretching its payables

for one quarter. If it stretches the payables it will forgo a 2% discount for timely payment. Based solely on cash flows, which is the cheaper solution? A) Stretching saves the firm approximately 8% per year. B) Use the bank loan; forgoing a cash discount is costly. C) Stretch the payables and finance at a savings of approximately 3.75% annually. D) Use the bank loan because it represents simple interest. 75) A firm starts the week with payables of $172,000. It pays $80,000 of outstanding bills, and

purchases $44,000 of raw materials on one month’s credit. What is the level of payables at the end of the week? A) $136,000 B) $208,000 C) $96,000 D) $216,000 76) A firm starts the week with payables of $172,000, it pays $80,000 of outstanding bills, and

purchases $44,000 of raw materials on one month’s credit. What is the change in its cash balance over the week? A) −$36,000 B) +$96,000 C) −$80,000 D) +$92,000 77) Which of the following will not reduce an imminent cash shortage? A) Phoning customers who have overdue bills. B) Issuing common stock to repay long-term debt. C) Postponing purchase of a new machine. D) Rolling over maturing bank debt.

Version 1

78) Zeta Stores places orders for 60% of the sales forecast in the next month and for 40% of the

sales forecast for the following month. It pays for these goods with a 2-month delay. If sales for August are forecast at $10 million and sales for September and October are forecast at $12 million in each month, what will be the forecast cash outflow in September? A) $10.8 million. B) $15.6 million. C) $4.8 million. D) $9.6 million. 79) Zeta Stores places orders for 60% of the sales forecast in the next month and for 40% of the

sales forecast for the following month. It pays for these goods with a 1-month delay. If sales for August are forecast at $10 million and sales for September and October are forecast at $12 million in each month, what will be the forecast cash outflow in September? A) $10.8 million B) $15.6 million C) $4.8 million D) $9.6 million 80) A firm that stretches its payables gains an extra 1-month cushion before it needs to pay for its

purchases of raw materials but it loses a 2% discount for prompt payment. This is like borrowing at an effective annual interest rate of: A) 19.40%. B) 24.00%. C) 26.53%. D) 27.43%. 81) Which statement does not correctly describe short-term financial decisions? A) Most firms finance short-term assets with short-term borrowing. B) Most firms maintain a positive investment in working capital. C) Most firms finance their investment in working capital with short-term debt. D) Liquidity is particularly valued by small firms that face relatively high costs to raising

funds on short notice. 82) There are three steps to constructing a cash budget. Which of the following is not one of

those steps? A) Calculate whether the firm is facing a cash shortage or surplus. B) Forecast the uses of cash. C) Set a policy for deciding how much time to give customers to pay. D) Forecast the sources of cash.

Version 1

83) Before settling on a final short-term financial plan, the manager needs to ask several

questions. Which question is the manager least likely to ask? A) Does the plan yield satisfactory financial ratios? B) Would the firm do better to arrange long-term financing to cover any cash shortage? C) Has the firm estimated its EVA correctly? D) Does the company need a larger reserve of cash or marketable securities to cover emergencies? 84) Clopton Incorporated forecasts cash sales of $18 million in January, $23 million in February,

and $25 million in March. Credit sales in these three months are forecast at $80 million, $110 million, and $145 million, respectively. On average, 50% of credit sales are paid for in the current month, 30% in the next month, and the remainder in the following month. What is the expected cash inflow in March? A) $121.5 million B) $102 million C) $127 million D) $146.5 million 85) When managers are continually short-term lenders, they are said to follow a: A) middle-of-the-road financing strategy. B) restrictive financing strategy. C) relaxed financing strategy. D) permanent working-capital strategy. 86) When the length of the financing is directly related to the life of the asset being financed, the

firm is said to follow a: A) policy of maturity matching. B) restrictive financing strategy. C) matched depreciation strategy. D) minimum working capital strategy. 87) Which one of these is most associated with a disadvantage of the relaxed strategy of long-

versus short-term financing? A) Transaction costs are required to continually obtain financing. B) Short-term investment income is often unattractive. C) Investment opportunities must frequently be ignored. D) Long-term financing has burdensome tax consequences.

Version 1

88) Which one of the following is a use of cash? A) Net income B) Repayment of a bank loan C) Reduction in accounts receivable D) Depreciation 89) Which of the following would increase the firm’s cash balance? A) Increase the cash dividend B) Increase the accounts payable C) Increase accounts receivable D) Increase inventory 90) Managers are alerted to projected cash shortages by means of the: A) statement of sources and uses of cash. B) pro forma balance sheet. C) cash budget. D) monthly bank statements. 91) In the preparation of cash budgets, capital expenditures are: A) not included because these items are depreciated. B) included as sources of operating cash. C) included as uses of cash and make the budget lumpy. D) traditionally offset as a use of cash by interest income. 92) Managers who "stretch their payables" are attempting to: A) repay more recent bills before earlier bills. B) improve their current ratio before preparing financial statements. C) offer finished goods at a discount for quicker repayment. D) obtain short-term financing. 93) Which one of the following would not be included as a source of short-term financing? A) Line of credit from a bank B) Increase in the minimum operating cash balance C) Sale of marketable securities D) Stretching of accounts payable

Version 1

94) For a recent period, a firm collected $38,200 on accounts receivable, paid $19,700 to

suppliers on trade credit, paid $12,000 in cash expenses, purchased for cash a $42,000 piece of equipment that will be depreciated straight-line to zero over 4 years, and had $59,000 of sales of which 15% were cash sales. The firm also paid $13,500 in taxes and interest. The beginning cash balance was $11,300. How much did the firm need to borrow in order to maintain a minimum cash balance of $10,000? A) $38,850 B) $37,550 C) $7,350 D) $30,000 95) The Boat Works started the month with $1.28 million in accounts receivable. Sales for the

month were $3.4 million. The firm collects 35% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A) $2.21 million B) $1.19 million C) $3.49 million D) $2.71 million 96) The Boat Works started the month with $3.21 million in accounts receivable. Sales for the

month were $7.84 million. The firm collects 18% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A) $4,621,200 B) $6,428,800 C) $9,061,000 D) $1,411,200 97) A firm that follows a relaxed strategy toward the total capital requirement will be a: A) short-term borrower. B) short-term lender. C) long-term lender. D) long-term borrower. 98) Issuing additional long-term debt of $5 million and buying new long-term assets worth $4

million and short-term assets worth $1 million will result in a net cash flow of: A) $5 million. B) $9 million. C) $0 million. D) $4 million.

Version 1

99) A firm has $50 million and $60 million credit sales during the first two quarters of the year,

respectively. Eighty percent of the receivables are collected in the same quarter and the balance in the next quarter. What will be the total collection for the firm in the second quarter? A) $55 million B) $58 million C) $88 million D) $98 million 100)

A firm has a need for cash in a specific quarter. Which of the following is least likely to be part of a short-term financial plan to raise cash? A) Bank loan B) New equity C) Securities sold D) Stretched payables

101)

Stretching payables costs a company 1% per month. This is equivalent to borrowing at what annual interest rate? A) 11.23% B) 11.97% C) 12.68% D) 13.02%

102)

A mattress store had monthly sales of $20,000, $18,000 and $15,000 in the months of December, January, and February, respectively. Collections are usually 50% in cash, 30% in one month and the balance at the end of two months. Assuming no bad debt, how much cash will the store collect in February? A) $16,600 B) $16,700 C) $16,800 D) $16,900

Version 1

Answer Key Test name: Ch19 1) TRUE 2) TRUE 3) FALSE 4) TRUE 5) TRUE 6) TRUE 7) TRUE 8) TRUE 9) FALSE 10) FALSE 11) TRUE 12) TRUE 13) TRUE 14) TRUE 15) FALSE 16) FALSE 17) TRUE 18) TRUE 19) TRUE 20) FALSE 21) TRUE 22) FALSE 23) TRUE 24) FALSE 25) TRUE 26) TRUE 27) TRUE 28) TRUE 29) FALSE 30) FALSE 31) FALSE 32) TRUE 33) FALSE 34) TRUE 35) FALSE 36) FALSE 37) FALSE

Version 1

38) C

39) C

Cash Flow = (0.4 × $34 million) + (0.6 × $38 million) = $36.4 million 40) C

CF = (0.7 × $170,000,000 + 0.3 × $140,000,000) − $90,000,000 − $58,000,000 = $13,000,000 41) A

42) A

Sales = $4,200 − $5,200 + $20,500 = $19,500 43) B

$3,100 + 1,750 − 2,000 − 2,450 = $400 44) A

$186,000 − $94,000 + $58,000 = $150,000 45) D

46) D

Thus, the firm needs to borrow $152.50. 47) A

$20,800 + 40,100 − 21,600 − 13,900 − 61,000 + (0.15 × $97,000) − 15,400 − 10,000 = −$46,450 Thus, the firm needs to borrow $46,450. 48) A

Ending A / R = $1,160,000 + 5,800,000 − 1,160,000 − (0.35 × $5,800,000) = $3,770,000 49) B

Ending A / R = $3,320,000 + 7,950,000 − 3,320,000 − (0.18 × $7,950,000) = $6,519,000 50) B

Version 1

Q2 collections = (1 − 0.80) × $51,000,000 + 0.80 × $61,000,000 = $59,000,000 51) C

52) D

CF = ($19,000 × 0.5) + ($22,000 × 0.3) + ($24,000 × 0.2) = $20,900 53) C 54) C 55) C 56) C

57) A 58) C

59) C

CF = (0.7 × $150,000,000 + 0.3 × $120,000,000) − $70,000,000 − $38,000,000 = $33,000,000 60) C 61) C 62) D 63) B 64) D 65) A 66) C 67) D 68) D 69) C 70) C

71) A

Sales = $4,000 − $5,000 + $20,000 = $19,000 72) B

$2,800 + 1,600 − 1,850 − 2,300 = $250

Version 1

73) A 74) C

Annual cost of foregone discount = 1.024raise to the power of 4 − 1 = 0.0824, or 8.24% Savings from stretching and financing = 12% − 8.24% = 3.76%, or approximately 3.75% 75) A

$172,000 − $80,000 + $44,000 = $136,000 76) C

Since the $44,000 is purchased on credit, the only change in cash balances is the payment of $80,000 in oustanding bills. 77) B 78) A 79) D 80) D

81) C 82) C 83) C 84) D

85) C 86) A 87) B 88) B 89) B 90) C 91) C 92) D 93) B 94) A

$11,300 + 38,200 − 19,700 − 12,000 − 42,000 + (0.15 × $59,000) − 13,500 − 10,000 = −$38,850 Thus, the firm needs to borrow $38,850. 95) A

Ending A / R = $1,280,000 + 3,400,000 − 1,280,000 − (0.35 × $3,400,000) = $2,210,000

Version 1

96) B

Ending A / R = $3,210,000 + 7,840,000 − 3,210,000 − (0.18 × $7,840,000) = $6,428,800 97) B 98) C

Issuing new long-term debt is a source of cash and buying new assets is a use of cash. So, the net cash flow is zero. 99) B

Q2 collections = (1 − 0.80) × $50,000,000 + 0.80 × $60,000,000 = $58,000,000 100) 101)

B C

102)

D CF = ($15,000 × 0.5) + ($18,000 × 0.3) + ($20,000 × 0.2) = $16,900

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) Large payments between businesses are generally made electronically through either CHIPS or Fedwire. ⊚ true ⊚ false 2) Inventory makes up the bulk of the current assets of retail firms. ⊚ true ⊚ false 3) The potential benefits of additional credit analysis should always be weighed against the

incremental costs. ⊚ true ⊚ false 4) Absent any possibility of repeat orders, if the default probability is less than the profit

margin, you should extend credit for the sale. ⊚ true ⊚ false 5) Firms are more likely to grant credit the higher the probability that a potential customer will

become a repeat customer. ⊚ true ⊚ false 6) The more liberal the terms of the collection policy, the lower the potential for bad debts and

unprofitable sales. ⊚ true ⊚ false 7) A firm that buys on credit is, in effect, borrowing from its supplier. ⊚ true ⊚ false 8) Just-in-time inventory management seeks to reduce inventory levels. ⊚ true ⊚ false

Version 1

9) Commercial paper is usually used to finance overseas trade. ⊚ true ⊚ false 10) Extending trade credit can increase the probability of repeat orders. ⊚ true ⊚ false 11) The decision to offer credit depends on the probability of payment. You should grant credit if

the expected profit from doing so is greater than the expected profit from refusing. ⊚ true ⊚ false 12) Bond ratings are an expensive source of credit information on publicly traded companies. ⊚ true ⊚ false 13) An aging schedule is a statement sent to customers who are delinquent in their payments. ⊚ true ⊚ false 14) Optimal inventory levels are lower when carrying costs are high, and when the cost of

restocking inventories is low. ⊚ true ⊚ false 15) Since defaults can be costly, it is cost-effective to undertake a full credit analysis of all

customers. ⊚ true ⊚ false 16) Checks that have been mailed but not yet cleared result in float. ⊚ true ⊚ false 17) Short-term securities have high interest-rate risk. ⊚ true ⊚ false

Version 1

18) Lock-box systems allow local banks to collect and process the firm's remittances from that

area. ⊚ true ⊚ false 19) As the number of inventory orders per year increases, the total order costs decrease. ⊚ true ⊚ false 20) Checks tend to be a more popular method of payment in the United States than in many other

developed countries. ⊚ true ⊚ false 21) Most money market instruments have a high degree of liquidity. ⊚ true ⊚ false 22) Repos are long-term unsecured loan agreements. ⊚ true ⊚ false 23) The cash cycle is the period between a firm's payment for materials and collection on its

sales. ⊚ true ⊚ false 24) Bank certificates of deposit are the safest and most liquid of all the money market securities. ⊚ true ⊚ false 25) A firm's inventory period can be estimated by the ratio of inventory to daily cost of goods

sold. ⊚ true ⊚ false 26) The cost of an ACH transaction is relatively small compared to a CHIPs of Fedwire? ⊚ true ⊚ false

Version 1

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 27) A firm that is located in New York receives on average 1,250 checks a day from its customers in the Twin Cities area. Average payment per check is $3,000. A bank in the Twin Cities is offering a lock-box arrangement for collection and processing of these checks at a cost of $.50 per check. This arrangement will reduce the float by 2 days. The daily interest rate for the firm is 0.02%. What is the net saving from the lock-box arrangement? A) $875 B) $1,750 C) $625 D) $1,500 28) What is the cash cycle for a firm with a receivables period of 55 days, a payables period of

30 days, and an inventory period of 60 days? A) 25 days B) 80 days C) 85 days D) 145 days 29) What is the cash cycle for a firm with $3.7 million average inventories, $1.5 million average

accounts payable, a receivables period of 40 days and annual sales of $27 million, and an annual cost of goods sold of $25 million? A) 31.96 days B) 54.77 days C) 139.54 days D) 72.12 days 30) What is the expected payoff on a $2,300 sale that has a 30% profit margin if there is a 20%

probability of default? A) $1,150 B) $138 C) $690 D) $230 31) A $1,800 invoice dated January 1 has credit terms of

, net 30. If the buyer pays

January 4, how much will he need to pay? A) $1,746 B) $1,620 C) $1,350 D) $1,800

Version 1

32) What is the daily net cost of holding a cash balance of $4.4 million, if the daily interest rate is

0.025% and the average transaction cost of investing money overnight is $145? A) $216 B) $361 C) $955 D) $1,245 33) If the probability of collection is 65%, should you grant credit to a customer wishing to

purchase a $2,005 item that cost $1,338.33 to produce? Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A) No; the expected loss is $35.08. B) No; the expected loss is $150. C) Yes; the expected profit is $35.08. D) Yes; the expected profit is $150. 34) A firm is considering a one-time sale of $108,000 to a customer. The cost of goods sold for

this sale is $98,000. If the probability of the customer paying is 0.8, what is the expected profit from this transaction? A) $0 B) −$11,600 C) +$8,640 D) +$11,600 35) What is the break-even probability of collection when the present value of revenues from a

sale is $124,000 and the present value of cost is $93,000? A) 1 B) 0.75 C) 0.62 D) 0.25 36) What is the annual gain to a firm with daily sales of $38,000 if it can speed up collections by

3 days, assuming an annual opportunity cost of funds of 8%? A) $3,040 B) $9,120 C) $38,000 D) $114,000

Version 1

37) How much money can be saved annually by setting up a lock-box system that will process

900 checks per day at a cost of $0.15 per check if each check averages $220, collection float is reduced by 3 days, and the annual interest rate is 8%? (Use a 365-day year.) A) −$3,825 B) −$1,755 C) $4,750 D) $47,401 38) A 12-month Treasury bill sells at a discount of 3%. What is the effective annual interest rate? A) 1.87% B) 2.03% C) 2.54% D) 4.07% 39) How much value would be added to a firm that could permanently reduce its cash collection

period by 2 days if daily collections average $12,000 and the opportunity cost is 5% annually? (Assume a 365-day year.) A) $1,200 B) $1,440 C) $12,000 D) $24,000 40) By using a lock box system, a firm is able to reduce its float by 3 days. Given an annual

interest rate of 3% and annual collections of $358 million, what is the projected annual interest earned by using the lock box? (Assume a 365-day year.) A) $68,276 B) $78,382 C) $88,274 D) $92,541 41) A firm’s annual opportunity cost of capital is 6%. By use of a lock box they can reduce their

cash collection period by 3 days. If daily collections are $22,600 what is the PV of their lock box? (Assume a 365-day year.) A) $67,800 B) $56,500 C) $45,200 D) $33,900

Version 1

42) Which of the following is not a current asset? A) An investment in a money market mutual fund B) Money due to suppliers C) Inventory of raw materials D) Unpaid customer bills 43) The economic order quantity: A) is the order size that minimizes the order costs. B) is independent of forecast sales. C) is based on sales, carrying costs, and order costs. D) increases as cost per order decreases. 44) Which of these firms will benefit the most from a lock-box service? A) A firm that has a large number of suppliers B) A firm that writes a large number of checks daily C) A firm that has a geographically dispersed customer base D) A firm that sells goods to a very limited number of customers 45) A firm that is located in New York receives on average 2,000 checks a day from its

customers in the Twin Cities area. Average payment per check is $1,500. A bank in the Twin Cities is offering a lock-box arrangement for collection and processing of these checks at a cost of $0.50 per check. This arrangement will reduce the float by 2 days. The daily interest rate for the firm is 0.02%. What is the net saving from the lock-box arrangement? A) $200 B) $400 C) $1,000 D) $1,200 46) Which one of the following terms of sale is the most restrictive? A) Net 30 B) , net 4 C) CBD D) COD 47) At what point does a customer's unpaid account become delinquent when the terms of sale

are

, net 60? A) 11 days after the sale B) 31 days after the sale C) 61 days after the sale D) 71 days after the sale

Version 1

48) Which statement is true about terms of trade credit of , net 30? A) A 10% cash discount is offered for payment before 30 days. B) A 2% cash discount can be taken for payment before the 10th of the following month. C) A 10% cash discount can be taken if paid by the second day after invoicing. D) No cash discount is offered after the tenth day. 49) What effective annual rate of interest is being charged to a customer who is granted

credit terms of , net 45 when the customer foregoes the discount and pays on the last date prior to being delinquent? (Assume a 365-day year.) A) 44.86% B) 48.29% C) 37.67% D) 41.84% 50) What is the cash cycle for a firm with a receivables period of 40 days, a payables period of

30 days, and an inventory period of 60 days? A) 10 days B) 50 days C) 70 days D) 130 days 51) With terms of

, net 60, what is the implied interest rate for forgoing a cash discount and paying at the end of the credit period? (Assume a 365-day year.) A) 25.63% B) 28.19% C) 39.25% D) 61.15%

52) What happens to the implied interest rate on trade credit as the time interval between the

discount period and payment period is decreased? A) The rate declines. B) The rate increases. C) The rate remains constant. D) It is impossible to predict without knowing the actual length of discount period.

Version 1

53) When sales are made without the accompaniment of a formal debt contract, the sales are said

to be on: A) conditional sale terms. B) open account. C) trade credit. D) sight draft. 54) Under the terms of a sight draft, the buyer's bank: A) is instructed to make immediate payment. B) treats the invoice like a postdated check. C) forwards the acceptance to the seller until due. D) enters into a factoring arrangement. 55) A time draft that has been signed by the customer is termed: A) a trade discount. B) a conditional sale. C) a trade acceptance. D) an overdue account. 56) Which one of the following statements is correct about banker's acceptances? A) They are equivalent to a sight draft. B) They represent the norm for installment sales. C) The bank guarantees payment of the invoice. D) The bank retains title to the merchandise. 57) Which one of the following is not included in the five Cs of credit? A) Character B) Condition C) Consumption D) Capital 58) Credit scoring systems can be used to: A) reduce the effective cost of trade. B) determine the cost of goods sold. C) evaluate Dun and Bradstreet reports. D) evaluate credit risk based on the borrower's characteristics.

Version 1

59) What is the cash cycle for a firm with $3 million average inventories, $1.5 million average

accounts payable, a receivables period of 40 days and annual sales of $20 million, and an annual cost of goods sold of $18 million? A) 14.59 days B) 46.25 days C) 136.25 days D) 70.42 days 60) Which of the following transactions is likely to incur the most float cost to the recipient? A) ACH B) Check C) CHIPs D) Fedwire 61) The set of rules that determines whether or not credit should be extended is known as: A) credit analysis. B) credit policy. C) multiple discriminate analysis. D) the terms of trade credit. 62) What credit decision is appropriate for a potential customer that offers a 75% chance of

paying on a $10,000 sale which has an 80% cost? A) Grant credit since the expected profit is $3,200. B) Grant credit since the expected profit is $800. C) Refuse credit since the expected profit is negative. D) Refuse credit since the expected loss is zero. 63) What is the expected payoff on a $2,000 sale that has a 30% profit margin if there is a 20%

probability of default? A) $1,000 B) $120 C) $600 D) $200 64) Firms should be more prepared to sell on credit to high-risk customers if the: A) profit margin is low. B) probability of repeat orders is low. C) profit margin is high. D) firm’s sales representative is paid on commission.

Version 1

65) Which one of the following statements typically describes the break-even probability of

collection for repeat sale customers? A) The break-even probability is higher than for single sale customers. B) The break-even probability is lower than for single sale customers. C) The break-even probability does not change between single sale and repeat sale customers. D) Sales should never be refused for customers offering the potential of repeat sales. 66) An aging schedule illustrates the relationship between: A) the time history with a customer and the number of repeat sales. B) the average sale size and profitability over time. C) customer ages and the average size of sales. D) an accounts receivable and its time outstanding. 67) Money market securities usually have a maturity of: A) more than 1 year. B) less than 1 year. C) 1 to 3 years. D) less than a week. 68) A $1,200 invoice dated January 1 has credit terms of

, net 30. If the buyer pays

January 4, how much will he need to pay? A) $1,164 B) $1,080 C) $900 D) $1,200 69) Which of the following is correct concerning terms of trade credit of

, EOM, net

90? A) The discount period expires on the last day of the month. B) The invoice becomes delinquent 90 days after the last day of the month. C) The discount period ends on the 10th day of the following month. D) The discount period ends either 10 days after invoicing or at the end of the month, whichever is earlier.

Version 1

70) If goods are sold on terms of

, net 90, what effective interest rate is if the purchaser pays on day 90? (Assume a 365-day year.) A) 20.00% B) 22.81% C) 24.93% D) 26.37%

71) Which one of the following changes to the terms of credit would increase the effective

annual interest rate charged? A) Increasing the cash discount percentage B) Extending the discount period and payment period by 10 days each C) Extending the payment period only D) Decreasing the discount period only 72) Which one of the following is most likely to discourage purchasers from taking a discount? A) A higher discount percentage B) A shorter payment period C) A longer discount period D) A longer payment period 73) Which of the following strategies should a cash-strapped firm adopt if the effective interest

rate charged on trade credit is lower than the bank's interest rate? A) Take the discount but pay after the discount period. B) Borrow from the bank and take the discount. C) Ignore the discount, pay at the end of the period. D) Take the discount and hope for longer payment float. 74) What is the daily net cost of holding a cash balance of $2.5 million, if the daily interest rate is

0.025% and the average transaction cost of investing money overnight is $50? A) $121 B) $171 C) $575 D) $675 75) Which one of the following credit agreements provides the least protection to the seller? A) Banker's acceptance B) Time draft C) Open account D) Commercial draft

Version 1

76) The purpose of credit analysis is to: A) reconcile the accounts receivable balance. B) modify the terms of trade credit. C) organize the right side of the balance sheet. D) decide whether or not to grant credit to a customer. 77) Which one of the following would not be a customary source of credit information on

customers? A) Dun and Bradstreet B) Chamber of Commerce C) Credit Bureau D) Customer's bank 78) The five Cs of credit refer to the: A) credit reports issued by Dun and Bradstreet. B) interpretation of numerical credit scoring systems. C) attributes that help determine creditworthiness. D) financial ratios used to determine a customer’s creditworthiness. 79) In field warehousing, the inventory is held by the: A) borrowing firm. B) lending institution. C) independent warehousing company. D) firm and the lender jointly. 80) In general, a firm's credit policy should grant credit whenever the expected: A) loss from default is less than the cost of the product. B) profit from granting credit exceeds the profit from refusing. C) profit exceeds the price of the product. D) probability of a loss is less than 50%. 81) If the probability of collection is 65%, should you grant credit to a customer wishing to

purchase a $2,000 item that cost $1,333.33 to produce? Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A) No; the expected loss is $33.33. B) No; the expected loss is $150.00. C) Yes; the expected profit is $33.33. D) Yes; the expected profit is $150.00.

Version 1

82) What is the break-even probability in the following case? A customer wishes to purchase a

$2,000 item that has been marked up to 50% over cost. Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A) 77.67% B) 55.67% C) 88.67% D) 66.67% 83) What is the minimum probability of collection that should be accepted by firms that have a

25% profit margin? Ignore the time value of money and assume that there is no chance of subsequent sales. A) 20% B) 25% C) 50% D) 75% 84) Which of the following would be more likely to justify granting credit? A) A higher profit margin B) A lower probability of payment C) A higher discount rate D) A lower selling price 85) Why should the possibility of a repeat order increase a firm’s willingness to grant credit? A) The expected cash flow from two orders is twice that from one order. B) The sales rep would earn increased commission. C) The customer can be given more time to pay. D) Payment on the first order increases the chance of payment on subsequent orders. 86) A revolving line of credit is: A) a secured loan to be amortized over three to five years. B) a one-time short-term, unsecured, amortized loan. C) an agreement allowing the firm to borrow up to a specific total amount on demand

from a bank. D) a long-term, permanent source of funding.

Version 1

87) A break-down of accounts receivable according to the length of time outstanding is known as

a(n): A) amortization schedule. B) sources of cash flow statement. C) receivables inventory. D) aging schedule. 88) Check conversion is the process of: A) recording all checks electronically for retention purposes. B) displaying a copy of all your checks on your bank statements. C) debiting your bank account at the point of sale when you pay by check. D) converting a one-time payment into repetitive payments of equal amount. 89) Which type of inventory would a bank be most willing to accept as security for a loan? A) Cabbages growing in a farmer's field B) Produce on the shelves of a grocery store C) An inventory of t-shirts featuring the winners of last month’s playoff game D) Boats owned by a boat dealer 90) A primary purpose of restricting the investment of idle cash balances to money market

instruments is to: A) obtain government guarantees on the investment. B) minimize transaction costs. C) minimize interest-rate risk. D) maximize possible capital appreciation. 91) A firm's inventory and accounts payable periods are 80 and 42 days, respectively. If the cash

cycle is 65 days, what is the firm's receivable period? A) 103 days B) 57 days C) 38 days D) 27 days 92) The longer the firm's accounts payable period, the: A) longer the firm's cash cycle. B) greater the delay in the accounts receivable period. C) less the firm must invest in net working capital. D) shorter the firm's inventory period.

Version 1

93) Commercial paper is unsecured. Therefore, the companies that issue this short-term security: A) are typically large firms with top credit quality. B) frequently default. C) are typically small firms with top credit quality. D) are firms that have government-sponsored guarantees for the debt. 94) Which one of the following is not a carrying cost to holding inventory? A) Risk of being short of inventory and unable to satisfy orders B) Lost interest on funds tied up in inventory C) Spoilage D) Possible obsolescence 95) A firm is considering a one-time sale of $100,000 to a customer. The cost of goods sold for

this sale is $90,000. If the probability of the customer paying is 0.8, what is the expected profit from this transaction? A) $0 B) −$10,000 C) +$8,000 D) +$10,000 96) What is the break-even probability of collection when the present value of revenues from a

sale is $100,000 and the present value of cost is $87,000? A) 1.00 B) 0.87 C) 0.74 D) 0.13 97) A firm with _____________ profit margin is best situated to extend credit to customers with

a high probability of default. A) a high B) an average C) a low D) a zero 98) Term loans: A) may be parceled out among a syndicate of banks. B) are commonly self-liquidating. C) are traded on the New York Stock Exchange. D) are commonly repaid within 270 days.

Version 1

99) What is the annual gain to a firm with daily sales of $30,000 if it can speed up collections by

3 days, assuming an annual opportunity cost of funds of 8%? A) $2,400 B) $7,200 C) $30,000 D) $90,000 100)

Which one of these is not a characteristic of a concentration system of collections? A) All surplus funds are electronically transferred to a centralized account. B) Check clearing times are increased. C) Customer payments are directed to a local collection center. D) Collection time is reduced.

101)

The Canine Kennel uses 600 cases of dog food annually and orders 40 cases in each shipment. The annual carrying cost per case is $5 and the economic order quantity is 25 cases. Which one of these statements best applies to this situation? A) The current annual ordering costs exceed $5 per case. B) The firm needs to increase its average inventory level of dog food. C) The current annual ordering costs are less than the carrying costs. D) The firm needs to reduce the number of orders placed per year.

102)

The Automated Clearing House (ACH): A) arranges for checks to be cleared. B) serves as an accounting system for credit cards. C) provides a mechanism for banks to transfer money directly to a firms’ suppliers or employees. D) is a system for making large-value international cash payments.

103)

Potential savings from a lock-box system will be reduced by: A) the additional processing time required. B) the additional mailing time required. C) local bank charges. D) an increase in interest rates.

104)

Which one of the following conditions would make a lock-box system potentially more attractive to a firm? A) Decline in interest rates B) A 2-day reduction in mail time rather than a 3-day reduction C) Larger payments D) Slower processing time

Version 1

105)

How much money can be saved annually by setting up a lock-box system that will process 500 checks per day at a cost of $0.15 per check if each check averages $220, collection float is reduced by 3 days, and the annual interest rate is 8%? (Use a 365-day year.) A) −$2,125 B) −$975 C) $2,650 D) $26,325

106)

Which one of the following is not an inventory carrying cost? A) Insurance expense for the inventory B) Opportunity cost of capital for inventory investment C) Cost of buying raw materials D) Cost of shelf space

107)

A 6-month Treasury bill sells at a discount of 1%. What is the effective annual interest rate? A) 0.85% B) 1.01% C) 1.52% D) 2.03%

108)

If the marginal order cost exceeds the marginal carrying cost of inventory, then the firm: A) has minimized its total carrying costs. B) should increase its order size. C) should decrease its order size. D) has maximized its order costs.

109)

Assume a firm can either hold cash paying no interest or invest in marketable securities. Which one of the following might induce the manager to hold higher cash balances today? A) The cost of borrowing is high relative to interest rates on marketable securities. B) Future cash flows are relatively predictable. C) The cost of cash balances is relatively high. D) Bank interest rates are expected to decrease.

Version 1

110)

Which of the following is not a money market instrument? A) U.S. Treasury bill with 91 days until maturity B) Commercial paper with 180 days until maturity C) 5-year Treasury bond D) A repurchase agreement, backed by U.S. government securities, with a 1-week maturity

111)

Which one of the following statements is true of repurchase agreements? A) Their initial maturity is greater than 1 year. B) They are an unsecured form of borrowing. C) U.S. Treasury securities serve as their collateral. D) They make explicit, rather than implicit, interest payments.

112)

Which of the following statements is false? A) Optimal inventory levels involve a trade-off between carrying costs and order costs. B) Carrying costs include the cost of storing goods as well as the cost of capital tied up in inventory. C) Optimal inventory levels are lower when storage or interest costs are high and are higher when restocking costs are high. D) Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal inventory level rises, but more than proportionately.

113)

How much value would be added to a firm that could permanently reduce its cash collection period by 2 days if daily collections average $10,000 and the opportunity cost is 5% annually? (Assume a 365-day year.) A) $1,000 B) $1,200 C) $10,000 D) $20,000

114)

Which of the following is not an advantage of wire transfer systems? A) Makes record-keeping easier to automate B) Allows individuals to pay for goods when travelling abroad C) Can ensure that payments arrive exactly on time D) Very low cost to additional transactions

Version 1

115)

By using a lock box system, a firm is able to reduce its float by 3 days. Given an annual interest rate of 3% and annual collections of $350 million, what is the projected annual interest earned by using the lock box? (Assume a 365-day year.) A) $66,303 B) $76,409 C) $86,301 D) $90,568

116)

A 3-month Treasury bill sells at a discount of 0.75%. What is the effective annual interest rate in basis points? A) 75.00 bps B) 75.15 bps C) 75.25 bps D) 75.35 bps

117)

A firm’s annual opportunity cost of capital is 6%. By use of a lock box they can reduce their cash collection period by 3 days. If daily collections are $20,000 what is the PV of their lock box? (Assume a 365-day year.) A) $60,000 B) $50,000 C) $40,000 D) $30,000

Version 1

Answer Key Test name: Ch20 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) TRUE 12) FALSE 13) FALSE 14) TRUE 15) FALSE 16) TRUE 17) FALSE 18) TRUE 19) FALSE 20) TRUE 21) TRUE 22) FALSE 23) TRUE 24) FALSE 25) TRUE 26) TRUE 27) A

Reduction in float = 1,250 × $3,000 × 2 days = $7,500,000 Daily interest savings = $7,500,000 × 0.02 = $1,500 Daily processing cost = $.50 × 1,250 = $625 Net daily savings = $1,500 − 625 = $875 28) C

Cash conversion cycle = 60 + 55 − 30 = 85 days 29) D

Version 1

30) D

Expected payoff = 0.8 × 0.3 × $2,300 − (0.2 × 0.70 × $2,300) = $230 31) A

Discounted payment = (1 − 0.03) × $1,800 = $1,746 32) C

Net opportunity cost = (0.00025 × $4,400,000) − $145 = $955 33) A

Expected profit = 0.65 × [$2,005 − $1,338.33] − (1 − 0.65) × $1,338.33 = −$35.08 34) B

Expected profit = 0.8 × ($108,000 − 98,000) − (1 − 0.8) × ($98,000) = −$11,600 35) B

p = $93,000 ÷ $124,000 = 0.75 36) B

Float is reduced by $114,000. If invested at 8% a year, gain = $114,000 × 0.08 = $9,120 37) B

Annual savings = (900 × $220 × 3 × 0.08) − (900 × $0.15 × 365) = −$1,755 38) B

Price of bill = 100 − 1 = 99.00 Annual interest rate = (100 ÷ 99.00)2raise to the power of 2 − 1 = 0.0203 39) D

40) C

Interest earned = (0.03 ÷ 365) × 3 × $358 million = $88,274 41) A

Version 1

42) B 43) C 44) C 45) A

Reduction in float = 2,000 × $1,500 × 2 days = $6,000,000 Daily interest savings = $6,000,000 × 0.0002 = $1,200 Daily processing cost = $0.50 × 2,000 = $1,000 Net daily savings = $1,200 − 1,000 = $200 46) C 47) C 48) D 49) A

50) C

Cash conversion cycle = 60 + 40 − 30 = 70 days 51) C

52) B 53) B 54) A 55) C 56) C 57) C 58) D 59) D

60) B 61) B 62) C

Expected profit from offering credit = 0.75 × PV($10,000 − 8,000) − 0.25 × PV($8,000) < $0

Version 1

63) D

Expected payoff = 0.8 × 0.3 × $2,000 − (0.2 × 0.70 × $2,000) = $200 64) C 65) B 66) D 67) B 68) A

Discounted payment = (1 − 0.03) × $1,200 = $1,164 69) C 70) D

71) A 72) D 73) C 74) C

Net opportunity cost = (0.00025 × $2,500,000) − $50 = $575 75) C 76) D 77) B 78) C 79) C 80) B 81) A

Expected profit = 0.65 × [$2,000 − $1,333.33] − (1 − 0.65) × $1,333.33 = −$33.33 82) D

p × [$3,000 − $2,000] − (1 −p) × $2,000 = 0 p = profit margin = 0.6667, or 66.67% 83) B 84) A 85) D 86) C 87) D 88) C 89) D

Version 1

90) C 91) D

Cash cycle = 65 = A / R period + 80 − 42→A / R period = 27 days 92) C 93) A 94) A 95) B

Expected profit = 0.8 × ($100,000 − 90,000) − (1 − 0.8) × ($90,000) = −$10,000 96) B

p = $87,000 ÷ $100,000 = 0.87 97) A 98) A 99) B

Float is reduced by $90,000. If invested at 8% a year, gain = $90,000 × 0.08 = $7,200 100) 101)

B C At 40 cases per order, the size of the order exceeds the EOQ of 25 cases. This means the carrying costs are larger than the order costs. See Figure 20.7 in the text. 102) 103) 104) 105)

C C C B Annual savings = (500 × $220 × 3 × 0.08) − (500 × $0.15 × 365) = −$975 106) 107)

C B Price of bill = 100 − 1 ÷ 2 = 99.5 Annual interest rate = (100 ÷ 99.5)2raise to the power of 2 − 1 = 0.0101 108) 109) 110) 111) 112) 113)

B A C C D D

Version 1

114) 115)

B C Interest earned = (0.03 ÷ 365) × 3 × $350 million = $86,301 116)

D Price of bill = 100 − 0.75 ÷ 4 = 99.8125 Annual interest rate = (100 ÷ 99.8125)4raise to the power of 4 − 1 = 0.007535 or 75.35 basis points 117)

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) When a firm is taken over, its management is usually replaced. ⊚ true ⊚ false 2) Takeovers are often described as part of a broader market for corporate control. ⊚ true ⊚ false 3) A vertical merger is one between firms at different levels of the production process. ⊚ true ⊚ false 4) Instead of selling part of its operations, companies sometimes spin off a business by

separating it from the parent firm and distributing to its shareholders the stock in the newly independent company. ⊚ true ⊚ false 5) Allergan’s sale of its generic drug business to Teva Pharmaceutical was an example of a

divestiture. ⊚ true ⊚ false 6) Carve-outs and spin-offs both provide shares of the new firm to the divesting firm's

shareholders. ⊚ true ⊚ false 7) If a segment of a business is unrelated to the rest of the firm's activities, that segment is more

likely to be spun off or carved out. ⊚ true ⊚ false 8) Changing management is the only reason that firms make acquisitions. ⊚ true ⊚ false

Version 1

9) A merger must have the approval of at least 51% of the shareholders of each firm. ⊚ true ⊚ false 10) The expected savings from merging two banks often come from consolidating operations and

eliminating redundant costs. ⊚ true ⊚ false 11) A conglomerate merger is defined as the merger of two or more Fortune 500 companies. ⊚ true ⊚ false 12) It is always more efficient to integrate vertically than to outsource part of one’s business. ⊚ true ⊚ false 13) By offering to buy shares directly from a target’s shareholders, the acquiring firm can bypass

the target firm's management altogether. ⊚ true ⊚ false 14) Vertical integration makes sense when two firms are highly dependent upon each other. ⊚ true ⊚ false 15) Evidence shows that investors will generally pay a premium for diversified firms. That is a

good reason for firms to merge. ⊚ true ⊚ false 16) Synergy is equal to the value of a combined firm minus the total value of the firms prior to

merger. ⊚ true ⊚ false 17) Target firms frequently deter potential bidders by devising poison pills, which make the

company unappetizing. ⊚ true ⊚ false

Version 1

18) Strictly speaking, the purchase of the stock or assets of another firm is an acquisition. ⊚ true ⊚ false 19) A typical poison pill may give existing shareholders the right to buy the company's shares at

half price as soon as a bidder acquires more than 15% of the shares. The bidder is not entitled to the discount. ⊚ true ⊚ false 20) Firm A's shareholders will be better off with a stock offer than with a cash offer if A makes

too generous of an offer for Firm B. ⊚ true ⊚ false 21) The Williams Act, in addition to state laws, sets forth the rules for tender offers. ⊚ true ⊚ false 22) Economies of vertical integration are one possible source of synergy in mergers. ⊚ true ⊚ false 23) Contrary to logic, firms that enjoy complementary resources in the production process are

rarely good candidates for merger. ⊚ true ⊚ false 24) An economic gain is derived from mergers when two firms are worth more combined than

separate. ⊚ true ⊚ false 25) Amendments to the corporate charter that attempt to circumvent mergers are known as

poison pills. ⊚ true ⊚ false

Version 1

26) On average, stockholders in target firms earn higher returns from mergers than the acquiring

firm's stockholders. ⊚ true ⊚ false 27) If investors believe a firm may be acquired, its market value is likely to be higher than its

stand-alone value. ⊚ true ⊚ false 28) Management buyouts are generally all-equity financed by the new shareholders. ⊚ true ⊚ false 29) Tax inversion refers to the fact that mergers often result in extra capital gains taxes for

shareholders. ⊚ true ⊚ false 30) One motive for acquiring a firm is to stop wastage of the target firm's cash reserves. ⊚ true ⊚ false 31) The 1980s were a time of little merger activity. ⊚ true ⊚ false 32) In general, shareholders of the target firm benefit from takeovers. ⊚ true ⊚ false 33) Leveraged buyouts are acquisitions where a large fraction of the purchase price is financed

with debt. ⊚ true ⊚ false 34) The value of the target firm's bonds tend to decrease when a leveraged buyout is announced. ⊚ true ⊚ false

Version 1

35) The free-cash-flow theory supports the notion that the market gain from an LBO is basically

the present value of the firm's future cash flows that would otherwise have been wasted. ⊚ true ⊚ false 36) Only the U.S. has antitrust laws that can affect mergers and acquisitions. ⊚ true ⊚ false 37) In a merger the acquiring firm buys only the debt of the target firm. ⊚ true ⊚ false 38) It is easier for individual investors to diversify their risk by buying shares in different firms

than for the firms to combine their operations. ⊚ true ⊚ false 39) In mergers financed by cash, the merger cost is not affected by the size of the merger gain. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 40) Firm B's 1 million shares of stock currently sell for $15 each, but firm A is preparing a tender offer of $19 per share. Firm A estimates the NPV of the merger to be $5.18 million. What percentage of the merger gains will be captured by firm B's stockholders? A) 44.31% B) 39.02% C) 55.69% D) 43.57% 41) ABC Corporation has offered 1 million shares having a total market value of $8.56 million

for XYZ. After the merger is announced, shares in ABC trade for $7.28 each. If ABC is confident about XYZ's value, then the cost of the merger: A) increased by $1.28 million. B) decreased by $1.28 million. C) increased by $9.84 million. D) remained constant.

Version 1

42) Firms A and B were each currently worth $68 million but generated a $20 million gain when

merged. If the cost of the merger was $5 million, how much did firm A pay for firm B? A) $68 million B) $73 million C) $78 million D) $83 million 43) CBA Corporation is worth $15 million as a stand-alone firm. ABC Corporation has offered

352,600 shares valued at $50 each to acquire CBA. After the announcement, however, the price of ABC's shares falls to $45. What was the cost of the merger? A) −$1.87 million B) $0.867 million C) $1.87 million D) $3.367 million 44) Firm B's 1.65 million shares of stock currently sell for $20 each. Firm A estimates the

economic gain from the merger to be $10 million and is prepared to offer $22 cash for each share of B. What percentage of the merger gain will be captured by firm B's shareholders? A) 33.00% B) 46.33% C) 82.50% D) 99.00% 45) XYZ Corporation has made a cash tender offer for 2 million shares of ABC Corporation at a

price of $35, which is $6.75 higher than ABC's current stand-alone value. What is the cost of the merger? A) $57.25 million B) $37.75 million C) $13.50 million D) Zero 46) A merger is expected to produce cost savings of $62 million and the acquired firm's

shareholders will receive a premium of 20% over the $162 million value of their firm. The gain of the merger to the acquirer is: A) $29.60 million. B) $39.60 million. C) $69.20 million. D) $187.60 million.

Version 1

47) Kates Café has 2 million shares outstanding at a price of $38 each. Hanks Heaters is

preparing a tender offer of $40 per share. Hanks estimates the NPV of the merger to be $8.30 million. What percentage of the merger gains will be captured by Kates’ stockholders? A) 32.52% B) 49.19% C) 65.85% D) 53.74% 48) Kates Café is looking to purchase Hanks Heaters for $31 million. Hanks heaters currently

has a market value of $27 million. Kates Café is valued at $46 million and forecasts $3 million of synergies for the merger. What is the likely value of Kates Café if the merger is successful? A) $45 million B) $46 million C) $47 million D) $49 million 49) When shareholders attempt to garner additional board votes in an attempt to oust

management, it is called a: A) management buyout. B) tender offer. C) proxy contest. D) poison pill. 50) When one firm merges with another, the: A) boards of directors will merge also. B) merger must be approved by 75% of the shareholders of the target firm. C) assets will be merged but the liabilities will not. D) target firm will cease to exist as a separate public company. 51) A tender offer is one in which the firm's: A) management offers to sell the company to an acquirer. B) board of directors offers to sell the company to the public. C) shareholders are given the opportunity to sell their shares to a would-be acquirer. D) management offers to buy all outstanding shares of the corporation.

Version 1

52) When an outside group acquires a firm, primarily through the use of borrowed funds, the

acquisition is known as a: A) management buyout. B) tender offer. C) leveraged buyout. D) successful proxy fight. 53) When a firm's management takes the firm private with the aid of substantial debt, it is known

as a management: A) tender offer. B) greenmail offer. C) buyout. D) hostile takeover. 54) A spinoff is an action in which: A) the management bids for and acquires the firm. B) one firm issues stock to acquire another firm. C) successful product lines are sold to competitors. D) a portion of the firm's assets is sold off to form a new company. 55) If an automobile manufacturer were to acquire one of the firms listed below, which

acquisition would be called a horizontal merger? A) A steel mill B) A rival manufacturer C) A tire producer D) A bank 56) If Snapper Lawnmowers were to acquire Briggs and Stratton (gasoline-powered engines), the

merger would be classified as a: A) conglomerate. B) leveraged buyout. C) horizontal merger. D) vertical merger. 57) A conglomerate merger occurs when: A) both partners are large in size. B) large synergies are expected to develop. C) firms from different industries merge. D) both management teams remain intact after the merger.

Version 1

58) Mergers may provide reductions in average production cost as a result of: A) increased market price. B) increased financing. C) economies of scale. D) diversification. 59) Which one of the following might you recommend to a firm with excessive free cash flow? A) Acquire a firm to diversify B) Acquire a firm to bootstrap earnings C) A leveraged buyout D) A repurchase of shares 60) Diversification is often a poor motive for mergers because: A) vertical integration is rarely successful. B) investors can diversify on their own account. C) it does not produce economies of scale. D) the increase in taxes overcomes any gains in earnings. 61) One indication that investors expect no synergy from a merger would be that the: A) total market value of the merged firms does not change. B) P/E ratio of the merged firms' changes. C) acquiring firm financed the merger with cash. D) merged firms are from different industries. 62) An increase in earnings per share may be increased by a merger if the: A) number of shares has increased. B) price of the acquirer's stock increases. C) acquirer’s P/E ratio is higher than that of the target. D) firm's additional earnings are spent on legal expenses of the merger. 63) The cost of a merger may outweigh the potential gain if the: A) present value of the acquired firm exceeds the price paid for it. B) present value of the merged firms is greater than the sum of their individual values. C) merger allows cost savings to occur. D) acquired firm's shareholders receive more than the value of their firm.

Version 1

64) Firm B's 1 million shares of stock currently sell for $12 each, but firm A is preparing a tender

offer of $18 per share. Firm A estimates the NPV of the merger to be $5 million. What percentage of the merger gains will be captured by firm B's stockholders? A) 33.33% B) 50.00% C) 66.67% D) 54.55% 65) The cost of a merger equals the: A) cash paid for the target firm. B) increase in total earnings minus the price paid. C) premium paid over the target's value as a separate entity. D) sum of cash and stock paid for the target firm. 66) ABC Corporation has offered 1 million shares having a total market value of $8 million for

XYZ. After the merger is announced, shares in ABC trade for $7 each. If ABC is confident about XYZ's value, then the cost of the merger: A) increased by $1 million. B) decreased by $1 million. C) increased by $9 million. D) remained constant. 67) In the case of a merger that is stock financed, the merger cost may change if the: A) value of the target firm's shares changes after the merger announcement. B) value of the acquiring firm's shares changes after the merger announcement. C) long-term interest rates increase. D) merger is either horizontal or vertical. 68) The shareholders of firm A have offered 1 million shares valued at $10 each to acquire firm

B. After the merger is announced, stock A trades for $9 per share. Which of the following statements is false? A) Firm A appears to have overbid for firm B. B) The NPV of the merger may differ from expectations. C) Shareholders of firm A absorb all the additional "cost." D) Firm A's stockholders are better off than if the merger were cash financed for $10 million.

Version 1

69) Large-scale efforts to make a firm less appealing in the midst of a potential merger are

known as: A) proxy fights. B) leveraged buyouts. C) shark attractants. D) poison pills. 70) Other things equal, which one of the following groups of stakeholders often lose value as a

result of an LBO? A) Selling stockholders B) Buying stockholders C) Pre-LBO bondholders D) Investment bankers 71) The free-cash-flow theory of takeovers predicts that firms: A) without free cash flow will become the most common LBOs. B) with free cash flow will continue to be the acquirers. C) with excess cash do not have a tendency to use it wisely. D) with excess cash tend to have the most carve-outs. 72) A change to the corporate charter that requires that any merger must be approved by a

supermajority of shareholders is known as: A) an LBO. B) a proxy contest. C) a carve-out. D) a shark-repellent. 73) Which of the following is not a mechanism for changing a firm’s management? A) A proxy contest B) A leveraged buyout C) A poison pill D) A takeover 74) Proxy fights generally occur when a group is trying to: A) rewrite the corporate charter. B) bring about economies of scale. C) replace the current board and management team. D) pursue a public tender offer.

Version 1

75) One of the reasons why proxy fights are often unsuccessful is that: A) management is always viewed as performing its job well. B) management can use corporate resources to defend against the fight. C) mergers are a cheaper form of changing management. D) shareholders are unconcerned with corporate management. 76) Which one of the following is false concerning a proposed merger of firms? A) The acquired firm will cease to exist. B) Shareholders of the acquired firm may receive securities in the acquiring firm. C) Mergers are sometimes combinations of equals. D) Shareholder approval to merge is not required. 77) A public offer to purchase the shares of existing stockholders in order to take the firm over is

called a: A) tender offer. B) carve-out. C) spin-off. D) divestiture. 78) When a management team buys the firm from current shareholders while continuing to

manage and often incurring large segments of debt, it is known as a: A) management buyout. B) spin-off. C) successful greenmail attempt. D) corporate breakup. 79) If Georgia Pacific (lumber products) were to acquire a national homebuilding firm, the

combination would be termed a: A) horizontal merger. B) vertical merger. C) conglomerate merger. D) spin-off by the national homebuilding firm. 80) Which one of the following is least likely to provide a motivation for vertical integration? A) A continuous source of raw materials B) A desire to spread fixed costs across more output C) Access to an efficient distribution channel D) Acquisition of an established customer base

Version 1

81) Cash-rich firms often make questionable acquisitions, rather than pay out the cash to

shareholders. This is: A) because diversification is too costly for individuals. B) an example of an agency problem. C) because diversification eliminates inefficiencies. D) an example of the bootstrap game. 82) Firms with substantial amounts of free cash flow often discover that: A) conglomerate mergers are the best use for the funds. B) accounting profits are what truly matter. C) they have become takeover targets. D) their capital budgets have been too low. 83) The "Bootstrap Game" is played somewhat in defiance of traditional merger logic in that it: A) provides immediate benefit through improved management. B) does not offer a positive NPV from the merger. C) stays in effect only until EPS are increased. D) does not require the approval of a majority of shareholders. 84) Mergers that attempt to bootstrap earnings may obtain increased current earnings per share at

the expense of: A) a higher price-earnings ratio. B) higher total combined market value. C) reduced future growth prospects. D) increased free cash flow. 85) Firms that are acquired to take advantage of bootstrapping often have: A) a lower price-earnings ratio than the acquirer. B) a higher price-earnings ratio than the acquirer. C) more outstanding shares than the acquirer. D) a higher market valuation than the acquirer. 86) If two merged firms are shown to have a higher combined market value than the sum of their

individual market values, then: A) there are economic gains. B) the firms were previously underpriced. C) the merger provides diversification to investors. D) there is no cost involved in the merger.

Version 1

87) If the shareholders of an acquired firm capture all of the merger's gain, then the: A) cost of the merger is zero. B) NPV of the merger is zero. C) EPS will increase. D) acquiring firm retains all merger benefits. 88) Why is it not sufficient to state that a merger should occur simply because the economic

gains are positive? A) Gains are typically of an accounting nature. B) Shareholders of the target firm may capture all of the gains. C) Merger costs should be negative after discounting. D) The merger's gain must also exceed its NPV. 89) Firms A and B were each currently worth $50 million but generated a $20 million gain when

merged. If the cost of the merger was $5 million, how much did firm A pay for firm B? A) $50 million B) $55 million C) $60 million D) $65 million 90) When two firms merge, the value of the acquiring firm will change by the: A) gain from the merger. B) NPV minus the cost of the merger. C) NPV of the merger. D) cost of the merger. 91) CBA Corporation is worth $15 million as a stand-alone firm. ABC Corporation has offered

350,000 shares valued at $50 each to acquire CBA. After the announcement, however, the price of ABC's shares falls to $45. What was the cost of the merger? A) −$1.75 million B) $0.75 million C) $1.75 million D) $3.25 million

Version 1

92) Which one of the following statements is correct concerning the cost of two firms merging?

The cost: A) is fixed when the merger is financed with cash. B) can be affected by postmerger gains if cash is used. C) decreases as the postmerger share price increases when stock is used to finance the merger. D) is not determined until after the merger, regardless of the type of financing. 93) Why might shareholders of an acquiring firm prefer to finance mergers with stock rather than

with cash? A) Stock financing is always less costly due to tax consequences. B) The EPS decreases when mergers are financed with cash. C) Target-firm shareholders will bear part of the cost if merger benefits were overestimated. D) All merger gains go to the acquirer when financed with stock. 94) Realizing the benefits of a merger is easier when the merging companies have differing: A) computer systems. B) pay structures. C) resources. D) company cultures. 95) The most likely interpretation of headlines that read "ABC Corporation adopts shark

repellent" is that ABC: A) wants to increase the difficulty of a takeover. B) has made a tender offer for the shares of another firm. C) will merge only with small-sized partners. D) desires to reduce the costs of being acquired. 96) Shares of a corporation can, under certain circumstances, be priced at different amounts to

different investors under the terms of a: A) proxy agreement. B) public tender offer. C) poison pill. D) shark repellent.

Version 1

97) What does empirical evidence suggest about the distribution of gains from mergers? A) Shareholders of the acquired firm gain the most. B) Shareholders of the acquiring firm gain the most. C) Neither group of shareholders is likely to gain. D) Both groups of shareholders gain equally. 98) What type of financing is typically instrumental in bringing about leveraged buyouts? A) Common-stock financing B) Preferred-stock financing C) Investment-grade bonds D) Speculative-grade bonds 99) According to the free-cash-flow theory of takeovers, many acquisitions are motivated by: A) an illogical assessment of earnings prospects. B) the remaining costs of the merger. C) the belief that free cash flow will no longer be misused. D) losses experienced by arbitrageurs and other speculators. 100)

Firm B's 1 million shares of stock currently sell for $20 each. Firm A estimates the economic gain from the merger to be $10 million and is prepared to offer $22 cash for each share of B. What percentage of the merger gain will be captured by firm B's shareholders? A) 20.00% B) 33.33% C) 50.00% D) 60.00%

101)

XYZ Corporation has made a cash tender offer for 2 million shares of ABC Corporation at a price of $20, which is $6 higher than ABC's current stand-alone value. What is the cost of the merger? A) $40 million B) $28 million C) $12 million D) Zero

Version 1

102)

A merger is expected to produce cost savings of $50 million and the acquired firm's shareholders will receive a premium of 20% over the $150 million value of their firm. The gain of the merger to the acquirer is: A) $20 million. B) $30 million. C) $50 million. D) $130 million.

103)

Which one of the following is not a method of changing the management of a firm? A) Proxy contest B) Merger and acquisition C) LBO D) MBO

104)

Which one of the following is correct concerning a spin-off? A) A division of a firm is reconstituted as a new firm. B) An unprofitable division is divested. C) A division of a firm is bought by its managers. D) The spin-off generates no free cash flow.

105)

Splitting one firm into four separate firms is an example of a: A) leveraged buyout. B) spin-off. C) management buyout. D) tender offer.

106)

The merger between Uptown Bank and Downtown Bank is an example of a: A) vertical merger. B) horizontal merger. C) conglomerate merger. D) direct merger.

107)

If Microsoft were to acquire Dell Computer, it would be an example of a: A) vertical merger. B) horizontal merger. C) conglomerate merger. D) distribution-channel merger.

Version 1

108)

Conglomerate mergers involve companies in: A) similar lines of business. B) different stages of the corporate life cycle. C) unrelated lines of business. D) different countries.

109)

A merger adds value by creating synergies. Which one of these is not a possible source of synergy? A) Economies of scale B) Economies of vertical integration C) Combined complementary resources D) Diversification

110)

Which one of the following is the most appropriate reason for an acquiring firm's shareholders to prefer using stock financing for acquisitions? A) There is no cash outflow. B) It mitigates the effects of overvaluation of the target firm. C) It mitigates the effects of undervaluation of the target firm. D) It avoids dilution of shares.

111)

Which one of the following statements is correct for a firm that has undergone a leveraged buyout? A) Its shares are no longer traded publicly. B) Its capital is mostly equity financed. C) Its shares are not traded publicly. D) It has a larger shareholder base.

112)

Empirical studies show that the operating efficiency of firms having undergone a leverage buyout _____________ over the following 3 years. A) increases B) decreases C) does not change D) shows no clear trend

Version 1

113)

Kates Café has 2 million shares outstanding at a price of $23 each. Hanks Heaters is preparing a tender offer of $25 per share. Hanks estimates the NPV of the merger to be $8 million. What percentage of the merger gains will be captured by Kates’ stockholders? A) 33.33% B) 50.00% C) 66.67% D) 54.55%

114)

Kates Café is looking to purchase Hanks Heaters for $20 million. Hanks heaters currently has a market value of $16 million. Kates Café is valued at $35 million and forecasts $3 million of synergies for the merger. What is the likely value of Kates Café if the merger is successful? A) $34 million B) $35 million C) $36 million D) $38 million

115)

Which of the following is an example of not an example of a shark repellant? A) Rights issue B) Staggered board C) Super majority D) Tender offer

Version 1

Answer Key Test name: Ch21 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) FALSE 9) FALSE 10) TRUE 11) FALSE 12) FALSE 13) TRUE 14) TRUE 15) FALSE 16) TRUE 17) TRUE 18) TRUE 19) TRUE 20) TRUE 21) TRUE 22) TRUE 23) FALSE 24) TRUE 25) FALSE 26) TRUE 27) TRUE 28) FALSE 29) FALSE 30) TRUE 31) FALSE 32) TRUE 33) TRUE 34) TRUE 35) TRUE 36) FALSE 37) FALSE

Version 1

38) TRUE 39) TRUE 40) D

41) B

Preannouncement: Cost of merger = ($8.56 × 1,000,000) − Value of acquired firm Post announcement: Cost of merger = ($7.28 × 1,000,000) − Value of acquired firm Difference = ($7.28 − 8.56) × 1,000,000 = −$1,280,000 Since the value of XYZ is assumed constant, the cost of the merger has decreased by $1.28 million. 42) B

Cash paid = $68,000,000 + 5,000,000 = $73,000,000 43) B

Cost = (352,600 × $45) − $15,000,000 = $867,000 44) A

B's % of the gain = [($22 − 20) × 1,650,000] / $10,000,000 = 0.33, or 33% 45) C

$6.75 × 2,000,000 = $13,500,000 46) A

GainA = $62,000,000 − ($0.20 × $162,000,000) = $29,600,000 47) A

48) A

Value = $46,000,000 + $3,000,000 − ($27,000,000 − $31,000,000) = $45,000,000 49) C 50) D 51) C 52) C

Version 1

53) C 54) D 55) B 56) D 57) C 58) C 59) D 60) B 61) A 62) C 63) D 64) D

65) C 66) B

Preannouncement: Cost of merger = ($8 × 1,000,000) − Value of acquired firm Post announcement: Cost of merger = ($7 × 1,000,000) − Value of acquired firm Difference = ($7 − 8) × 1,000,000 = −$1,000,000 Since the value of XYZ is assumed constant, the cost of the merger has decreased by $1 million. 67) B 68) C 69) D 70) C 71) C 72) D 73) C 74) C 75) B 76) D 77) A 78) A 79) B 80) B 81) B 82) C 83) B

Version 1

84) C 85) A 86) A 87) B 88) B 89) B

Cash paid = $50,000,000 + 5,000,000 = $55,000,000 90) C 91) B

Cost = (350,000 × $45) − $15,000,000 = $750,000 92) A 93) C 94) C 95) A 96) C 97) A 98) D 99) C 100) A

B's % of the gain = [($22 − 20) × 1,000,000] / $10,000,000 = 0.20, or 20% 101)

C $6 × 2,000,000 = $12,000,000 102)

A GainA = $50,000,000 - ($0.20 × $150,000,000) = $20,000,000 103) 104) 105) 106) 107) 108) 109) 110) 111) 112) 113)

D A B B A C D B C A A

Version 1

114)

A Value = $35,000,000 + $3,000,000 − ($16,000,000 − $20,000,000) = $34,000,000 115)

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) The New York Stock Exchange is one of few markets to have a higher daily volume than the foreign exchange market. ⊚ true ⊚ false 2) The direct exchange rate quotes the number of U.S. dollars that can be exchanged for one

unit of a foreign currency. ⊚ true ⊚ false 3) The number of pesos that can be purchased with one U.S. dollar is referred to as an indirect

quote. ⊚ true ⊚ false 4) According to interest rate parity, the interest rate differential must be equal to the differential

between forward and spot exchange rates. ⊚ true ⊚ false 5) The international Fisher effect states that nominal interest rates should be equal in all

countries. ⊚ true ⊚ false 6) The spot rate is $/C$ = 1.02. The 3-month forward rate is $/C$ = 1.03. The Canadian dollar

is selling at a forward premium. ⊚ true ⊚ false 7) Interest rate parity suggests that it is cheaper to borrow in a currency with a low nominal rate

of interest. ⊚ true ⊚ false 8) Transaction risk can usually be identified and hedged. ⊚ true ⊚ false

Version 1

9) A U.S. importer of a Japanese product should sell Japanese yen forward to avoid the risk of

an appreciation of the yen. ⊚ true ⊚ false 10) Interest rate parity tells us that the cost of buying yen forward is exactly the same as the cost

of borrowing dollars, buying yen in the spot market, and leaving them on yen deposit. ⊚ true ⊚ false 11) Even if a firm neither owes nor is owed foreign currency, it still may be affected by currency

fluctuations. ⊚ true ⊚ false 12) You can purchase a futures contract on any currency. ⊚ true ⊚ false 13) The forward exchange rate is the rate for immediate exchange of two currencies. ⊚ true ⊚ false 14) If the yen is trading at a forward discount relative to the dollar, then you'll receive less yen

per dollar in the future. ⊚ true ⊚ false 15) Futures contracts offer an alternative way to buy foreign currency forward. ⊚ true ⊚ false 16) If inflation is expected to be higher in the U.S. than in Mexico, then the peso is forecasted to

depreciate against the dollar. ⊚ true ⊚ false

Version 1

17) According to the international Fisher effect, the differences in nominal interest rates across

countries reflect the differences in their expected rates of inflation. ⊚ true ⊚ false 18) Forward rates are always equal to the actual future exchange rates. ⊚ true ⊚ false 19) Forward contracts are standardized contracts sold in organized exchanges. ⊚ true ⊚ false 20) The law of one price implies that when converted into the same currency a commodity

should sell at the same price in all countries. ⊚ true ⊚ false 21) The nominal interest rate is the difference between the real interest rate and inflation. ⊚ true ⊚ false 22) If the international Fisher effect is valid, then expected real interest rates in all countries

should be equal. ⊚ true ⊚ false 23) Buying currency in the forward market is a common method of hedging currency risk. ⊚ true ⊚ false 24) If real interest rates are different across countries, investors will shift their money into

countries with high real interest rates. ⊚ true ⊚ false 25) An indirect quote is the rate of one unit of foreign currency expressed in U.S. dollars. ⊚ true ⊚ false

Version 1

26) If the interest rate in one country increases, then the value of that country's currency increases

in the forward market. ⊚ true ⊚ false 27) If the USD is trading at a forward premium relative to the Euro, we should expect goods to

be more expensive for holders of USDs in the future. ⊚ true ⊚ false MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 28) How many dollars will it take for a U.S. citizen to purchase a Japanese product priced at 69,000 yen if the indirect exchange rate is JPY122 = USD1? A) $565.57 B) $689.12 C) $5,656 D) $84,180 29) If the Yen is trading at a spot price of 112 yen to 1 USD and the 1-year forward rate is 118

yen to 1 USD? What is the premium or discount of the Yen, relative to the USD? A) 5.36% premium B) 5.24% discount C) 5.24% premium D) 5.36% discount 30) If the direct exchange rate between U.S. dollars and pounds sterling is GBP / USD = 1.56,

how much should you be willing to pay to receive £410? A) $205.00 B) $262.82 C) $430.50 D) $639.60 31) Which one of the following is correct if you have contracted to purchase 1,048 Swiss francs

3 months forward at a rate of USD / CHF = 1.6? A) You pay $655 today for the francs. B) You pay $1.00 today for the francs. C) You pay $655 three months from now for the francs. D) You pay $1.00 three months from now for the francs.

Version 1

32) If the spot exchange rate between euros and dollars is EUR / USD = 1.1 before the dollar

depreciates by 10%, how many dollars will it take after the depreciation has occurred to pay an invoice of €580? A) $638 B) $709 C) $580 D) $401 33) Suppose that inflation next year is 8% in Japan and 4% in the United States. If the current

spot rate is JPY110 = USD1, what is the expected spot rate at the end of the year? A) USD / JPY = 105.83 B) USD / JPY = 106.15 C) USD / JPY = 114.23 D) USD / JPY = 114.93 34) The pound is expected to appreciate by 2% against the dollar. If the expected inflation rate in

the United States is 6.20% and purchasing power parity holds, what is the expected inflation rate in the United Kingdom? A) 2.5% B) 4.1% C) 5.3% D) 9.3% 35) Current 1-year interest rates are 4.30% and 8.30% in the United States and Spain,

respectively. The anticipated inflation in the United States is 2.30%. If the international Fisher effect holds, what is the expected inflation rate in Spain? A) 4.30% B) 4.34% C) 6.22% D) 6.00% 36) Consider the following spot exchange rates for the British pound, the Japanese yen, the euro

and the Swedish krona: GBP / USD= 1.60, USD / JPY = 105, EUR / USD = 0.625, and USD / SEK = 6.2. If gold sells for $328 per ounce in the United States, which one of the following prices for 1 ounce of gold seems to violate the law of one price? A) £205.00 B) ¥34,440 C) €424 D) kr1,817

Version 1

37) If purchasing power parity holds, what is the expected German inflation rate if the U.S.

expected inflation rate is 3%, the spot exchange rate is EUR / USD = 0.849, and the expected spot rate is EUR / USD = 0.807? A) 1.3% B) 5.6% C) 8.4% D) 9.9% 38) The spot exchange rate for the Canadian dollar is USD / CAD = 1.16. The 6-month interest

rate in the United States is 2.5% and 3.0% in Canada. What is the 6-month forward rate for the Canadian dollar? A) USD / CAD = 1.146 B) USD / CAD = 1.166 C) USD / CAD = 1.126 D) USD / CAD = 1.161 39) Assume the spot exchange rate for the Swiss franc is USD / CHF = .97 and the 1-year

forward rate is USD / CHF = 0.941. If the 1-year interest rate in the U.S. is 5%, what is the 1year interest rate in Switzerland? A) 2.24% B) 1.86% C) 1.74% D) 1.57% 40) The 2-year interest rate is 6% in Mexico and 3% in the USA. An American company

forecasts that a new plant in Mexico will produce cash flow of 1.43 million pesos in year 2. The current spot rate is USD / MXN = 21.3; what is the expected dollar cash flow from the plant in year 2? A) $30.28 million B) $63,390 C) $65,177 D) $1.39 million 41) The current 1-year nominal interest in the United States is 7.64%. If the anticipated inflation

for the coming year in the United States is 3.3%, what is the real interest rate in the U.S.? A) 4.02% B) 4.20% C) 4.31% D) 6.99%

Version 1

42) You can make a one year $1,030,000 investment in Mexico at an interest rate of 12%.

Conversely, you may borrow in the USA at a rate of 4%. If the spot exchange rate is 11 Peso per 1 USD and the one year forward rate is 12 Peso per 1 USD, what profit will you make from such an investment? A) $13,733 profit B) $13,733 loss C) $41,200 profit D) $41,200 loss 43) High inflation rates are usually associated with: A) low nominal interest rates. B) high nominal interest rates. C) high real interest rates. D) low real interest rates. 44) If the international Fisher effect holds, what will be the effect of an increase of a country's

nominal interest rates on the country's currency? A) The currency will appreciate. B) The currency will depreciate. C) There will be no significant change in the currency's value. D) The currency will sell at a forward premium. 45) If purchasing power parity holds, what will happen to the currency of a country with high

inflation? A) The currency will appreciate. B) The currency will depreciate. C) There will be no significant change in the currency's value. D) The currency will sell at a forward premium. 46) You can value overseas investments using the NPV of the cash flows. Which of the

following adjustment is necessary to calculate the NPV? A) Adjust the cost of capital by the forward exchange rate and then discount the foreign cash flows B) Convert the foreign cash flows into domestic currency and use the domestic opportunity cost of capital for discounting C) Use the domestic discount rate to discount the foreign cash flows D) Convert the foreign cash flow into domestic currency and use the foreign cost of capital for discounting

Version 1

47) If the exchange rate of euros/U.S. dollars is 1.351 = EUR/USD, then: A) it takes 1.35 euros to buy one U.S. dollar. B) the euro is worth less than one U.S. dollar. C) one dollar is worth approximately €0.74. D) one dollar is worth approximately €1. 48) How many dollars will it take for a U.S. citizen to purchase a Japanese product priced at

60,000 yen if the indirect exchange rate is JPY104 = USD1? A) $576.92 B) $700.47 C) $5,769 D) $62,400 49) If the Yen is trading at a spot price of 111 yen to 1 USD and the 1-year forward rate is 115

yen to 1 USD? What is the premium or discount of the Yen, relative to the USD? A) 3.60% premium B) 3.48% discount C) 3.48% premium D) 3.60% discount 50) Country A has a higher inflation rate than Country B. In this case Country A will have the: A) a depreciating currency. B) higher nominal interest rate. C) an appreciating currency. D) higher real interest rate. 51) A sandwich costs $6.79 in the U.S. The exchange rate is USD/CAD = 0.98. What does the

identical sandwich have to cost in Canada for the law of one price to exist? A) C$6.93 B) C$6.79 C) C$6.65 D) C$6.86 52) Suppose the spot rate for the Canadian dollar is USD/CAD = 1.034 , the 3-month forward

rate is USD/CAD = 1.036, and the 1-year forward rate is USD/CAD = 1.039. If no other information is available, what will be your guess about the spot rate in 1 year? A) 1.034 B) 1.036 C) 1.039 D) 1.037

Version 1

53) Suppose that the spot exchange rates against the U.S. dollar are:

USD / SEK = 9.3924 USD / CHF = 1.5231 USD / JPY = 123.380 What rate do you think a Japanese bank would quote for exchanging Swiss francs into Swedish krone? A) CHF / SEK = 6.167 B) CHF / SEK = 0.162 C) CHF / SEK = 13.136 D) CHF / SEK = 1 54) Suppose that a bank quotes the following rates:

CHF / JPY = 58.00 USD / CHF = 1.52 USD / JPY = 123.38 Which of the following transactions would produce an arbitrage profit for a U.S. investor? A) Buy 123.38 yen, exchange them for Swiss francs, and sell the Swiss francs that you receive. B) Buy 1.52 Swiss francs, exchange them for Japanese yen, and sell the yen that you receive. C) Buy both Japanese yen and Swiss francs. D) There are no transactions that would not involve at least some risk. 55) Suppose the 1-year interest rate in Canada is 4% while it is 3% in the U.S. The indirect spot

rate is USD / CAD = 1.02. What is the indirect 1-year forward rate? A) USD / CAD = 1.0299 B) USD / CAD = 1.0608 C) USD / CAD = 1.0200 D) USD / CAD = 1.0302 56) If the direct exchange rate between U.S. dollars and pounds sterling is GBP / USD = 1.50,

how much should you be willing to pay to receive £350? A) $175.00 B) $233.33 C) $367.50 D) $525.00

Version 1

57) The main purpose in contracting to purchase foreign currency in the forward market is to: A) earn a premium on the exchange. B) lock into a future currency price now. C) take advantage of future price reductions. D) avoid the more expensive spot rates. 58) Which one of the following is correct if you have contracted to purchase 1,000 Swiss francs

3 months forward at a rate of USD / CHF = 1.6? A) You pay $625 today for the francs. B) You pay $1,600 today for the francs. C) You pay $625 three months from now for the francs. D) You pay $1,600 three months from now for the francs. 59) If the spot exchange rate of Mexican pesos for U.S. dollars is USD / MXN = 9.8 and the peso

is trading at a forward premium of 3%, then you will receive: A) more than 9.8 pesos per dollar in the future. B) less than 9.8 pesos per dollar in the future. C) 9.83 pesos per dollar in the future. D) 10.09 pesos per dollar in the future. 60) If the spot exchange rate between euros and dollars is EUR / USD = 1.1 before the dollar

depreciates by 10%, how many dollars will it take after the depreciation has occurred to pay an invoice of €500? A) $550 B) $611 C) $500 D) $345 61) The theory that, when measured in a common currency, the price of a product should be the

same in two countries is referred to as the law of: A) exchange rates. B) large numbers. C) spot rates. D) one price.

Version 1

62) If prices in the United States rise less rapidly than in Canada, which of the following would

be expected according to purchasing power parity? A) The value of the Canadian dollar will decline, relative to the U.S. dollar. B) The value of the U.S. dollar will decline, relative to the Canadian dollar. C) Inflation in the U.S. will exceed inflation in Canada. D) The exchange rate will be unaffected by the price changes. 63) If exchange rates adjust to reflect inflation differentials across countries, then: A) the law of one price is wrong. B) spot and forward rates will be equal. C) nominal interest rates will be equal across countries. D) purchasing power parity holds. 64) Suppose that inflation next year is 8% in Japan and 4% in the United States. If the current

spot rate is JPY107 = USD1, what is the expected spot rate at the end of the year? A) USD / JPY = 102.72 B) USD / JPY = 103.04 C) USD / JPY = 111.12 D) USD / JPY = 111.82 65) The pound is expected to appreciate by 2% against the dollar. If the expected inflation rate in

the United States is 5% and purchasing power parity holds, what is the expected inflation rate in the United Kingdom? A) 1.3% B) 2.9% C) 4.1% D) 7.0% 66) Which one of the following is more likely to be roughly equal across countries? A) Nominal interest rates B) Real interest rates C) Inflation rates D) Forward premium 67) The international Fisher effect predicts that differences in nominal interest rates between

countries reflect differences in: A) real rates of interest. B) purchasing power parity. C) the standard of living. D) expected inflation.

Version 1

68) Expected inflation in the United States is 6%. What do you expect to happen to prices in

Japan, if the nominal interest rate is 10% in the United States and 6% in Japan? A) Expected Japanese inflation is 1.79%. B) Expected Japanese inflation is 2.15%. C) Expected Japanese inflation is 6.22%. D) Expected Japanese inflation is 10.00%. 69) Suppose the one-year interest rate in the United States is 7%. What would you expect the

interest rate to be in the UK if expected inflation is 4% in the United States and 8% in the UK? A) 5.19% B) 7.93% C) 9.08% D) 11.12% 70) You exchange USD100,000 into Hong Kong dollars today at USD / HKD = 7.8, earn 7% on

your Hong Kong investment, and exchange back into U.S. dollars at a rate of USD / HKD = 8.0. How much wealthier are you as a result? A) $2,600 B) $4,325 C) $6,000 D) $9,744 71) Which one of the following is advised when evaluating a capital project in a foreign country

if you are concerned about political risk? A) The project should be abandoned until this risk disappears. B) The project's cost of capital rate should be decreased to offset the perceived risk. C) The domestic discount rate should be increased to account for the added risk. D) The project cash flows should be decreased to recognize the possibility of bad outcomes. 72) Current 1-year interest rates are 4% and 8% in the United States and Spain, respectively. The

anticipated inflation in the United States is 2%. If the international Fisher effect holds, what is the expected inflation rate in Spain? A) 4.00% B) 4.04% C) 5.92% D) 6.00%

Version 1

73) If you buy yen forward when the yen is selling at a forward premium, you will get: A) more yen than if you buy yen today on the spot market. B) fewer yen than if you buy yen today on spot market. C) the same number of yen as on the spot market, but with a lower commission. D) the expectation of more yen, but the difference is not locked in. 74) According to the expectations theory of exchange rates, what change is expected in the future

spot exchange rate if the forward rate trades at an 8% discount? A) The spot rate is expected to appreciate by 8%. B) The spot rate is expected to depreciate by 8%. C) The spot rate is expected to depreciate by 4%. D) No change is expected in the spot rate. 75) If interest rates are higher in Italy than in the United States, U.S. investors can earn a higher

expected return by investing in Italian bonds unless the euro is expected to: A) appreciate against the dollar. B) depreciate against the dollar. C) offer a higher real rate of return than the dollar. D) offer a lower real rate of return than the dollar. 76) You are importing TV sets worth ¥10 million from a Japanese manufacturer, and this amount

is payable after 6 months. You can hedge your exchange risk by: A) buying Japanese yen in the forward market. B) selling Japanese yen in the forward market. C) borrowing Japanese yen. D) doing nothing – it is impossible to hedge. 77) Buckingham plc, a British corporation, owes $1 million due in 2 months. How can

Buckingham hedge the exchange risk? A) Sell pounds in the spot market B) Buy pounds in the forward market C) Sell dollars in the spot market D) Buy dollars in the forward market 78) A firm must make a large future payment in a foreign currency and wants to hedge the

associated exchange rate risk. Which one of the following identifies the cost of such a hedge? A) Difference between expected and current spot rates B) Difference between expected and current forward rates C) Difference between the forward premium and the forward discount D) Difference between the forward rate and the expected future spot rate

Version 1

79) An indirect exchange rate can be converted to a direct exchange rate by: A) dividing the indirect rate by the number of U.S. dollars required to purchase one unit

of the other currency. B) dividing the indirect rate by 100. C) multiplying the indirect rate by the spot rate. D) taking the inverse of the indirect rate. 80) Yesterday the spot exchange rate of yen-to-dollar was USD / JPY = 105. What is today's spot

exchange rate if the yen has appreciated 10% against the dollar today? A) USD / JPY = 94.5 B) USD / JPY = 95.5 C) USD / JPY = 116.7 D) USD / JPY = 105 81) Which one of the following is correct when foreign currency is bought in the forward

market? A) A fixed amount is paid when initiating the contract. B) A fixed amount is paid at the end of the contract. C) The amount to be paid is determined and paid at the end of the contract. D) The amount to be paid is determined periodically and paid in installments during the contract. 82) Which one of these is an example of operational hedging? A) Producing goods in a foreign country for sale in the U.S B) Manufacturing goods in the country where they will be sold C) Producing products in one location and distributing them internationally D) Offsetting every spot trade with an opposing forward trade 83) Today, you purchased 125,000 yen 6-months forward at USD / JPY = 130 . The spot rate

today is USD / JPY = 128. If the yen appreciates by 10% over the next six months, how many dollars must you pay to acquire the 125,000 yen? A) $0 B) $961.54 C) $976.56 D) $1,085.07

Version 1

84) Which of the following is correct when contracting ahead in the forward exchange market? A) At contract close you pay either the forward rate that was contracted or the then-

current rate. B) Contracting ahead is always cheaper than waiting to pay spot rates. C) Your cost is locked in from the beginning of the contract, regardless of market changes. D) Paying the spot price is safer than contracting forward. 85) Consider the following spot exchange rates for the British pound, the Japanese yen, the euro

and the Swedish krona: GBP / USD= 1.60, USD / JPY = 105, EUR / USD = 0.625, and USD / SEK = 6.2. If gold sells for $290 per ounce in the United States, which one of the following prices for 1 ounce of gold seems to violate the law of one price? A) £181.25 B) ¥30,450 C) €405 D) kr1,798 86) Assume you can exchange $1 for either C$1.03 or €0.74. How many Canadian dollars can be

acquired with one euro? A) C$0.7622 B) C$1.2900 C) C$1.3919 D) C$0.7184 87) According to the theory of purchasing power parity, exchange rates will adjust to offset

differences in: A) interest rates across countries. B) forward rates across countries. C) expected inflation rates across countries. D) international Fisher rates. 88) If purchasing power parity holds, what is the expected German inflation rate if the U.S.

expected inflation rate is 3%, the spot exchange rate is EUR / USD = 0.667, and the expected spot rate is EUR / USD = 0.625? A) 2.8% B) 7.1% C) 9.9% D) 11.4%

Version 1

89) What would you expect to occur if the expected rate of inflation in the United States is

considerably lower than the expected inflation in Germany? A) The expected spot rate of €/$ will decrease. B) The current spot rate of €/$ will increase. C) The dollar should appreciate against the euro. D) The dollar should depreciate against the euro. 90) What would you expect to be the relationship between real rates of interest in Japan and the

United States if inflation is expected to be 3% in Japan and 6% in the United States? A) Japan's real interest rate should be 3% higher than in the United States. B) Japan's real interest rate should be 3% lower than in the United States. C) Japan's real interest rate should be half as high as in the United States. D) Real interest rates should be equal in both countries. 91) If nominal interest rates are 5% in the United States and 8% in Mexico, you should convert

the expected cash flows on your Mexican project into U.S. dollars: A) by assuming that the Mexican peso will appreciate by about 3% a year. B) by assuming that the Mexican peso will depreciate by 8% a year. C) by assuming that the dollar will appreciate by 5% a year. D) by assuming that the Mexican peso will depreciate by about 3% a year. 92) You can invest in the United States at 6% or invest in an equally risky Australian investment

that offers 20%. This is too good to be true! The current exchange rate is USD / AUD = 1.65. Which one of the following do you suspect about this 1-year investment? A) Expected inflation is higher in the United States. B) The 1-year forward exchange rate is USD / AUD = 1.8679. C) Real interest rates are higher in the United States. D) The Australian dollar is selling forward at an 8.48% premium relative to the dollar. 93) Which one of these is probably the best means of reducing or offsetting political risk? A) Refusing any foreign government assistance in building the infrastructure required for

your foreign operations B) Borrowing money in the country in which you have foreign operations to fund those activities C) Manufacturing a complete product in a foreign country using only resources from that country D) Paying for all foreign operations with cash originating in the home country

Version 1

94) Which one of the following appears to be a safe assumption when there is no difference

between the forward and spot exchange rates between two currencies? A) The countries have equal nominal interest rates. B) The spot rate is expected to change. C) Expected inflation is less than the nominal rate. D) Both currencies are selling at a premium relative to the other. 95) What is the expected spot rate for Japanese yen one year from now if the current spot rate is

USD / JPY = 106 and the yen is selling 1-year forward at USD / JPY = 114? A) USD / JPY = 78.9 B) USD / JPY = 98.0 C) USD / JPY = 106.0 D) USD / JPY = 114.0 96) The international Fisher effect is valid in the long run because: A) inflation rates are equal in different countries. B) investors will move their money into countries with high real interest rates. C) investors will move their money into countries with high nominal interest rates. D) investors will move their money into countries with low inflation. 97) The spot exchange rate for the Canadian dollar is USD / CAD = 1.02. The 6-month interest

rate in the United States is 2.5% and 3.0% in Canada. What is the 6-month forward rate for the Canadian dollar? A) USD / CAD = 1.005 B) USD / CAD = 1.025 C) USD / CAD = 0.985 D) USD / CAD = 1.02 98) One of the drawbacks of using forward contracts to hedge foreign exchange risk from

payables is that the: A) transaction costs in the forward market are high. B) forward rates are always lower than spot rates. C) hedged currency could appreciate during the period. D) hedged currency could depreciate during the period.

Version 1

99) A U.S. firm has a contractual payment of £1 million due in 3 months. Which one of the

following actions would incur exchange rate risk? A) Buy pounds now at the current spot rate. B) Buy pounds in 3 months at the current spot rate. C) Contract forward today to buy pounds in 3 months. D) Buy pounds today in the futures market. 100)

Assume the spot exchange rate for the Swiss franc is USD / CHF = 0.90 and the 1-year forward rate is USD / CHF = 0.871. If the 1-year interest rate in the U.S. is 5%, what is the 1year interest rate in Switzerland? A) 2.00% B) 1.62% C) 1.50% D) 1.33%

101)

What is the cost of hedging a 2 million euro commitment if the spot rate is EUR / USD = 1.60, the forward rate is EUR / USD = 1.55, and the spot rate is not expected to change before payment becomes due? A) $0 B) $25,000 C) $40,323 D) $36,667

102)

The 2-year interest rate is 6.0% in Mexico and 3.0% in the USA. An American company forecasts that a new plant in Mexico will produce cash flow of 1.3 million pesos in year 2. The current spot rate is USD / MXN = 20.0; what is the expected dollar cash flow from the plant in year 2? A) $27.54 million B) $61,373 C) $63,160 D) $1.26 million

103)

You have estimated the cash flows in pesos from a project in Switzerland and also the dollar-based cost of capital for the project. To compute the project NPV in dollars, you now need to compute the: A) current spot rate only. B) opportunity cost of capital measured in terms of the foreign currency. C) implied forward exchange rate for each year in which the project has cash flows. D) actual spot rates for each year in which the project has cash flows.

Version 1

104)

If managers are worried about the political risks involved in an overseas investment, they should probably adjust: A) the discount rate. B) the projected cash flows. C) both the discount rate and the cash flows. D) the exchange rate.

105)

If the direct quote for the euro is EUR / USD = 1.35, then the indirect quote for the euro

is: A) USD / EUR = 0.51. B) USD / EUR = 0.74. C) USD / EUR = 0.68. D) USD / EUR = 0.65. 106)

Assume the current spot price is GBP / USD = 1.32 and the 3-month forward rate is GBP / USD = 1.34. Which one of these statements is correct given these rates? A) The pound is selling at a forward premium relative to the dollar. B) The real interest rate in the U.S. is higher than the real rate in the U.K. C) The dollar is expected to appreciate. D) The dollar is selling at a forward premium relative to the pound.

107)

The spot exchange rate for the British pound is GPB / USD = 1.30. The annual inflation rate in the U.S. is 2% compared with 4% in the U.K. What is the anticipated exchange rate at the end of the year if purchasing power parity is valid? A) GBP / USD = 1.28 B) GBP / USD = 1.39 C) GBP / USD = 1.51 D) GBP / USD = 1.63

108)

The current 1-year nominal interest in the United States is 7%. If the anticipated inflation for the coming year in the United States is 2.5%, what is the real interest rate in the U.S.? A) 4.21% B) 4.39% C) 4.50% D) 7.18%

Version 1

109)

The one-year forward rate is quoted as 115 yen per 1 USD. The spot rate is quoted as 112 yen per 1 USD. What is the one-year interest rate in Japan is the U.S. one-year interest rate is 3.5%? A) 3.50% B) 4.98% C) 6.27% D) 7.85%

110)

You can make a one year $1,000,000 investment in Mexico at an interest rate of 12%. Conversely, you may borrow in the USA at a rate of 4%. If the spot exchange rate is 11 Peso per 1 USD and the one year forward rate is 12 Peso per 1 USD, what profit will you make from such an investment? A) $13,333 profit B) $13,333 loss C) $40,000 profit D) $40,000 loss

Version 1

Answer Key Test name: Ch22 1) FALSE 2) TRUE 3) TRUE 4) TRUE 5) FALSE 6) FALSE 7) FALSE 8) TRUE 9) FALSE 10) TRUE 11) TRUE 12) FALSE 13) FALSE 14) FALSE 15) TRUE 16) FALSE 17) TRUE 18) FALSE 19) FALSE 20) TRUE 21) FALSE 22) TRUE 23) TRUE 24) TRUE 25) FALSE 26) FALSE 27) FALSE 28) A

69,000¥ × ($ ÷ 122¥) = $565.57 29) D

Discount = (¥118 − ¥112) ÷ ¥112 = 0.0536 30) D

₤410 × 1.56 = $639.60 31) C

Version 1

1,048 ÷ 1.60 = $655 32) B

(580 × 1.1) ÷ 0.90 = $709 33) C

Expected spot rate = 110 × [1.08 ÷ 1.04] = 114.23 = USD / JPY 34) B

1.02 = 1.0620 ÷ (1 + UK inflation) → UK inflation = 0.041, or 4.1% 35) C

Inflation in Spain = [1.0830 ÷ (1.0430 ÷ 1.0230)] − 1 = 0.0622, or 6.22% 36) C

£205.00 × 1.60 = $328 ¥34,440 ÷ 105 = $328 €424 × 0.625 = $265.00 violates the law of one price. kr1,817 ÷ 6.2 = $328 37) C

1 + expected German inflation = 1.03 × 0.849 ÷ 0.807= 1.084 38) B

6-month forward rate = 1.16 × (1.03 ÷ 1.025) = USD / CAD = 1.166 39) B

Swiss interest rate = 1.05 × 0.941 ÷ 0.97 − 1 = 0.0186, or 1.86% 40) B

2-year forward rate = 21.3 × (1.06 ÷ 1.03)2raise to the power of 2 = MXN22.559 = USD1 Expected cash flow = $1.43 million ÷ 22.559 = $63,390 41) B

r = 1.0764 ÷ 1.033 − 1 = 0.0420, or 4.20% 42) B

Version 1

Cost of U.S. loan = 1,030,000 × 1.04 = $1,071,200 Value of Mexican investment = ($1,030,000 × 11 × 1.12) ÷ 12 = $1,057,467 Profit = $1,057,467 − $1,071,200 = −$13,733 43) B 44) B 45) B 46) B 47) C 48) A

60,000¥ × ($ ÷ 104¥) = $576.92 49) D

Discount = (¥115 − ¥111) ÷ ¥111 = 0.0360 50) A 51) C

$6.79 × (C$0.98 ÷ $1) = C$6.65 52) C 53) A

Cross-rate = SEK9.3924 = CHF1.5231 CHF / SEK = 6.167 54) A

$1 buys 123.38 yen, which can be converted into 123.38 ÷ 58.00 = 2.127 francs, which in turn buys 2.127 ÷ 1.52 = $1.40. This implies $0.40 arbitrage profit per exchange. 55) A

1-year forward rate = C$1.02 × (1.04 ÷ 1.03) = C$1.0299 56) D

₤350 × 1.50 = $525.00 57) B 58) C

1,000 ÷ 1.6 = $625 59) B 60) B

Version 1

(500 × 1.1) ÷ 0.9 = $611 61) D 62) A 63) D 64) C

Expected spot rate = 107 × [1.08 ÷ 1.04] = 111.12 = USD / JPY 65) B

1.02 = 1.05 ÷ (1 + UK inflation) → UK inflation = 0.029, or 2.9% 66) B 67) D 68) B

1.06 ÷ 1.10 = (1 + Japanese inflation) ÷ 1.06 → Japanese inflation = 0.0215, or 2.15% 69) D

1.07 ÷ 1.04 = (1 + r) ÷ 1.08 → r = 0.1112, or 11.12% 70) B

($100,000 × 7.8 × 1.07 ÷ 8) − $100,000 = $4,325 71) D 72) C

Inflation in Spain = [1.08 ÷ (1.04 ÷ 1.02)] − 1 = 0.0592, or 5.92% 73) B 74) A 75) B 76) A 77) D 78) D 79) D 80) A

Today's spot rate = 105 × 0.9 = 94.5 = USD / JPY 81) B 82) B 83) B

Version 1

Dollar cost = 125,000 ÷ 130 = $961.54 84) C 85) C

£181.25 × 1.60 = $290 ¥30,450 ÷ 105 = $290 €405 × 0.625 = $253.13 violates the law of one price. kr1,798 ÷ 6.2 = $290 86) C

1.03 ÷ 0.74 = C$1.3919 87) C 88) C

1 + expected German inflation = 1.03 × 0.667 ÷ 0.625 = 1.099 89) C 90) D 91) D 92) B

Forward rate = 1.65 × 1.20 ÷ 1.06 → USD / AUD = 1.8679 93) B 94) A 95) D 96) B 97) B

6-month forward rate = 1.02 × (1.03 ÷ 1.025) = USD / CAD = 1.025 98) D 99) B 100) B

Swiss interest rate = 1.05 × 0.871 ÷ 0.9 − 1 = 0.0162, or 1.62% 101)

C Cost of hedge = Cost of buying at forward price − Cost of buying at expected spot price = 2,000,000 ÷ 1.55 − 2,000,000 ÷ 1.60 = $40,323 102)

Version 1

2-year forward rate = 20 × (1.06 ÷ 1.03)2raise to the power of 2 = MXN21.182 = USD1 Expected cash flow = $1.3 million ÷ 21.182 = $61,373 103) 104) 105) 106) 107)

C B B A A Expected exchange rate = 1.30 × 1.02 ÷ 1.04 = 1.28 108)

B r = 1.07 ÷ 1.025 − 1 = 0.0439, or 4.39% 109)

C 1-year Japanese rate = (115 ÷ 112) × 1.035 − 1 = 0.0627 or 6.27% 110)

B Cost of U.S. loan = 1,000,000 × 1.04 = $1,040,000 Value of Mexican investment = ($1,000,000 × 11 × 1.12) ÷ 12 = $1,026,667 Profit = $1,026,667 − $1,040,000 = −$13,333

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) The seller of a put option is betting that the market value of the stock will decrease. ⊚ true ⊚ false 2) The VIX is an estimate of expected future market volatility. ⊚ true ⊚ false 3) A call option is worthless if the underlying stock is worthless. ⊚ true ⊚ false 4) The lower limit on a call option's value is equal to the greater of zero or the exercise price

minus the stock price. ⊚ true ⊚ false 5) A strategy of buying the stock and selling the put is called a protective put. ⊚ true ⊚ false 6) The value of a call option increases as the exercise price decreases. ⊚ true ⊚ false 7) The Financial Accounting Standards Board (FASB) requires that companies recognize the

fact that employee stock options are valuable and therefore are an expense just like salaries and wages. ⊚ true ⊚ false 8) The Financial Accounting Standards Board (FASB) stipulates that companies must use an

option valuation model to estimate the fair value of any option grants and then deduct this value when calculating profits. ⊚ true ⊚ false

Version 1

9) The value of both call and put options increases as the variability of the stock price

decreases. ⊚ true ⊚ false 10) Callable bonds allow the investor to redeem the bond at face value or let the bond remain

outstanding until maturity. ⊚ true ⊚ false 11) Warrants do not expire. ⊚ true ⊚ false 12) Convertible bonds give the investor the option to acquire the firm's stock in exchange for the

value of the underlying bond. ⊚ true ⊚ false 13) Callable bonds give the call option to the issuing firm and hence reduce the value of the

bond. ⊚ true ⊚ false 14) The longer the time until expiration of a call option, the lower the value of the option. ⊚ true ⊚ false 15) Only at the expiration date can an investor expect to find the value of call options above their

lower bound. ⊚ true ⊚ false 16) Stock price volatility is beneficial to option holders. ⊚ true ⊚ false

Version 1

17) Unlike call options, the option to abandon a real asset can never be more valuable as time to

expiration increases. ⊚ true ⊚ false 18) A callable bond gives the issuer a potentially valuable option in the case of changing interest

rates. ⊚ true ⊚ false 19) At expiration a call option will have no value if the stock price is less than exercise price. ⊚ true ⊚ false 20) At expiration a put option will have no value if the stock price is less than the exercise price. ⊚ true ⊚ false 21) A protective put is a way to eliminate the downside risk of holding stock. ⊚ true ⊚ false 22) The value of a call option increases as the exercise price increases. ⊚ true ⊚ false 23) When the stock price is very high compared with the exercise price, the value of the call

option approximates the difference between the stock price and the present value of the exercise price. ⊚ true ⊚ false 24) Warrants are long-term call options on a company's stock issued by an organized stock

exchange. ⊚ true ⊚ false 25) A warrant is a long-term call option that is always "in the money" at the time of issuance. ⊚ true ⊚ false

Version 1

26) A callable bond will have a lower value than a straight bond with the same coupon rate and

maturity. ⊚ true ⊚ false 27) The floor of a convertible bond is the value of the underlying bond. ⊚ true ⊚ false 28) The value of a convertible bond is always less than the value of a straight bond with similar

coupon and maturity. ⊚ true ⊚ false 29) Awarding company executives with warrants as compensation incentivizes them to increase

the value of the company’s stock price. ⊚ true ⊚ false MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 30) What is the option buyer's total profit or loss per share if a call option is purchased for $5, has a $50 exercise price, and the stock is valued at $50 at expiration? A) −$8 B) −$5 C) $6 D) $11 31) An investor purchased a share of stock for $51 and at the same time paid $2 to purchase a put

option on the stock with an exercise price of $40. What is her profit or loss if the stock is worth $30 at expiration? A) $15 B) −$15 C) −$13 D) $13

Version 1

32) A stock is currently selling for $87 per share. What is the lower limit on the value of a call

option with an exercise of $124? A) −$37 B) $0 C) $27 D) $37 33) How much must the stock be worth at expiration in order for the buyer of a call option to

break even if the exercise price is $70 and the cost of the call was $8? A) $62 B) $70 C) $74 D) $78 34) If a $1,000 convertible bond with a market value of $798 has a conversion ratio of 44 when

the firm's stock is selling for $17 per share, then: A) the bond will be converted immediately. B) the bond is violating its price floor. C) conversion now would give the investor a profit of $748. D) the conversion value of the bond is $748. 35) If a $1,000 convertible bond has a conversion ratio of 48 and the firm's equity is currently

selling for $24 per share, then the bond: A) should trade for at least $848. B) should trade for at least $1,000. C) should trade for at least $1,152. D) is essentially worth less. 36) A 10% convertible bond has a conversion ratio of 39. The firm’s common stock is currently

selling at $24. If the bond is about to mature, what is its value? A) $936 B) $1,000 C) $1,064 D) $1,936

Version 1

37) Joe sold a put option on ZZZ Corporation with an exercise price of $41. The option is about

to expire and ZZZ stock is currently trading at $28 per share. What is the value of Joe’s position? A) $13 B) −$13 C) $9 D) $17 38) A 10-year convertible bond has a face value of $1,000, a 9% coupon, and a conversion ratio

of 30. The stock is currently priced at $46. If a comparable straight bond would have a yield of 9%, what is the minimum value of the call option provided by the convertible? A) $0 B) $16 C) $380 D) $76 39) Kingston Lisle shares are currently selling at $68. The value of a call option on the

company’s shares with an exercise price of $60 and several months to expiration is: A) less than $8. B) greater than $8. C) equal to $8. D) zero. 40) You purchased a call option with an exercise price of $50. If you exercise the option when

the stock price is $66, your proceeds will be: A) $16. B) $0. C) $10. D) $22. 41) You purchased a stock for $52 a share, a call option with an exercise price of $51, and a put

option with an exercise price of $50. What will be the value of your position when the options expire if the stock price is $53? A) $55 B) $53 C) $56 D) $2

Version 1

42) You purchased a stock for $57 a share, sold a call option with an exercise price of $54, and

bought a put option with an exercise price of $59. What will be the value of your position when the options expire if the stock price is $62 a share? A) $62 B) $60 C) $70 D) $54 43) You purchased a stock and a put option on the stock with an exercise prices of $49 a share.

What will be the value of your position when the option expires if the stock price is $28 a share? A) $49 B) $28 C) $21 D) $41 44) You pay $5 for a call option with an exercise price of $20. If you exercise the option when

the underlying stock is valued at $43, what is your net profit from the investment? A) $18 B) $5 C) $23 D) $41 45) The writer of a call option hopes that the stock price will: A) decrease. B) increase. C) split. D) produce quarterly cash dividends. 46) Adding warrants as a "sweetener" to bonds will: A) reduce the value of the bond. B) increase the coupon rate of the bond. C) increase the value of the package. D) make the bond riskier.

Version 1

47) If you own a call and a put on a stock with the same exercise price and exercise date, your

payoffs will: A) be positive only if the stock price rises. B) be positive only if the stock price declines. C) always be positive and will increase with the size of the stock price change. D) always be positive but will be larger if the stock price is relatively stable. 48) Which one of the following is true for the owner of a call option? A) The loss potential is unlimited. B) The profit potential is unlimited. C) The option price exceeds the exercise price. D) There is no expiration date, unless the option is a European call. 49) An increase in which one of the following will reduce the value of a call option? A) Interest rate B) Time to expiration C) Volatility of stock price D) Exercise price 50) What is the difference between an American call option and a European call option? A) The European call has a final exercise date. B) The American call trades only on domestic stocks. C) The European call can be exercised only on one day. D) The American call generates profits regardless of which direction the stock moves. 51) What is the option buyer's total profit or loss per share if a call option is purchased for $5,

has a $50 exercise price, and the stock is valued at $53 at expiration? A) −$5 B) −$2 C) $3 D) $8 52) The maximum possible payoff to the owner of a put options is: A) the stock price. B) the exercise price minus the stock price. C) the option’s exercise price. D) there is no maximum.

Version 1

53) Which one of the following option traders receives the price of the option? A) Option sellers B) Option buyers C) Both option sellers and buyers D) Neither buyers nor sellers receive the price 54) Which one of the following is true for an investor who purchased a share of stock for $45 and

purchased a put option on the stock with an exercise price of $45? A) The investor profits when the stock decreases in value. B) The minimum payoff on the position is $45. C) The investor is protected against upside potential. D) Increases in the value of the stock will go to the seller of the put. 55) An investor purchased a share of stock for $42 and at the same time paid $2 to purchase a put

option on the stock with an exercise price of $40. What is her profit or loss if the stock is worth $30 at expiration? A) $6 B) −$6 C) −$4 D) $4 56) Which combination of positions will protect the owner from downside risk? A) Buy the stock and buy a call option B) Sell the stock and buy a call option C) Buy the stock and buy a put option D) Buy the stock and sell a put option 57) If you feel strongly that a stock price will move a lot, but are unsure of the direction, you

could: A) buy both a put and a call. B) sell both a put and a call. C) buy a put and sell a call. D) buy two puts.

Version 1

58) A stock is currently selling for $70 per share. What is the lower limit on the value of a call

option with an exercise of $90? A) −$20 B) $0 C) $10 D) $20 59) Why does the value of a call option increase as the interest rate increases? A) The stock seller must pay the call owner more interest. B) The present value of the exercise price is reduced. C) As interest rates increase, stock prices increase. D) Interest rate increases reduce the option value. 60) Which of the following statements is true of the holder of a call option? A) Option holders pay no income taxes. B) Holders of a call option have restricted profits. C) Option holders do not receive dividends. D) Investors in call options do not have to exercise them and therefore cannot sustain

losses. 61) How much must the stock be worth at expiration in order for the buyer of a call option to

break even if the exercise price is $50 and the cost of the call was $4? A) $46 B) $50 C) $52 D) $54 62) What is the most an investor can lose if he sells a call on the firm's stock with an exercise

price of $100? A) $100 B) $0 C) $50 D) Unlimited losses 63) Which one of the following call options would command the higher price, other things

equal? (All months are within the same calendar year.) A) October expiration, $45 exercise price B) December expiration, $40 exercise price C) March expiration, $45 exercise price D) June expiration, $40 exercise price

Version 1

64) Put-call parity states that: A) price of stock + price of call = price of put + PV(exercise price). B) price of stock + PV(exercise price) = price of call + price of put. C) price of stock + price of put = price of call + PV(exercise price). D) price of stock = price of put + price of call − exercise price. 65) Executive stock options are issued with the hope that the recipients will: A) sell the shares they currently own thereby diversifying the firm's ownership. B) work to increase the value of the firm's stock. C) never exercise them. D) sell their shares at the option's exercise price. 66) The major difference between options on real assets and options on financial assets is that

options on: A) financial assets are costly. B) financial assets have a higher probability of positive payoff. C) real assets are implicit, rather than explicit. D) real assets are not influenced by price volatility. 67) The option to abandon a project investing in real assets can be considered to have an exercise

price equal to the: A) historical cost of the asset. B) resale value of the asset at abandonment. C) foregone revenues anticipated from the project. D) foregone interest on the bonds used to finance the real assets. 68) Investors who hold warrants essentially have a: A) put option on the firm's bonds. B) put option on the firm's equity. C) call option on the firm's bonds. D) call option on the firm's equity. 69) The conversion ratio for a convertible bond equals the: A) number of interest payments that must be received prior to conversion. B) number of bonds necessary to convert into one share of stock. C) number of shares of stock that can be exchanged for one bond. D) floor value beneath which the bond price cannot fall.

Version 1

70) If a $1,000 convertible bond with a market value of $950 has a conversion ratio of 25 when

the firm's stock is selling for $36 per share, then: A) the bond will be converted immediately. B) the bond is violating its price floor. C) conversion now would give the investor a profit of $900. D) the conversion value of the bond is $900. 71) If a $1,000 convertible bond has a conversion ratio of 50 and the firm's equity is currently

selling for $22 per share, then the bond: A) should trade for at least $900. B) should trade for at least $1,000. C) should trade for at least $1,100. D) is essentially worth less. 72) Which one of the following conditions will typically be present when a firm calls a bond

prior to maturity? A) The firm is in poor financial health. B) Interest rates have risen substantially since the bond was issued. C) Interest rates have fallen substantially since the bond was issued. D) The call option is about to expire. 73) The value of a callable bond equals the value of a straight bond: A) plus the value of the bondholder's call option. B) minus the value of the bondholder's call option. C) plus the value of the issuer's call option. D) minus the value of the issuer's call option. 74) A 10% convertible bond has a conversion ratio of 25. The firm’s common stock is currently

selling at $35. If the bond is about to mature, what is its value? A) $875 B) $1,000 C) $1,125 D) $1,875 75) Which one of the following statements is correct? A) A convertible bond will be worth less than a similar non-convertible bond. B) A callable bond will be worth less than a similar non-callable bond. C) A callable bond will be worth more than a similar convertible bond. D) Warrants are always worth more than convertible bonds.

Version 1

76) A put and a call both have the same maturity and both have an exercise price which is equal

to the current stock price. The interest rate is 5%. Which option should sell for a higher price? A) The put B) Both should sell for the same price C) The call D) Can’t say without knowing the variability of the stock 77) Which one of the following is correct for the owner of a June call on XYZ Corporation with

an exercise price of $60? XYZ Corporation currently trades at $55 and the option at $3. A) XYZ stock will go to $63 per share within the option period. B) The option should be exercised now. C) The option owner's current profit is $3 per share. D) The option may expire without value. 78) A professional sports franchise has a generous offer to buy their team, but would first like to

see if they can negotiate a new city-financed stadium before considering the offer. What kind of option would they like to have during the negotiation? A) Abandonment option B) Flexibility option C) Warrant D) Call 79) At what point does the value of a call option lie furthest above its lower bound (that is, the

maximum of zero or the stock price − exercise price)? A) When the stock price is zero. B) When the stock price is very high relative to the exercise price. C) When the stock price equals the exercise price. D) It depends on the maturity of the option. 80) You own a September put on CBA Corporation with an exercise price of $80. CBA stock

currently trades at $80 and the put at $5. Which of the following is unambiguously true? A) The option will continue to gain value until its September expiration. B) The owner should exercise now in order to avoid further losses. C) Decreases in the CBA stock price will be translated directly into additional option value. D) $20 is the maximum value for this option.

Version 1

81) The buyer of a put option has a(n) _________ to sell the underlying asset and the option

seller has a(n) _________ to buy the underlying asset. A) obligation; obligation B) obligation; right C) right; right D) right; obligation 82) Joe sold a put option on ZZZ Corporation with an exercise price of $40. The option is about

to expire and ZZZ stock is currently trading at $28 per share. What is the value of Joe’s position? A) $12 B) −$12 C) $8 D) $16 83) Maria sold a call option on XXX Corporation with an exercise price of $50. The option is

about to expire and XXX stock is currently trading at $40. What is the value of Maria's position? A) −$10 B) $0 C) $7 D) $10 84) The payoffs from investing in an option contract are designed so that: A) both the buyer and the seller of the contract will profit. B) the seller's (buyer's) gain is the buyer's (seller's) loss. C) roughly 20% of sellers and 50% of buyers profit. D) there are no profits but there are also no losses. 85) Under what circumstance will the buyer of a put option need to fulfill her obligation? A) When the stock price has declined below the exercise price. B) When the stock price has increased above the exercise price. C) The put buyer has an equal obligation regardless of the relationship between stock

and exercise prices. D) The put buyer has no obligation.

Version 1

86) Which one of the following statements is correct for an investor who has purchased portfolio

insurance by owning a stock and buying a put option on that stock? A) The investor profits when the stock price declines. B) Maximum profitability occurs when the stock price equals the exercise price. C) The value of the position can decline no further than the option’s exercise price. D) The option will certainly be exercised. 87) A call option will have the highest value when the stock price is: A) far above the exercise price. B) closest to the exercise price. C) approaching zero. D) less than the exercise price. 88) When does a change in the value of a call option come closest to matching the change in the

price of the stock? A) When the stock is priced far above the exercise price. B) When the stock is priced far below the exercise price. C) When the stock is priced near zero. D) Changes in call value always come close to matching changes in stock price. 89) At what point is the dollar payoff from owning a call option on a stock greater than the

payoff from owning the stock itself? A) When stock price exceeds exercise price at expiration. B) When exercise price exceeds stock price at expiration. C) When stock price equals exercise price at expiration. D) Call payoff never exceeds stock payoff. 90) What is the lower bound on the value of a put option? A) Maximum of zero or (exercise price − stock price) B) Maximum of zero or (stock price − exercise price) C) Stock price − exercise price D) Exercise price − stock price 91) The value of a call option increases as the time to expiration increases because the: A) exercise price continually decreases. B) opportunity increases for the stock price to exceed the exercise price. C) dividends accumulate while waiting to be paid. D) option can be repeatedly exercised.

Version 1

92) Stocks that have more volatile price changes have more valuable call options because call

holders: A) capture upside potential without additional downside risk. B) realize that volatility decreases the present value of the exercise price. C) have too little variability in the exercise price. D) have transferred all risk to put holders. 93) Of the following four put options that can be purchased on a stock, which would you expect

to have the highest price? (All option months are in the same calendar year.) A) September put; $65 exercise price B) September put; $75 exercise price C) December put; $65 exercise price D) December put; $75 exercise price 94) A share of stock is currently priced at $20 and will change with equal likelihood to either $40

or $10. A call option with a $20 exercise price is available on the stock. The interest rate is zero. Which of the following positions will provide (approximately) the same payoffs as the option? A) Buy 0.667 shares and lend $6.67 B) Buy 0.667 shares and borrow $6.67 C) Buy 0.5 shares D) Sell 0.667 shares and borrow $0.667 95) Which of the following is not a real option? A) If tanker rates fall, the company can lay off its fleet. B) The extra warehouse space allows the company to expand. C) The company replaces an aging machine tool. D) If oil prices rise, the company can switch to using gas. 96) Real options are: A) options on real assets such as an option to abandon. B) call and put options traded on organized exchanges. C) call options such as warrants and convertible bonds. D) put options such as those held by shareholders of a firm with financial leverage. 97) Corporations that attach warrants to their bonds are hoping to: A) repurchase shares of outstanding stock. B) convert the bonds into stock at a later date. C) increase the value of the bonds. D) increase the price of their shares.

Version 1

98) If a convertible bond can be thought of as a straight bond with a call option, then the call is

owned by the _________, and the exercise price is the _________. A) debt issuer; stock price B) debt issuer; straight bond value C) bond investor; stock price D) bond investor; straight bond value 99) Why should a convertible bond always be valued at more than its bond value or its

conversion value up until maturity? A) The bond holder is receiving higher interest rates. B) The holder can decide later whether to own the bond or the stock. C) The conversion ratio may be decreased. D) The bond does not have to be given up to exercise the option. 100)

A 10-year convertible bond has a face value of $1,000, a 9% coupon, and a conversion ratio of 30. The stock is currently priced at $35. If a comparable straight bond would have a yield of 9%, what is the minimum value of the call option provided by the convertible? A) $0 B) $5 C) $50 D) $65

101)

Which one of the following is correct? A) There is an upper bound on a callable bond's price. B) Callable bond prices are higher than those of comparable straight bonds. C) The attraction of callable bonds to the issuer increases as interest rates increase. D) The investor in a callable bond owns the call option.

102)

The value of a call option at expiration will be equal to the maximum of zero or the: A) stock price. B) exercise price. C) stock price minus the exercise price. D) exercise price minus the stock price.

103)

Kingston Lisle shares are currently selling at $75. The value of a call option on the company’s shares with an exercise price of $60 and several months to expiration is: A) less than $15. B) greater than $15. C) equal to $15. D) zero.

Version 1

104)

You purchased a call option with an exercise price of $50. If you exercise the option when the stock price is $60, your proceeds will be: A) $10. B) $0. C) $4. D) $16.

105)

Three months ago you bought a put option with an exercise price of $100. What is the value of this option at expiration if the stock price is $110? A) $10 B) −$110 C) $0 D) −$10

106)

A firm is planning to issue a callable bond with a coupon rate of 8% and 10 years to maturity. A straight bond with a similar coupon is priced at $1,000. If the value of the issuer's call option is $60, what is the value of the callable bond? A) $940 B) $970 C) $1,000 D) $1,060

107)

A stock is selling for $85 at the expiration of an option contract. Which of the following options on the stock will most likely be exercised? A) Call option with exercise price of $65 B) Put option with exercise price of $65 C) Call option with exercise price of $85 D) Put option with exercise price of $85

108)

Which one of the following changes will reduce the value of a call option? A) An increase in the stock price B) An increase in the exercise price C) An increase in the volatility of the stock price D) An increase in interest rates

109)

An investor who sells a put option profits if: A) stock prices go up. B) stock prices go down. C) the put is exercised. D) interest rates go up.

Version 1

110)

A call option has an exercise price of $60. When the option expires, the price of the stock is exactly $60. What is the value of your call option? A) $1 B) −$1 C) Zero D) $60

111)

The value of a put at expiration is defined as the: A) minimum of zero or (stock price − exercise price). B) minimum of zero or (exercise price − stock price). C) maximum of zero or (stock price − exercise price). D) maximum of zero or (exercise price − stock price).

112)

You purchased a stock for $36 a share, a call option with an exercise price of $35, and a put option with an exercise price of $34. What will be the value of your position when the options expire if the stock price is $37? A) $39 B) $37 C) $40 D) $2

113)

You purchased a stock for $43 a share, sold a call option with an exercise price of $40, and bought a put option with an exercise price of $45. What will be the value of your position when the options expire if the stock price is $48 a share? A) $48 B) $46 C) $56 D) $40

114)

You purchased a stock and a put option on the stock with an exercise prices of $40 a share. What will be the value of your position when the option expires if the stock price is $28 a share? A) $40 B) $28 C) $12 D) $32

Version 1

115)

If you sell a put option, your maximum payoff is equal to: A) the maximum of zero or the stock price − the exercise price. B) the maximum of the exercise price − the stock price or zero. C) zero. D) the exercise price.

116)

You pay $4 for a call option with an exercise price of $20. If you exercise the option when the underlying stock is valued at $26, what is your net profit from the investment? A) $2 B) $4 C) $6 D) $8

117)

A put option with 70 days until expiration has an exercise price of $30 and the underlying stock currently trades at a price of $27. Which of the following is the most likely option price? A) $1.00 B) $2.00 C) $3.00 D) $4.00

Version 1

Answer Key Test name: Ch23 1) FALSE 2) TRUE 3) TRUE 4) FALSE 5) FALSE 6) TRUE 7) TRUE 8) TRUE 9) FALSE 10) FALSE 11) FALSE 12) TRUE 13) TRUE 14) FALSE 15) FALSE 16) TRUE 17) FALSE 18) TRUE 19) TRUE 20) FALSE 21) TRUE 22) FALSE 23) TRUE 24) FALSE 25) FALSE 26) TRUE 27) TRUE 28) FALSE 29) TRUE 30) B

$50 − 5 − 50 = −$5 31) C

$40 − 51 − 2 = −$13 32) B

Version 1

Lower limit on call = max[0,(stock price − exercise price)] = max[0,($87 − 124)] = $0 33) D

Break even = $70 + 8 = $78 34) D

Conversion value = 44 × $17 = $748 35) C

Conversion value = 48 × $24 = $1,152 36) B

Conversion value = 39 × $24 = $936. Investors will prefer to let the bond mature and receive $1,000. 37) B

Value of Joe’s Position = $28 − $41 = −$13 38) C

Bond value = $1,000 because coupon rate = market rate Conversion value = 30 × $46 = $1,380 Value of call = $1,380 − 1,000 = $380 39) B 40) A

$66 − $50 = $16 proceeds 41) A

Stock value = $53 Call value = $2 Put value = $0 Total = $53 + $2 + $0 = $55 42) D

Stock value = $62 Call position = −$8 Put position = $0 Total = $62 − $8 + $0 = $54 43) A

Version 1

Stock value = $28 Put position = $21 Total = $28 + $21 = $49 44) A

Gross profit = $43 − 20 = $23 Net profit = $23 − 5 = $18 45) A 46) C 47) C 48) B 49) D 50) C 51) B

$53 − 5 − 50 = −$2 52) C 53) A 54) B 55) C

$40 − 42 − 2 = −$4 56) C 57) A 58) B

Lower limit on call = max[0,(stock price − exercise price)] = max[0,($70 − 90)] = $0 59) B 60) C 61) D

Break even = $50 + 4 = $54 62) D 63) B 64) C 65) B 66) C 67) B 68) D

Version 1

69) C 70) D

Conversion value = 25 × $36 = $900 71) C

Conversion value = 50 × $22 = $1,100 72) C 73) D 74) B

Conversion value = 25 × $35 = $875. Investors will prefer to let the bond mature and receive $1,000. 75) B 76) C

From put-call parity: C = Stock Price + P − PV (Exercise Price) If the Exercise Price = Stock Price, then PV (Exercise Price) < Stock Price (time value of money). → Price of the Call > Price of Put. 77) D 78) A 79) B 80) C 81) D 82) B

Value of Joe’s Position = $28 − $40 = −$12 83) B 84) B 85) D 86) C 87) A 88) A 89) D 90) A 91) B 92) A 93) D

Version 1

94) B

If share price falls to $10, option is worth $0 and position in share is worth $6.67 − $6.67 = $0 If share price rises to $40, option is worth $20 and position in share is worth 0.667 × $40 − $6.67 = $20 95) C 96) A 97) C 98) D 99) B 100) C

Bond value = $1,000 because coupon rate = market rate Conversion value = 30 × $35 = $1,050 Value of call = $1,050 − 1,000 = $50 101) 102) 103) 104)

A C B A $60 − $50 = $10 proceeds 105)

C Stock price is greater than exercise price, so the put option has zero value. 106)

A Value of Callable Bond = $1,000 - $60 = $940 107) 108) 109) 110) 111) 112)

A B A C D A Stock value = $37 Call value = $2 Put value = $0 Total = $37 + $2 + $0 = $39 113)

Version 1

Stock value = $48 Call position = −$8 Put position = $0 Total = $48 − $8 + $0 = $40 114)

A Stock value = $28 Put position = $12 Total = $28 + $12 = $40 115) 116)

C A Gross profit = $26 − 20 = $6 Net profit = $6 − 4 = $2 117)

D With significant time to expire, an in-the-money put option will have value greater than the difference between exercise price and stock price.

Version 1

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false. 1) The majority of large companies use derivatives in some way to manage their risk. ⊚ true ⊚ false 2) Insurance is often an effective way to reduce risk when the insurance company can spread its

risk over many different policies. ⊚ true ⊚ false 3) A swap is an arrangement by two counterparties to exchange one stream of cash flows for

another. ⊚ true ⊚ false 4) A company that hedges simply passes the risk on to someone else. ⊚ true ⊚ false 5) Unless the corporation has reason to believe that the odds are stacked in its favor, it should

use derivatives for speculation, not for hedging. ⊚ true ⊚ false 6) Futures contracts are custom-tailored forward contracts. ⊚ true ⊚ false 7) Properly managed, hedging can be a very profitable activity. ⊚ true ⊚ false 8) Firms use options to speculate not to reduce risk. ⊚ true ⊚ false

Version 1

9) Mexico purchased call options to lock in the price of its oil and create a base floor for its

revenue stream. ⊚ true ⊚ false 10) A firm might enter a swap contract whereby it agrees to make a series of regular payments in

one currency in return for receiving a series of payments in another currency. ⊚ true ⊚ false 11) Swap contracts can be based on either interest rates or currencies. ⊚ true ⊚ false 12) A commodity producer can place a floor on its revenues by selling put options on the

commodity. ⊚ true ⊚ false 13) A producer that uses options to reduce downside risk is buying a "protective put." ⊚ true ⊚ false 14) A commodity producer that uses put options to reduce the risk of a fall in commodity prices

is effectively buying insurance. ⊚ true ⊚ false 15) An oil producer would sell, rather than buy, crude oil futures to protect against falling oil

prices. ⊚ true ⊚ false 16) Futures contracts are standardized to expire on the same day each year. ⊚ true ⊚ false 17) Buyers of financial futures place an order to buy a financial asset at a future date. ⊚ true ⊚ false

Version 1

18) Speculators are a necessary component of well-functioning futures markets. ⊚ true ⊚ false 19) Forward contracts are marked to market. ⊚ true ⊚ false 20) In a typical interest rate swap the two parties will exchange a series of fixed payments for a

series of payments that are linked to the level of interest rates. ⊚ true ⊚ false 21) Hedging may increase a company’s debt capacity. ⊚ true ⊚ false 22) By using options a firm can (at a cost) protect against increases in raw material prices, while

continuing to benefit from price decreases. ⊚ true ⊚ false 23) Unlike options, the purchase of a futures contract is a binding obligation to purchase at a

fixed price at contract maturity. ⊚ true ⊚ false 24) The profit to the buyer of a futures contract is equal to the initial futures price minus the

ultimate market price. ⊚ true ⊚ false 25) Investors can hedge against a change in house prices by purchasing real estate futures

contracts. ⊚ true ⊚ false

Version 1

26) Exchange traded futures contracts allow the seller to choose the place of delivery for the

commodity. ⊚ true ⊚ false 27) Both the seller and the buyer in a futures contract are required to put up margin. ⊚ true ⊚ false 28) A farmer can avoid delivery on a futures contract by buying an offsetting futures contract. ⊚ true ⊚ false 29) Companies should always leave investors to hedge for themselves. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 30) A milling company buys a futures contract that requires it to take delivery of 5,000 bushels of wheat at a price of $7.20 per bushel. The next day, the price of the future is $7.34. The miller: A) must pay an extra $0.14 a bushel into its margin account. B) can withdraw $0.14 from its margin account. C) does not need to do anything until the contract matures. D) can’t say without knowing what happened to the spot price. 31) Yesterday you sold six-month futures on the S&P index at a price of 2,112. Today the index

closed at 2,050 and the future at 2,164. You get a call from your broker. He is: A) asking you to pay $52 times the contract size into your margin account. B) asking you to pay $62 times the contract size into your margin account. C) telling you that you can withdraw $52 times the contract size from your margin account. D) telling you that you can withdraw $62 times the contract size from your margin account.

Version 1

32) A futures contract calls for delivery of 69,000 pounds of soybean oil. What happens to the

seller of a soybean oil futures contract at 41 cents per pound if the futures price closes the next day at 42 cents per pound? A) The contract is marked to market with a $690 loss. B) The contract is marked to market with a $690 gain. C) Futures contracts are voided if the price increases prior to expiration. D) Nothing happens until the expiration of the contract. 33) ABC Corporation borrows $6.8 million at 10% from a bank and swaps this loan for a 12%

yen loan. The spot exchange rate is JPY105 = USD1. How much does ABC pay annually to the bank? A) ¥1.69 million only B) ¥7.87 million only C) ¥75.18 million D) ¥85.68 million only 34) Hershey's Chocolate is concerned about cocoa prices, which are currently $3,090 a ton.

Analysts project that the cost of cocoa purchases could vary from $2,990 to $3,190 a ton. A September call option can be purchased with a $3,040 exercise price for $190. What is Hershey's worst-case scenario if it purchases these options? A) Cocoa prices will rise to $3,100 and Hershey is protected only to a price of $3,040. B) Cocoa prices will not change from their current level and Hershey will have wasted the cost of the option. C) Cocoa prices will not rise above Hershey's break-even price of $3,185, which equals the sum of the exercise price plus the cost of the option. D) Cocoa prices will fall below $3,040 and Hershey will lose the $190 cost of the option. 35) A gasoline distributor buys a gasoline futures contract to receive 49,000 gallons of gasoline

at $3.01 per gallon. How is the account marked to market if gasoline futures close the next day at $3.04? A) A loss of $1,470 is posted to the account. B) A gain of $1,470 is posted to the account. C) A loss of $14,700 is posted to the account. D) A gain of $14,700 is posted to the account.

Version 1

36) The seller of a pork bellies futures contract at $1.54 per pound noted that the closing price of

pork bellies was $1.57 today. What will happen to this contract, which requires delivery of 53,000 pounds of pork bellies at expiration? A) A loss of $530 is posted to the account. B) A gain of $530 is posted to the account. C) A loss of $1,590 is posted to the account. D) A gain of $1,590 is posted to the account. 37) The seller of a copper futures contract noticed that his account was marked with a gain of

$532 yesterday. If the standardized contract requires delivery of 26,600 pounds of copper, what happened that day to the price of copper? A) The price closed down $0.02 per pound. B) The price closed up $0.02 per pound. C) The price closed down $0.20 per pound. D) The price closed up $0.20 per pound. 38) On $10 million of loans, Firm A is paying a fixed $808,000 in interest payments while Firm

B is paying LIBOR plus 50 basis points. The current LIBOR rate is 7.15 percent. Firms A and B have agreed to swap interest payments. How much will be paid to which firm this year? A) A pays $858,000 to Firm B. B) B pays $43,000 to Firm A. C) B pays $50,000 to Firm A. D) A pays $43,000 to Firm B. 39) A farmer hedged his risk by buying put options on wheat with an exercise price of $7.60 at a

price of $0.14 per bushel. If the price of wheat at the expiration of the contract is $7.60, what is the net revenue from each bushel of wheat? A) $7.46 B) $7.53 C) $7.60 D) $7.74 40) Big Corporation borrows $2.2 million at a fixed rate of 7% from a bank and swaps this loan

for a SOFR + 1% loan. SOFR is at 2%. How much will the company receive from the bank at the annual settlement of the swap? A) $154,000 B) $88,000 C) $66,000 D) $44,000

Version 1

41) The derivatives market is characterized by: A) shrinking activity. B) the introduction of new contracts. C) low turnover. D) regular IPOs. 42) A bond investor who is worried about future fluctuations in interest rates could: A) enter into a swap to pay both a fixed and a floating rate. B) enter into a swap to pay a fixed rate and receive a floating rate. C) enter into a swap to pay a floating rate and pay a fixed rate. D) enter into a swap to receive both a fixed and a floating rate. 43) Which one of the following is not generally considered a benefit of hedging? A) Hedging reduces business risk. B) Hedging allows prices to be locked in ahead of time. C) Hedging can be very profitable. D) Hedging can stabilize profits. 44) Which one of the following futures contracts is written on an asset that cannot be delivered? A) U.S. Treasury bills B) Wheat C) Standard and Poor's index D) British pounds 45) How might a firm such as General Mills protect itself against fluctuations in raw material

prices for breakfast cereals? A) Buy commodity futures B) Sell commodity futures C) Buy put options on commodities D) Sell put options on commodities 46) The buyer of a credit default swap: A) gains protection against a fall in house prices. B) gains protection against default by a pension scheme. C) insures the seller against a fall in house prices. D) gains insurance against default on a bond.

Version 1

47) What form of insurance would you suggest for a producer that wishes to be protected from

future price decreases but wants to benefit from any future price increases? A) Buy a call option on the asset B) Sell a call option on the asset C) Buy a put option on the asset D) Sell a put option on the asset 48) Which one of the following is not correct concerning futures contracts? A) Futures contracts entail an obligation rather than an option. B) The contract price is set at the beginning of the contract. C) The contracts are exchange-traded. D) Gains and losses are not settled until the contract expires. 49) Selling a futures contract may be appropriate for someone who wishes to: A) lock in a future sales price. B) lock in a future purchase price. C) speculate that future spot prices are going up. D) have a ready market in which to sell a product. 50) A speculator who buys a futures contract is betting that prices will _____________ by the

expiration of the contract. A) decrease B) increase C) remain constant D) guarantee high profits 51) A speculator who sells a futures contract is betting that prices will _____________ by the

expiration of the contract. A) decrease B) increase C) remain constant D) be unusually volatile 52) What happens to the price of a futures contract as expiration draws closer? A) The futures price exceeds the spot price of the asset. B) The futures price is exceeded by the spot price of the asset. C) The futures price approaches the spot price of the asset. D) There is no relationship between the futures price and spot price as the contract

approaches expiration.

Version 1

53) When a commodity futures reaches its expiration, the seller usually: A) delivers the commodity to the futures buyer. B) delivers the commodity to the futures exchange. C) takes an offsetting futures position and settles in cash. D) adds the profit or loss to his margin account and continues to trade. 54) A commodity producer who is worried about future prices can best hedge by: A) buying a futures contract. B) selling a futures contract. C) buying a call option. D) selling a call option. 55) A farmer sells corn futures for March delivery at $7.50 per bushel. In March the spot price of

corn is $7.20 per bushel. Which of the following is correct? A) The farmer would have been better off without the futures contract. B) The futures buyer is required to deliver corn to the farmer at $7.20. C) The farmer will receive $7.35 per bushel which is the average of the spot and futures prices. D) The farmer has locked in an effective price of $7.50 per bushel. 56) A milling company buys a futures contract that requires it to take delivery of 5,000 bushels

of wheat at a price of $6.80 per bushel. At expiration the spot price of wheat is $6.68 per bushel. The miller: A) has saved $0.12 per bushel through hedging. B) has locked in an effective price of $6.80 per bushel. C) can choose not to take delivery since the price declined. D) has locked in an effective price of $6.68 per bushel. 57) A milling company buys a futures contract that requires it to take delivery of 5,000 bushels

of wheat at a price of $6.75 per bushel. The next day, the price of the future is $6.80. The miller: A) must pay an extra $0.05 a bushel into its margin account. B) can withdraw $0.05 from its margin account. C) does not need to do anything until the contract matures. D) can’t say without knowing what happened to the spot price.

Version 1

58) Yesterday you sold six-month futures on the S&P index at a price of 2,100. Today the index

closed at 2,050 and the future at 2,140. You get a call from your broker. He is: A) asking you to pay $40 times the contract size into your margin account. B) asking you to pay $50 times the contract size into your margin account. C) telling you that you can withdraw $40 times the contract size from your margin account. D) telling you that you can withdraw $50 times the contract size from your margin account. 59) Which one of the following would not be regulated in a standardized futures contract? A) Quantity of asset to be traded B) Quality of asset to be traded C) The spot price D) Date of settlement 60) The purpose of a margin account for a futures contract is to: A) guarantee a minimum margin of profit for the contract holder. B) allow futures traders to have more than one contract simultaneously. C) provide a cushion for the exchange against defaults on the contract. D) hold interest payments until expiration. 61) The process of marking a futures contract to market means that: A) the profitability of the contract is locked in from the onset of the contract. B) the amount of commodity to be delivered changes as prices change. C) contracts are closed out as soon as they become unprofitable. D) profits or losses are settled daily. 62) A futures contract calls for delivery of 60,000 pounds of soybean oil. What happens to the

seller of a soybean oil futures contract at 41 cents per pound if the futures price closes the next day at 42 cents per pound? A) The contract is marked to market with a $600 loss. B) The contract is marked to market with a $600 gain. C) Futures contracts are voided if the price increases prior to expiration. D) Nothing happens until the expiration of the contract.

Version 1

63) A futures contract seller is obligated to deliver 5,000 bushels of soybeans for $12.00 per

bushel at expiration. If soybean futures close at $12.10 the next day, the seller: A) has a loss of $500 thus far on the contract. B) has a profit of $500 thus far on the contract. C) has no profit or loss, but is still obligated to deliver 5,000 bushels at $12.00. D) will receive a check for $500 from the buyer of the contract. 64) What has happened to cause a $250 loss to be marked to the margin account of a futures

contract buyer? A) The commodity futures price decreased on that day. B) The commodity futures price increased on that day. C) The commodity spot price decreased on that day. D) The commodity spot price increased on that day. 65) The effect of marking a futures contract to market is similar to: A) doubling the total payments by the contract buyer. B) doubling the total payments by the contract seller. C) closing the current position and opening a new position daily. D) imposing a daily fee on both buyers and sellers. 66) The primary purpose of financial futures is to: A) benefit from increases in interest rates. B) protect against swings in interest rates or prices of financial assets. C) translate one currency into another. D) guarantee the repayment of loan principal. 67) The basic difference between speculators and hedgers in futures contracts is that speculators: A) will profit regardless of the direction of price change. B) do not have an offsetting position in the underlying commodity. C) are concerned only with long-term price movements. D) take a position in more than one commodity at a time. 68) If there is an excess of market participants who want to buy the futures as a hedge, then: A) speculators will come into the market to sell the futures. B) speculators will see a potential profit from also buying the futures. C) speculators will steer clear of the futures market. D) the market may have to close down until there is a balance of supply and demand.

Version 1

69) Which one of the following is not correct concerning forward contracts? Forward contracts: A) are not standardized. B) do not set the price until the end of the contract. C) are not traded on organized exchanges. D) are not marked to market daily. 70) You enter into a forward contract to take delivery of 1 million euros 3 months from now.

What happens to the price you will pay at expiration if the euro depreciates during the contract period? A) Your price will increase. B) Your price will decrease. C) Your price was fixed at the onset of the contract. D) Your price was fixed but you will receive correspondingly more euros due to the depreciation. 71) Which one of the following is a reason for firms to engage in currency swaps? A) They will be required to repay only the interest. B) They can obtain more favorable terms by borrowing in a different currency. C) The debt will not show on their balance sheets. D) You can borrow in the currency with the lowest interest rate without taking on any

currency risk. 72) When two borrowers engage in a currency swap, they agree to: A) a one-time currency exchange equal to the principal amount borrowed. B) make payments to each other in a different currency. C) pay to each other any depreciation or appreciation of the currency. D) exchange fixed-rate interest payments for variable-rate interest payments. 73) In an interest rate swap, borrowers typically exchange fixed-rate payments in one currency

for: A) fixed-rate payments in another currency. B) variable-rate payments in another currency. C) fixed-rate payments in the same currency. D) variable-rate payments in the same currency.

Version 1

74) ABC Corporation borrows $5 million at 10% from a bank and swaps this loan for a 12% yen

loan. The spot exchange rate is JPY105 = USD1. How much does ABC pay annually to the bank? A) ¥1.26 million only B) ¥5.71 million only C) ¥52.50 million D) ¥63.00 million only 75) Which of the following statements is correct? A) Futures contracts and options contracts are economically similar, but vary in how

they are traded. B) Forward contracts and futures contracts are economically similar, but vary in how they are traded. C) Forward contracts and options contracts are economically similar, but vary in how they are traded. D) Forward contracts, futures contracts, and options contracts are all economically similar, but vary in how they are traded. 76) The term derivatives refers to: A) forwards and futures. B) swaps and options. C) forwards, futures, swaps, and options. D) forwards, futures, and swaps. 77) A derivatives contract: A) increases the risk of both the hedger and speculator. B) increases the risk of the hedger and decreases the risk of the speculator. C) reduces the risk of the hedger and increases the risk of the speculator. D) reduces risk in both cases.

Version 1

78) Hershey's Chocolate is concerned about cocoa prices, which are currently $3,000 a ton.

Analysts project that the cost of cocoa purchases could vary from $2,900 to $3,100 a ton. A September call option can be purchased with a $2,950 exercise price for $145. What is Hershey's worst-case scenario if it purchases these options? A) Cocoa prices will rise to $3,100 and Hershey is protected only to a price of $2,950. B) Cocoa prices will not change from their current level and Hershey will have wasted the cost of the option. C) Cocoa prices will not rise above Hershey's break-even price of $3,095, which equals the sum of the exercise price plus the cost of the option. D) Cocoa prices will fall below $2,950 and Hershey will lose the $145 cost of the option. 79) If you buy a forward contract, you agree to buy the product: A) at a later date at a price to be set in the future. B) today at its current price. C) at a later date at a price set today. D) if and only if its price rises above its exercise price. 80) If you sell a forward contract, you agree to: A) deliver a product at a later date for a price set today. B) receive a product at a later date at the price on that later date. C) receive a product at a later date for a price set today. D) deliver a product at a later date for a price set on that later date. 81) One distinguishing difference between the buyer of a futures contract and the buyer of an

option contract is that the futures buyer: A) pays a much higher up-front price than option buyers. B) has an obligation to purchase, not a choice. C) can lose no more than the initial outlay. D) has increased rather than reduced risk. 82) In general, when deciding whether one needs to buy or sell futures contracts in order to

hedge, the rule could be: A) buy futures if you have the underlying asset and sell futures if you need the underlying asset. B) sell futures if you have the underlying asset and buy futures if you need the underlying asset. C) buy futures if you want to speculate, sell futures if you want to hedge. D) buy futures if you are willing to have unlimited risk, sell futures if you want capped risk.

Version 1

83) As time draws closer to contract expiration, futures prices can be expected to: A) increase as the demand for delivery intensifies. B) decrease as speculators resolve the uncertainty of prices. C) move similarly to broad-based market indices, such as the S&P 500. D) converge upon the spot price. 84) Why are most futures contracts not settled through delivery of the product? A) Most contracts are settled through the margin account. B) Most contracts expire with neither party having an obligation to the other party. C) Most participants cancel their futures contracts through purchase of an option

contract. D) It is easier and cheaper to settle in cash or by an offsetting futures transaction. 85) The price for immediate delivery of a product is called the: A) spot price. B) exercise price. C) forward price. D) the impact price. 86) If you enter into an interest rate swap, the company taking the opposite side is called the: A) swap payer. B) swap counterparty. C) swap maker. D) off-taker. 87) A gasoline distributor buys a gasoline futures contract to receive 42,000 gallons of gasoline

at $2.94 per gallon. How is the account marked to market if gasoline futures close the next day at $2.97? A) A loss of $1,260 is posted to the account. B) A gain of $1,260 is posted to the account. C) A loss of $12,600 is posted to the account. D) A gain of $12,600 is posted to the account. 88) The seller of a pork bellies futures contract at $1.41 per pound noted that the closing price of

pork bellies was $1.44 today. What will happen to this contract, which requires delivery of 40,000 pounds of pork bellies at expiration? A) A loss of $400 is posted to the account. B) A gain of $400 is posted to the account. C) A loss of $1,200 is posted to the account. D) A gain of $1,200 is posted to the account.

Version 1

89) The typical sequence of cash flows in a futures contract is: A) purchase price plus a margin account up-front, differences are settled at expiration. B) margin account up-front, differences are posted daily and settled in cash if margin

drops too low. C) margin account up-front, all differences settled at expiration. D) all funds are paid at expiration of the contract. 90) The seller of a copper futures contract noticed that his account was marked with a $500 gain

yesterday. If the standardized contract requires delivery of 25,000 pounds of copper, what happened that day to the price of copper? A) The price closed down $0.02 per pound. B) The price closed up $0.02 per pound. C) The price closed down $0.20 per pound. D) The price closed up $0.20 per pound. 91) Which of the following contracts is not a financial future? A) Eurodollar deposit futures B) Yen futures C) Orange juice futures D) Standard & Poor’s futures 92) Which one of the following is not true of the financial futures markets? A) Financial futures trade on the Chicago Mercantile Exchange. B) When many financial future mature, the seller cannot deliver the asset to the buyer. C) A major use of financial futures is protection from interest rate risk. D) Trading in financial futures is significantly less risky than trading in commodity

futures. 93) A clothes producer hedges its future cotton purchases by buying cotton futures. The futures

contract provides the producer with 50,000 pounds of cotton at a price of $0.80 per pound. By contract expiration the producer finds that cotton prices have declined to $0.73 per pound. As a result of the futures contracts, the producer will: A) lose $3,500 per contract in the futures market which offsets gains in the cash market. B) gain $3,500 per contract in the futures market which offsets losses in the cash market. C) lose $3,500 per contract in the futures market and suffer an opportunity cost in the cash market. D) gain $3,500 per contract in the futures market and gain $0.07 per pound in the cash market.

Version 1

94) Which one of the following futures contract holders is speculating? A) A wheat farmer who sells wheat futures B) A cattle rancher who buys live cattle futures C) A candy maker who buys sugar futures D) An oil producer who sells crude oil futures 95) The activities of speculators are necessary in the futures markets in order to: A) prevent hedgers from trading options. B) provide a continual stream of profit to hedgers. C) help ensure futures prices are fair value. D) understand the direction of future price changes. 96) Those who invest in derivative instruments that increase rather than reduce risk are known

as: A) option traders. B) futures traders. C) hedgers. D) speculators. 97) Which one of the following characteristics is similar in both futures and forward contracts? A) Future transactions are conducted at a price agreed upon earlier. B) Contracts are sold through organized exchanges. C) Contract terms are standardized by type of commodity. D) Price changes are settled daily in a process known as mark-to-market. 98) A contract to buy Japanese yen three months forward at a price of ¥105/$ will: A) insulate the buyer from changes in interest rates. B) protect the buyer from changes in exchange rates. C) lock in a profit based on current exchange rates. D) require delivery of the yen at the Nasdaq Exchange. 99) Zeta Corporation wishes to obtain a loan denominated in Swiss francs but the U.S. market

offers better credit terms. What should Zeta do? A) Borrow francs in Switzerland, exchange for dollars, and arrange a currency swap. B) Borrow francs in Switzerland, exchange for dollars, and arrange an interest rate swap. C) Borrow dollars in the U.S. exchange for francs, and arrange an interest rate swap. D) Borrow dollars in the U.S. exchange for francs, and arrange a currency swap.

Version 1

100)

Currency swaps are used to: A) lock in an exchange rate for future delivery of a foreign currency. B) effectively transform loans originated in one currency to a different currency. C) transform fixed-rate loans into variable-rate loans. D) exchange foreign currencies in amounts not possible in the foreign exchange market.

101)

On $10 million of loans, Firm A is paying a fixed $700,000 in interest payments while Firm B is paying LIBOR plus 50 basis points. The current LIBOR rate is 6.25 percent. Firms A and B have agreed to swap interest payments. How much will be paid to which firm this year? A) A pays $750,000 to Firm B. B) B pays $25,000 to Firm A. C) B pays $50,000 to Firm A. D) A pays $25,000 to Firm B.

102)

Four investors buy sugar futures. Three are speculators and one is hedging. Which of the following is unambiguously hedging? A) Wheat farmer B) Mutual fund C) Soft drink producer D) Hedge fund

103)

A firm can reduce the risk of upward movement in raw material prices by: A) buying a call option. B) selling a put option. C) buying a put option. D) selling a futures contract.

104)

A farmer can hedge the risk of downward movement in the price of his product by: A) buying a call option. B) selling a put option. C) buying a put option. D) buying a futures contract.

105)

A sensible corporate risk strategy needs answers to three of these questions. An answer to which question is not required for a sensible strategy? A) What are the major risks that the company faces? B) Is the company being paid for taking these risks? C) Can we spot any mispriced derivative contracts? D) Can the company reduce the probability of a bad outcome?

Version 1

106)

A farmer hedged his risk by buying put options on wheat with an exercise price of $6.70 at a price of $0.14 per bushel. If the price of wheat at the expiration of the contract is $6.70, what is the net revenue from each bushel of wheat? A) $6.56 B) $6.63 C) $6.70 D) $6.84

107)

Which of the following strategies does not reduce risk? A) Building flexibility into the firm’s operations B) Increasing the proportion of the firm’s costs that are fixed C) Taking out an insurance policy D) Hedging with derivative contracts

108)

Which of these statements is not true? A) Transactions to reduce risk are unlikely to add value if investors can easily undertake similar transactions. B) Hedging may reduce the costs of financial distress. C) Transactions to reduce risk always add value. D) Hedging is a zero-sum game.

109)

Which one of the following statements is correct? A) An option seller makes more profits than an option buyer. B) A futures seller makes more profits than a futures buyer. C) The profit realized by the buyer of futures will be equal to the loss incurred by the seller. D) Both the buyer and the seller of a futures contract can earn a profit.

110)

The most active trading in forward contracts is in: A) U.S. Treasury bills. B) the Standard and Poor's index. C) wheat crops. D) foreign currencies.

111)

At the expiration of a futures contract, the futures price will be: A) greater than the spot price. B) equal to the spot price. C) less than the spot price. D) greater than the forward price.

Version 1

112)

Which one of the following is the major difference between forward and futures contracts? A) Futures contracts are more expensive than forward contracts. B) Forward contracts are traded on the forward exchanges. C) Futures contracts are always delivered. D) Forward contracts are not marked to market.

113)

Which contract is more likely to have risk associated with the other person trading the same derivative? A) Forward B) Futures C) Option D) Stock

114)

Big Corporation borrows $1 million at a fixed rate of 7% from a bank and swaps this loan for a SOFR + 1% loan. SOFR is at 2%. How much will the company receive from the bank at the annual settlement of the swap? A) $70,000 B) $40,000 C) $30,000 D) $20,000

115)

A farmer plans to harvest 10,000 bushels of wheat and shorts 2 futures contracts at a price of $5.50 per bushel. At expiration of the contract the spot price and futures price are both $5.10. How much will be the total proceeds to the farmer when she closes the contract and sells her wheat? A) $47,000 B) $51,000 C) $55,000 D) $59,000

116)

To help reduce the risk associated with a futures contract to the other parties involved in the transaction, an investor will be required to provide a: A) letter of credit. B) lien on other assets. C) margin. D) personal guarantee.

Version 1

Answer Key Test name: Ch24 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) FALSE 6) FALSE 7) FALSE 8) FALSE 9) FALSE 10) TRUE 11) TRUE 12) FALSE 13) TRUE 14) TRUE 15) TRUE 16) FALSE 17) TRUE 18) TRUE 19) FALSE 20) TRUE 21) TRUE 22) TRUE 23) TRUE 24) FALSE 25) TRUE 26) FALSE 27) TRUE 28) TRUE 29) FALSE 30) A

$7.20 − $7.34 = −$0.14 31) A 32) A 33) D

Annual interest payment = ($6,800,000 × 105) × 0.12 = ¥85,680,000

Version 1

34) D 35) B

(Next Day Price - Today's Price) × Gallons of Gasoline = Gain ÷ Loss ($3.04 − $3.01) × 49,000 = $1,470 36) C

(Next Day Price - Today's Price) × Pounds of Pork Bellies = Loss ÷ Gain (Positive is a loss, since this is the seller of futures) ($1.54 − $1.57) × 53,000 = −$1,590 37) A

Mark to market = $532 = $x × 26,600 → x = $0.02 A seller of a futures contract gains when the closing price declines. 38) B

Fixed Payment - (LIBOR + Basis Points) × Loan Size = Amount B Pays A $808,000 − (0.0715 + 0.0050) × $10,000,000 = $43,000 39) A

Net revenue = −cost of option + option payoff + price of wheat Net revenue = −$0.14 + ($7.60 − $7.60) + $7.60 = $7.46 40) B

41) B 42) B 43) C 44) C 45) A 46) D 47) C 48) D 49) A 50) B 51) A 52) C 53) C 54) B 55) D

Version 1

56) B 57) A 58) A 59) C 60) C 61) D 62) A 63) A

($12.10 - $12.00) × 5,000 = $500 64) A 65) C 66) B 67) B 68) A 69) B 70) C 71) B 72) B 73) D 74) D

Annual interest payment = ($5,000,000 × 105) × 0.12 = ¥63,000,000 75) B 76) C 77) C 78) D 79) C 80) A 81) B 82) B 83) D 84) D 85) A 86) B 87) B

(Next Day Price - Today's Price) × Gallons of Gasoline = Gain ÷ Loss ($2.97 − $2.94) × 42,000 = $1,260 88) C

Version 1

(Next Day Price - Today's Price) × Pounds of Pork Bellies = Loss ÷ Gain (Positive is a loss, since this is the seller of futures) ($1.41 − $1.44) × 40,000 = −$1,200 89) B 90) A

Mark to market = $500 = $x × 25,000 → x = $0.02 A seller of a futures contract gains when the closing price declines. 91) C 92) D 93) A

($.73 − $.80) × 50,000 = −$3,500 94) B 95) C 96) D 97) A 98) B 99) D 100) B 101) B

Fixed Payment - (LIBOR + Basis Points) × Loan Size = Amount B Pays A $700,000 − (.0625 + .0050) × $10,000,000 = $25,000 102) 103) 104) 105) 106)

C A C C A Net revenue = −cost of option + option payoff + price of wheat Net revenue = −$0.14 + ($6.70 − $6.70) + $6.70 = $6.56 107) 108) 109) 110) 111) 112) 113)

B C C D B D A

Version 1

114)

115)

C Total proceeds = 10,000 × $5.50 = $55,000 116)

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) The before-tax cost of debt for Hardcastle Industries, Incorporated is currently 8.0%, but it will increase to 8.25% when debt levels reach $600 million. The debt-to-total assets ratio for Hardcastle is 40% and its capital structure is composed of debt and common equity only. If Hardcastle changes its target capital structure to 50% debt / 50% equity, which of the following describes the effect on the level of new investment at which the cost of debt will increase? The level will: A) decrease. B) change, but can either increase or decrease. C) increase. 2) An analyst gathered the following information about a capital budgeting project:

The proposed project cost $10,000. The project is expected to increase pretax net income and cash flow by $3,000 in each of the next eight years. The company has 50% of its capital in equity at a cost of 12%. The pretax cost of debt capital is 6%. The company’s tax rate is 33%. The project’s net present value is closest to: A) $1,551. B) $6,604. C) $7,240. 3) Which of the following stakeholders are most likely to benefit from a company’s growth and

excellent financial performance? A) Governments. B) Creditors. C) Customers.

Version 1

4) Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the

expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over the subsequent seven years. It will then cost $170,000 to close down the mine over the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return? A) $376,872. B) $280,913. C) $325,859. 5) Which of the following statements about corporate governance is most accurate? Corporate

governance: A) best practices are essentially the same in developed economies. B) is defined in the same way in most countries. C) may be focused only on shareholder interests.

Version 1

6) Arlington Machinery currently has assets on its balance sheet of $300 million that is financed

with 70% equity and 30% debt. The executive management team at Arlington is considering a major expansion that would require raising additional capital. Jeffery Marian, an analyst with Arlington Machinery, has put together the following schedule for the costs of debt and equity: Amount of New Debt After-tax Cost (in millions) of Debt $0 to $49 $50 to $99 $100 to $149

4.0% 4.2% 4.5%

Amount of New Equity (in millions) $0 to $99 $100 to $199 $200 to $299

Cost of Equity

7.0% 8.0% 9.0%

In a presentation to Arlington’s executive management team, Marian makes the following statements: Statement 1: If we maintain our target capital structure of 70% equity and 30% debt, the breakpoint at which our cost of equity will increase to 9.0% is approximately $286 million in new capital. Statement 2: If we want to finance total assets of $600 million, our weighted average cost of capital (WACC) for the additional financing needed will be 7.56%. Marian’s statements are:

A) B) C)

Statement 1

Statement 2

Correct Incorrect Correct

Incorrect Incorrect Correct

A) Option A B) Option B C) Option C 7) The effect of a company announcement that they have begun a project with a current cost of

$10 million that will generate future cash flows with a present value of $20 million is most likely to: A) only affect value of the firm’s common shares if the project was unexpected. B) increase the value of the firm’s common shares by $20 million. C) increase value of the firm’s common shares by $10 million.

Version 1

8) The following is a schedule of Tiger Company’s new debt and equity capital costs ($

millions): Amount of New Debt < $30 $30 − $60 > $60

After-tax Cost of Debt 3.5% 4.0% 4.7%

Amount of New Equity < $60 $60 − $90 > $90

Cost of Equity 8.5% 10.3% 12.5%

The company has a target capital structure of 30% debt and 70% equity. Tiger needs to raise an additional $135.0 million of capital for a new project while maintaining its target capital structure. The company’s second debt break point and its marginal cost of capital (MCC) are closest to:

Debt Break Point #2 A) B) C)

MCC

$200 million $100 million $200 million

8.4% 8.4% 10.0%

A) Option A B) Option B C) Option C 9) Ashlyn Lutz makes the following statements to her supervisor, Paul Ulring, regarding the

basic principles of capital budgeting: Statement 1: The timing of expected cash flows is crucial for determining the profitability of a capital budgeting project. Statement 2: Capital budgeting decisions should be based on the after-tax net income produced by the capital project. Which of the following regarding Lutz’s statements is most accurate?

A) B) C)

Statement 1

Statement 2

Incorrect Correct Correct

Correct Correct Incorrect

A) Option A B) Option B C) Option C

Version 1

10) The stakeholders most likely to be concerned with their legal liabilities are: A) directors. B) regulators. C) creditors. 11) Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1

has an initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight years. Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per year for the next four years. Both projects should be financed at Torch’s weighted average cost of capital. Torch’s current stock price is $40 per share, and next year’s expected dividend is $1.80. The firm’s growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%. Torch has a target capital structure of 50% equity and 50% debt. If Torch takes on either project, it will need to be financed with externally generated equity which has flotation costs of 4%. Suresh is aware that there are two common methods for accounting for flotation costs. The first method, commonly used in textbooks, is to incorporate flotation costs directly into the cost of equity. The second, and more correct approach, is to subtract the dollar value of the flotation costs from the project NPV. If Suresh uses the cost of equity adjustment approach to account for flotation costs rather than the correct cash flow adjustment approach, will the NPV for each project be overstated or understated?

A) B) C)

Project 1 NPV

Project 2 NPV

Understated Understated Overstated

Understated Overstated Overstated

A) Option A B) Option B C) Option C 12) Assume a firm uses a constant WACC to select investment projects rather than adjusting the

projects for risk. If so, the firm will tend to: A) reject profitable, low-risk projects and accept unprofitable, high-risk projects. B) accept profitable, low-risk projects and reject unprofitable, high-risk projects. C) accept profitable, low-risk projects and accept unprofitable, high-risk projects.

Version 1

13) The debt of Savanna Equipment, Incorporated has an average maturity of ten years and a

BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be subordinate to the firm’s existing debt. The company’s marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is: A) More than 5.0%. B) Between 3.3% and 5.0%. C) 5.0%. 14) Hanson Aluminum, Incorporated is considering whether to build a mill based around a new

rolling technology the company has been developing. Management views this project as being riskier than the average project the company undertakes. Based on their analysis of the projected cash flows, management determines that the project’s internal rate of return is equal to the company’s marginal cost of capital. If the project goes forward, the company will finance it with newly issued debt with an after-tax cost less than the project’s IRR. Should management accept or reject this project? A) Accept, because the marginal cost of the new debt is less than the project’s internal rate of return. B) Reject, because the project reduces the value of the company when its risk is taken into account. C) Accept, because the project returns the company’s cost of capital. 15) The financial manager at Genesis Company is looking into the purchase of an apartment

complex for $550,000. Net after-tax cash flows are expected to be $65,000 for each of the next five years, then drop to $50,000 for four years. Genesis’ required rate of return is 9% on projects of this nature. After nine years, Genesis Company expects to sell the property for after-tax proceeds of $300,000. What is the respective internal rate of return (IRR) and net present value (NPV) on this project? A) 6.66%; −$64,170. B) 7.01%; −$53,765. C) 13.99%; $166,177.

Version 1

16) A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate of

7.5% (assume annual payments). The bonds trade at a price of $98 in the open market. The firm’s marginal tax rate is 35%. Using the bond-yield plus method, what is the firm’s cost of equity risk assuming an add-on of 4%? A) 13.34%. B) 12.11%. C) 11.50%. 17) The stakeholder theory of corporate governance is primarily focused on: A) the interests of various stakeholders rather than the interests of shareholders. B) increasing the value a company. C) resolving the competing interests of those who manage companies and other groups

affected by a company’s actions. 18) A company prepares a chart with the net present value (NPV) profiles for two mutually

exclusive projects with equal lives of five years. Project Jones and Project Smith have the same initial cash outflow and total undiscounted cash inflows, but 75% of the cash inflows for Project Jones occur in years 1 and 2, while 75% of the cash inflows for Project Smith occur in years 4 and 5. Which of the following statements is most accurate regarding these projects? A) Project Smith has a higher internal rate of return than Project Jones. B) There is a range of discount rates in which the company should choose Project Jones and a range in which it should choose Project Smith. C) There is a range of discount rates in which the optimal decision is to reject both projects. 19) Which of the following steps is least likely to be an administrative step in the capital

budgeting process? A) Forecasting cash flows and analyzing project profitability. B) Conducting a post-audit to identify errors in the forecasting process. C) Arranging financing for capital projects. 20) A North American investment society held a panel discussion on the topics of capital costs

and capital budgeting. Which of the following comments made during this discussion is the least accurate? A) Any given project’s NPV will decline when a breakpoint is reached. B) An increase in the after-tax cost of debt may occur at a break point. C) A project’s internal rate of return decreases when a breakpoint is reached.

Version 1

21) Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock

last year. Its common stock is trading at £40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and to maintain its historic payout ratio going forward. In estimating Axle’s after-tax cost of capital, an analyst’s estimate of Axle’s cost of common equity would be closest to: A) 9.2%. B) 8.8%. C) 9.0%. 22) Stolzenbach Technologies has a target capital structure of 60% equity and 40% debt. The

schedule of financing costs for the Stolzenbach is shown in the table below: Amount of New Debt After-tax Cost (in millions) of Debt $0 to $199 $200 to $399 $400 to $599

4.5% 5.0% 5.5%

Amount of New Equity (in millions) $0 to $299 $300 to $699 $700 to $999

Cost of Equity

7.5% 8.5% 9.5%

Stolzenbach Technologies has breakpoints for raising additional financing at both: A) $400 million and $700 million. B) $500 million and $700 million. C) $500 million and $1,000 million. 23) An analyst with Laytech Corporation is evaluating two machines as possible replacements

for an existing stamping machine. He estimates that machine 1 has a cost of $5 million and that purchasing it would produce a profitability index of 1.20. He estimates that machine 2 has a cost of $6 million and that purchasing it would produce a profitability index of 1.17. Based on these estimates he should conclude that: A) machine 2 should be chosen. B) neither project is preferred to the other. C) machine 1 should be chosen. 24) Which of the following is most accurate for two independent projects with conventional cash

flows? A) An analyst will not encounter the problem of multiple IRRs. B) A firm that rations investment capital will choose the one with the higher NPV. C) The project with the higher IRR will also have the higher NPV.

Version 1

25) Pfluger Company’s accounts payable department receives an invoice from a vendor with

terms of 2/10 net 30. If Pfluger pays the invoice on its due date, the cost of trade credit is closest to: A) 27.9%. B) 43.5%. C) 44.6%. 26) With sales of $45 million, the operating earnings of Poston Industries are $3.8 million. Fixed

operating costs are $4.2 million, net profit margin is 4.5%, and unit variable costs are $35.50. At the current level of sales, Poston’s degree of operating leverage is closest to: A) 1.2. B) 1.6. C) 2.1. 27) Randox Industries has the following investment policy statement: "In order to achieve the

safety and liquidity necessary in the investment of excess cash balances, the CFO or his designee may invest excess cash balances in 30-day U.S. Treasury bills, or in banker’s acceptances with maturities of less than 31 days or 30-day certificates of deposit, where the credit rating of the issuing bank is A+ or higher." This policy statement is: A) inappropriate because both banker’s acceptances and certificates of deposit are illiquid. B) inappropriate because it is too restrictive. C) appropriate because these are all safe, liquid securities. 28) An investment policy statement for a firm’s short-term cash management function would

least appropriately include: A) procedures to follow if the investment guidelines are violated. B) information on who is allowed to invest corporate cash. C) a list of permissible securities. 29) A firm is choosing among three short-term investment securities:

Security 1: A 30-day U.S. Treasury bill with a discount yield of 3.6%. Security 2: A 30-day banker’s acceptance selling at 99.65% of face value. Security 3: A 30-day time deposit with a bond equivalent yield of 3.65%. Based only on these securities’ yields, the firm would: A) prefer the time deposit. B) prefer the banker’s acceptance. C) prefer the U.S. Treasury bill.

Version 1

30) Which of the following strategies is most likely to be considered good payables management? A) Paying trade invoices on the day they arrive. B) Taking trade discounts only if the firm’s annual return on short-term investments is

less than the discount percentage. C) Paying invoices on the last day to still get the supplier’s discount for early payment. 31) Which of the following is least likely an indicator of a firm’s liquidity? A) Cash as a percentage of sales. B) Amount of credit sales. C) Inventory turnover. 32) An appropriate cash management strategy for a company that has a seasonally high need for

cash prior to the holiday shopping season would least likely include: A) investing in U.S. Treasury notes at other times of the year because they are highly liquid. B) allowing short-term securities to mature without reinvestment. C) borrowing funds though a bank line of credit. 33) A firm has average days of receivables outstanding of 22 compared to an industry average of

29 days. An analyst would most likely conclude that the firm: A) has a lower cash conversion cycle than its peer companies. B) has better credit controls than its peer companies. C) may have credit policies that are too strict. 34) A banker’s acceptance that is priced at $99,145 and matures in 72 days at $100,000 has a(n): A) bond equivalent yield greater than its effective annual yield. B) money market yield greater than its discount yield. C) discount yield greater than its bond equivalent yield. 35) With respect to inventory management,: A) a decrease in a firm’s days of inventory on hand indicates better inventory

management and can lead to increased profits. B) an increase in days of inventory on hand can be the result of either good or poor inventory management. C) a firm with inventory turnover higher than the industry average can be expected to have better profitability as a result.

Version 1

Answer Key Test name: Corporate Finance 1) A

A break point refers to a level of new investment at which a component’s cost of capital changes. The formula for break point is:

As indicated, as the weight of a capital component in the capital structure increases, the break point at which a change in the component’s cost will decline. No computation is necessary, but when Hardcastle has 40% debt, the breakpoint is $600,000,000 / 0.4 = $1.5 billion. If Hardcastle’s debt increases to 50%, the breakpoint will decline to $600,000,000 / 0.5 = $1.2 billion. 2) A

WACC = (wd)(kd)(1 − t) + (wce)(kce) WACC = (0.5)(6%)(1 − 0.33) + (0.5)(12%) = 8.0% The increase in after-tax cash flows for each year is 3,000 × (1 − 0.33) = $2,010. I = 8; N = 8; PMT = $2,010; CPT→PV = $11,550.74 NPV = PV income − cost = $11,550.74 − $10,000 = $1,550.74 3) A

Governments receive greater tax revenues when financial performance is excellent and profits are higher. Creditors do not receive extra returns for performance better than that is adequate to repay debt. Customers seek company stability and ongoing relationships with the company. 4) B

The key to this problem is identifying this as a NPV problem even though the first cash flow will not occur until the following year. Next, the year of each cash flow must be property identified; specifically: CF0 = $0; CF1 = −430,000; CF2−8 = +$200,000; CF9 = −$170,000. One simply has to discount all of the cash flows to today at a 16% rate. NPV = $280,913. 5) C

Under the shareholder theory of corporate governance, practices are primarily those that support shareholder interests, while under the stakeholder theory of corporate governance, the interests of various affected groups are considered and balanced. Corporate governance practices and definitions vary across countries.

Version 1

6) C

Marian’s first statement is correct. A breakpoint calculated as (amount of capital where component cost changes / weight of component in the WACC). The component cost of equity for Arlington will increase when the amount of new equity raised is $200 million, which will occur at ($200 million / 0.70) = $285.71 million, or $286 million of new capital. Marian’s second statement is also correct. If Arlington wants to finance $600 million of total assets, the firm will need to raise $600 − $300 = $300 million of additional capital. Using the target capital structure of 70% equity and 30% debt, Arlington will need to raise $300 × 0.70 = $210 million in new equity and $300 × 0.30 = $90 million in new debt. Looking at the capital schedules, these levels of new financing correspond with rates of 9.0% and 4.2% for costs of equity and debt respectively, and the WACC is equal to (9.0% × 0.70) + (4.2% × 0.30) = 7.56%. 7) A

Stock prices reflect investor expectations for future investment and growth. A new positive-NPV project will increase stock price only if it was not previously anticipated by investors. 8) C

Debt break point #2 = $60 million / 0.30 = $200 million. $135 million × 30% = $40.5 million new debt $135 million × 70% = $94.5 million new equity MCC = 4.0%(0.30) + 12.5%(0.70) = 9.95%. 9) C

Lutz’s first statement is correct. The timing of cash flows is important for making correct capital budgeting decisions. Capital budgeting decisions account for the time value of money. Lutz’s second statement is incorrect. Capital budgeting decisions should be based on incremental aftertax cash flows, not net (accounting) income. 10) A

Directors are legally responsible for their decisions and actions as board members. Neither regulators nor creditors face significant legal liabilities for their actions. 11) C

Version 1

The incorrect method of accounting for flotation costs spreads the flotation cost out over the life of the project by a fixed percentage that does not necessarily reflect the present value of the flotation costs. The impact on project evaluation depends on the length of the project and magnitude of the flotation costs, however, for most projects that are shorter, the incorrect method will overstate NPV, and that is exactly what we see in this problem. Correct method of accounting for flotation costs: After-tax cost of debt = 8.0% (1 − 0.30) = 5.60% Cost of equity = ($1.80 / $40.00) + 0.05 = 0.045 + 0.05 = 9.50% WACC = 0.50(5.60%) + 0.50(9.50%) = 7.55% Flotation costs Project 1 = $200,000 × 0.5 × 0.04 = $4,000 Flotation costs Project 2 = $100,000 × 0.5 × 0.04 = $2,000 NPV Project 1 = −$200,000 − $4,000 + (N = 8, I = 7.55%, PMT = $55,000, FV = 0 →CPT PV = $321,535) = $117,535 NPV Project 2 = −$100,000 − $2,000 + (N = 4, I = 7.55%, PMT = $40,000, FV = 0 →CPT PV = $133,823) = $31,823 Incorrect Adjustment for cost of equity method for accounting for flotation costs: After-tax cost of debt = 8.0% (1 − 0.30) = 5.60% Cost of equity = [$1.80 / $40.00(1 − 0.04)] + 0.05 = 0.0469 + 0.05 = 9.69% WACC = 0.50(5.60%) + 0.50(9.69%) = 7.65% NPV Project 1 = −$200,000 + (N = 8, I = 7.65%, PMT = $55,000, FV = 0 →CPT PV = $320,327) = $120,327 NPV Project 2 = −$100,000 + (N = 4, I = 7.65%, PMT = $40,000, FV = 0 →CPT PV = $133,523) = $33,523 12) A

The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable, high- risk projects because the hurdle rate of return used will be too low relative to the risk of the project. The firm should increase the required rate of return for high-risk projects. 13) A

The after-tax cost of debt similar to Savanna’s existing debt iskd(1 − t) = 8.33% (1 − 0.4) = 5.0%. Because the anticipated new debt will be subordinated in the company’s debt structure, investors will demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the new debt is more than 5.0%. 14) B

Version 1

The marginal (or weighted average) cost of capital is the appropriate discount rate for projects that have the same level of risk as the firm’s existing projects. For a project with a higher degree of risk, cash flows should be discounted at a rate higher than the firm’s WACC. Since this project’s IRR is equal to the company’s WACC, its NPV must be zero if the cash flows are discounted at the WACC. If the cash flows are discounted at a rate higher than the WACC to account for the project’s higher risk, the NPV must be negative. Therefore, the project would reduce the value of the company, so management should reject it. A company considers its capital raising and budgeting decisions independently. Each investment decision must be made assuming a WACC which includes each of the different sources of capital and is based on the long-run target weights. 15) B

IRR Keystrokes: CF0 = −$550,000; CF1 = $65,000; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1. NPV Keystrokes: CF0 = −$550,000; CF1 = $65,000; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1. Compute NPV, I = 9. Note: Although the rate of return is positive, the IRR is less than the required rate of 9%. Hence, the NPV is negative. 16) B

If the bonds are trading at $98, the required yield is 8.11%, and the market value of the issue is $3.92 million. To calculate this rate using a financial calculator (and figuring the rate assuming a $100 face value for each bond), N = 4; PMT = 7.5 = (0.075 × 100); FV = 100; PV = −98; CPT → I/Y = 8.11. By adding the equity risk factor of 4%, we compute the cost of equity as 12.11%. 17) C

Resolving the conflicting interests of both shareholders and other stakeholders is the focus of corporate governance under stakeholder theory. Shareholders are among the groups whose interests are considered under stakeholder theory. 18) C

Version 1

If the total undiscounted cash flows from two projects are equal, their NPV profiles intersect the vertical axis at the same value. The NPV profile will have a steeper slope for Project Smith, which has more of its cash inflows occurring later in its life, and therefore the IRR of Project Smith (its intersection with the horizontal axis) must be less than the IRR of Project Jones. The NPV for Project Jones will be greater at any rate of discount, and Project Jones will be preferred over the entire range. However, if the discount rate applied to the cash flows is greater than the IRR of Project Jones, both projects will have negative NPVs and the company should reject both of them. 19) C

Arranging financing is not one of the administrative steps in the capital budgeting process. The four administrative steps in the capital budgeting process are: 2. Idea generation 3. Analyzing project proposals 4. Creating the firm-wide capital budget 5. Monitoring decisions and conducting a post-audit 20) C

The internal rate of return is independent of the firm’s cost of capital. It is a function of the amount and timing of a project’s cash flows. 21) A

We can estimate the company’s expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 − 2.40/3.00) = 3% The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model pricing, the required return on equity is 2.47 / 40 + 3% = 9.18%. 22) C

Stolzenbach will have a break point each time a component cost of capital changes, for a total of three marginal cost of capital schedule breakpoints. Break pointDebt > $200mm = ($200 million ÷ 0.4) = $500 million Break pointDebt > $400mm = ($400 million ÷ 0.4) = $1,000 million Break pointEquity > $300mm = ($300 million ÷ 0.6) = $500 million Break pointEquity > $700mm = ($700 million ÷ 0.6) = $1,167 million 23) A

The NPV of purchasing machine 1 is 1.20(5 million) − 5 million = 1 million. The NPV of purchasing machine 2 is 1.17(6 million) − 6 million = 1.02 million. Parker should choose machine 2 because it has the higher NPV.

Version 1

24) A

The problem of multiple IRRs is encountered only when the cash flows have an unconventional pattern. 25) C

"2/10 net 30" is a discount of 2% of the invoice amount for payment within 10 days, with full payment due in 30 days. Cost of trade credit on day 30 =

26) C

Operating earnings = EBIT = Sales − TVC − Fixed operating costs

27) B

The policy statement is inappropriate because it is too restrictive. A policy statement should focus on meeting the specific safety and liquidity needs of the firm but should also allow the flexibility to increase yield within these constraints. There are many other securities potentially suitable for cash management that would provide equivalent or better liquidity and safety of principal at least equivalent to that of the securities issued by A+ rated banks. 28) C

An investment policy statement typically begins with a statement of the purpose and objective of the investment portfolio, some general guidelines about the strategy to be employed to achieve those objectives, and the types of securities that will be used. A list of permitted securities for investment would be limited and likely too restrictive. A list of permitted security types is appropriate and can provide the necessary flexibility to increase yield within the safety and liquidity constraints appropriate for the firm. 29) B

We can compare the yields of these securities on any single basis. The preferred basis is the bond equivalent yield. Security 1 = discount is 3.6% (30 / 360) = 0.3% BEY = (0.3 / 99.7) (365 / 30) = 3.661% BEY of Security 2 = (0.35 / 99.65) × (365 / 30) = 4.273% BEY of Security 3 = 3.65% 30) C

Version 1

Paying invoices on the last day to get a discount (for early payment) is likely the most advantageous strategy for a firm. If the annualized percentage cost of not taking advantage of the discount is less than the firm’s short-term cost of funds, it would be advantageous to pay on the due date. However, the discount percentage is not an annualized rate, so it cannot be compared directly to the firm's annual return on short-term investments. Paying prior to the discount cutoff date or prior to the due date sacrifices interest income for no advantage. 31) B

No inferences about liquidity are warranted based on this measure. A firm may have higher credit sales than another simply because it has more sales overall. Cash as a proportion of sales and inventory turnover are indicators of liquidity. 32) A

Treasury notes have maturities between 2 and 10 years and, thus, have maturities longer than those of securities suitable for cash management. Allowing short-term securities to mature without reinvesting the cash generated would be one way to meet seasonal cash needs. Shortterm bank borrowing or issuing commercial paper that can be paid off when holiday sales generate cash would be appropriate strategies for dealing with a predictable short-term need for cash. 33) C

The firm’s average days of receivables should be close to the industry average. A significantly lower average days receivables outstanding, compared to its peers, is an indication that the firm’s credit policy may be too strict and that sales are being lost to peers because of this. We can not assume that stricter credit controls than the average for the industry are “better.” We cannot conclude that credit sales are less, they may be more, but just made on stricter terms. The average days of receivables are only one component of the cash conversion cycle. 34) B

The money market yield is the holding period yield times 360/72 and is always greater than the discount yield which is the actual discount from face value times 360/72, since the holding period yield is always greater than the percentage discount from face value. A security’s discount yield and its money market yield are always less than its bond equivalent yield, and its effective annual yield is always greater than its bond equivalent yield. 35) B

Version 1

An increase in inventory could indicate poor sales and an accumulation of obsolete items or could be the result of a conscious effort to have adequate supplies to avoid losses from not having items to satisfy customer orders (stock outs). Higher-than-average inventory turnover could indicate better inventory management or could indicate that a less than optimal inventory is being maintained by the company.

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) The process that ensures that two securities positions with identical future payoffs, regardless of future events, will have the same price is called: A) the law of one price. B) arbitrage. C) exchange parity. 2) When interest rates and futures prices for an asset are uncorrelated and forwards are less

liquid than futures, it is most likely that the price of a forward contract is: A) equal to the price of a futures contract. B) greater than the price of a futures contract. C) less than the price of a futures contract. 3) An analyst determines that a portfolio with a 35% weight in Investment P and a 65% weight

in Investment Q will have a standard deviation of returns equal to zero. Investment P has an expected return of 8%. Investment Q has a standard deviation of returns of 7.1% and a covariance with the market of 0.0029. The risk-free rate is 5% and the market risk premium is 7%. If no arbitrage opportunities are available, the expected rate of return on the combined portfolio is closest to: A) 7%. B) 6%. C) 5%. 4) Which of the following is an example of an arbitrage opportunity? A) A stock with the same price as another has a higher rate of return. B) A portfolio of two securities that will produce a certain return that is greater than the

risk- free rate of interest. C) A put option on a share of stock has the same price as a call option on an identical share.

Version 1

5) MBT Corporation recently announced a 15% increase in earnings per share (EPS) over the

previous period. The consensus expectation of financial analysts had been an increase in EPS of 10%. After the earnings announcement the value of MBT common stock increased each day for the next five trading days, as analysts and investors gradually reacted to the better than expected news. This gradual change in the value of the stock is an example of: A) efficient markets. B) inefficient markets. C) speculation. 6) The spot price of an asset is 62 and the risk-free rate is 2.5%. If the net cost of carry for the

asset over the next six months is −3 in present value terms, the no-arbitrage 6-month forward price is closest to: A) 66.6 B) 65.8 C) 59.7 7) It is possible to profit from arbitrage when there are no costs or benefits to holding the

underlying asset and the forward contract price is: A) greater than the present value of the spot price. B) less than the future value of the spot price. C) less than the present value of the spot price. 8) A net benefit from holding the underlying asset of a forward contract will: A) decrease the value of the forward contract at expiration. B) increase the value of the forward contract during its life. C) decrease the no-arbitrage forward price at initiation. 9) Bea Moran wants to establish a long derivatives position in a commodity she will need to

acquire in six months. Moran observes that the six-month forward price is 45.20 and the sixmonth futures price is 45.10. This difference most likely suggests that for this commodity: A) there is an arbitrage opportunity among forward, futures, and spot prices. B) futures prices are negatively correlated with interest rates. C) long investors should prefer futures contracts to forward contracts. 10) Derivatives valuation is based on risk-neutral pricing because: A) this method provides an intrinsic value to which investors apply a risk premium. B) the risk of a derivative is based entirely on the risk of its underlying asset. C) risk tolerances of long and short investors are assumed to offset.

Version 1

11) Which of the following is the best interpretation of the no-arbitrage principle? A) The information flow is quick in the financial market. B) There is no way you can find an opportunity to make a profit. C) There is no free money. 12) Which of the following statements about arbitrage opportunities is most accurate? A) Engaging in arbitrage requires a large amount of capital. B) The market prices of two assets or portfolios that have the same future payoffs cannot

differ for protracted periods. C) Arbitrage is referred to as the law of one price. 13) The price of a pay-fixed receive-floating interest rate swap is: A) determined by expected future short-term rates. B) negative when floating rates are highly volatile. C) zero when floating rates and fixed rates are equal. 14) Compared to European put options on an asset, otherwise identical American put options on

the asset are most likely to be more valuable if: A) the asset value is significantly lower than the exercise price. B) the options are out-of-the-money. C) the asset pays dividends during the life of the option. 15) The calculation of derivatives values is based on an assumption that: A) arbitrage opportunities do not arise in real markets. B) arbitrage opportunities are exploited rapidly. C) investors are risk neutral. 16) For two European put options that differ only in their time to expiration, which of the

following is most accurate? The longer-term option: A) is worth at least as much as the shorter-term option. B) is worth more than the shorter-term option. C) can be worth less than the shorter-term option. 17) Which of the following portfolios has the same future cash flows as a protective put? A) Long call option, long risk-free bond, short the underlying asset. B) Long call option, long risk-free bond. C) Short call option, long risk-free bond.

Version 1

18) For a European style put option: A) exercise value is equal to the underlying stock price minus its exercise price. B) intrinsic value is equal to its market price plus its exercise value. C) time value is equal to its market price minus its exercise value. 19) The time value of a European call option with 30 days to expiration will most likely be: A) less than the current option premium if the option is currently in-the-money. B) equal to the intrinsic value if the exercise price is greater than the current spot price. C) greater than the current option premium if the option is currently out-of-the-money. 20) The value of a European put option at expiration is most likely to be increased by: A) a lower risk-free interest rate. B) a higher exercise price. C) higher volatility of the underlying asset price. 21) Other things equal, a short put position would become more valuable as a result of an

increase in: A) the price of the underlying asset. B) the volatility of the price of the underlying asset. C) the time to expiration. 22) The time value of an option is most accurately described as: A) increasing as the option approaches its expiration date. B) the amount by which the intrinsic value exceeds the option premium. C) equal to the entire premium for an out-of-the-money option.

Version 1

Answer Key Test name: Derivatives 1) B

If two securities have identical payoffs regardless of events, the process of arbitrage will move prices toward equality. Arbitrageurs will buy the lower priced position and sell the higher priced position, for an immediate profit without any future liability. The law of one price (for securities with identical payoffs) is not a process; it is ‘enforced’ by arbitrage. 2) A

When interest rates and futures prices are uncorrelated the prices of forward and futures on the same asset will be equal. Liquidity is not an issue as no-arbitrage prices are based on riskless hedges that are held until settlement of the derivative security. 3) C

If the no-arbitrage condition is met, a riskless portfolio (a portfolio with zero standard deviation of returns) will yield the risk-free rate of return. 4) B

An arbitrage opportunity exists when a combination of two securities will produce a certain payoff in the future that produces a return that is greater than the risk-free rate of interest. Borrowing at the riskless rate to purchase the position will produce a certain future amount greater than the amount required to repay the loan. 5) B

A critical element of efficient markets is that asset prices respond immediately to any new information that will affect their value. Large numbers of traders responding in similar fashion to the new information will create a temporary imbalance in supply and demand, and this will adjust asset market values. 6) B

F0(T) = [S0 − net cost of carry] × (1 + Rf)T = [62 − (−3)] × (1.025)6/12 = 65.81 7) B

An opportunity for arbitrage exists if the forward price is not equal to the future value of the spot price, compounded at the risk-free rate over the period of the forward contract. 8) C

Version 1

Compared to an underlying asset with no net holding cost or benefit, a net benefit from holding the underlying asset will decrease the no-arbitrage forward price at initiation and the value of a forward contract during its life. Holding costs and benefits have no effect on the value of a forward contract at expiration. 9) B

Differences may exist between forward and futures prices for otherwise identical contracts if futures prices are correlated with interest rates. If futures prices are negatively correlated with interest rates, daily settlement of long futures contracts will require cash when interest rates are increasing and produce cash when interest rates are decreasing. As a result the futures price will be lower than the forward price. The difference in price does not provide an arbitrage opportunity or suggest that investors should prefer forward or futures contracts. 10) B

Because the risk of a derivative is based entirely on the risk of its underlying asset, we can construct a perfectly hedged portfolio of a derivative and its underlying asset. The future payoff of a perfectly hedged position is certain and can therefore be discounted at the risk-free rate. 11) C

An arbitrage opportunity is the chance to make a riskless profit with no investment. In essence, finding an arbitrage opportunity is like finding free money. As you recall, in arbitrage, you observe two identical assets with different prices. Your immediate response should be to buy the cheaper one and sell the expensive one short. You can then deliver the cheap one to cover your short position. Once you take the initial arbitrage position, your arbitrage profit is locked in. The no-investment statement referenced in the text refers to the assumption that when you short the expensive asset, you will be given access to the cash created by the short sale. With this cash, you now have the money to buy the cheaper asset. The no-investment assumption means that the first person to observe a market pricing error will have the financial resources to correct the pricing error instantaneously all by themselves. 12) C

Arbitrage is often referred to as the law of one price. Because when exploiting an arbitrage opportunity an arbitrageur will often simultaneously sell the higher-priced asset and buy the lower-priced asset, no capital may be required. Price differences may persist when short sales are not possible of because the difference is not great enough to outweigh the transaction costs of exploiting it. 13) A

The price of an interest rate swap refers to the fixed rate specified in the swap. This price is calculated as a function of expected future short-term rates.

Version 1

14) A

Early exercise of an in-the-money American put option is valuable when the asset value is significantly below the exercise price (i.e. they are deep in-the money). The payment of interest or dividends from the underlying asset increases put values, so it does not make early exercise valuable as it does with call options. 15) B

Derivatives valuation is based on the assumption that any arbitrage opportunities in financial markets are exploited rapidly so that assets with identical cash flows are forced toward the same price. It does not assume arbitrage opportunities do not arise or that investors are risk neutral. 16) C

For European puts, it is possible that the longer term option can be less valuable than a shorterterm option. 17) B

The put-call parity relationship shows that a protective put (long put, long underlying asset) has the same future payoff as a fiduciary call (long call, long risk-free bond). 18) C

The time value of an option (either a put or a call) is equal to its market price minus its exercise value. A put's exercise value is the maximum of zero or its exercise price minus the stock price. Intrinsic value is another term for exercise value. 19) A

The option premium is made up of time value and intrinsic value. Intrinsic value is positive if an option is in-the-money and zero otherwise. Time value is always positive for call options. If the option still has 30 days until expiration and is in-the-money, the option premium will be the positive intrinsic value, plus the positive time value. Hence, the time value will be less than the premium. If the option is out-of-the-money, the intrinsic value will be zero, and the option premium will be equal to the time value. If the exercise price is greater than the current spot price, the call option is out-of-the-money and hence the intrinsic value again is zero. But as the call option still has time to expiration, the time value will be positive. 20) B

Version 1

The value of an option at expiration is the greater of zero or its exercise value. A higher exercise price increases the exercise value of a put option because it gives the holder the right to sell the underlying asset for a higher price. The risk-free interest rate and volatility of the underlying asset price only affect the time value of options, which is zero at expiration. 21) A

An increase in the price of the underlying asset would decrease the value of a put option, which would make a long position in the put less valuable and a short position more valuable. An increase in either the volatility of the underlying asset price or time to expiration would increase the put value and decrease the value of a short position. 22) C

The price (or premium) of an option is its intrinsic value plus its time value. An out-of-themoney option has an intrinsic value of zero, so its entire premium consists of time value. Time value is zero at an option’s expiration date. Time value is the amount by which an option's premium exceeds its intrinsic value.

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) If money wages increase, other things equal, the most likely result is a: A) short-run inflationary gap. B) long-run inflationary gap. C) short-run recessionary gap. 2) When demand for a good is inelastic, a higher price will: A) have no impact on the demand for the good. B) lead to an increase in total expenditures for the good. C) fail to reduce the quantity demanded for the good. 3) Which of the following is least relevant when explaining why monopoly firms can earn

positive economic profits over the long term? A) The existence of economies of scale. B) Control over production input resources. C) The ability to use price discrimination. 4) A price index that is calculated using the current weights of the index’s basket of goods and

services is known as a: A) hedonic price index. B) chained price index. C) Laspeyres price index. 5) Which of the following is least accurate regarding the allocative efficiency associated with

price discrimination? Price discrimination: A) leads to production where the sum of consumer surplus and producer surplus is greater than it would be otherwise. B) results in gains to the discriminating firm by selling to consumers with relatively inelastic demand. C) leads to a decrease in allocative efficiency. 6) The current annual inflation rate, as measured by using the Consumer Price Index (CPI), is

best defined as: A) percentage change in the CPI from its base period. B) percentage change in the CPI from a year ago. C) increase in the CPI from a year ago.

Version 1

7) Which of the following is least likely to be considered a reason why regulation of monopolies

is not effective? A) Regulators do not know the firm’s cost structure. B) Regulation shifts industry demand and increases prices. C) Regulation reduces the incentive for firms to reduce costs. Regulation is not associated with a shift in industry demand. 8) If the government is running a budget deficit, which of the following relationships are least

likely to occur in the economy at the same time? Exports relative to imports exports < imports exports < imports exports > imports

A) B) C)

Savings relative to investment private savings > private investment private savings < private investment private savings < private investment

A) Option A B) Option B C) Option C 9) Which of the following is least accurate with regard to advertising for firms operating under

monopolistic competition? A) Advertising expenses are high relative to perfect competition and monopoly. B) Advertising may decrease average total cost. C) The increase to average total costs associated with advertising increases as output increases. 10) In order for effective price discrimination to occur the seller must: A) maximize revenue by selling at the highest price possible. B) face a demand curve with a negative slope. C) have more than one identifiable group of customers with the same price elasticities of

demand for the product. 11) Which of the following is least accurate regarding the relationship between price (P),

marginal revenue (MR), average total cost (ATC), and marginal cost (MC) at the profit maximizing output under monopoly? A) P = MR. B) MR = MC. C) MR < ATC.

Version 1

12) Steve Walker, CFA, is attending an economics lecture, during which the lecturer makes the

following two statements about consumer price inflation: Statement 1: High-definition televisions are considerably more expensive than traditional models. This means consumers are spending more money per television unit, which represents a form of inflation. Statement 2: Employment contracts with automatic increases based on the Consumer Price Index fail to increase wages as much as the increase in the cost of living because of biases in the price index. Should Walker agree or disagree with these statements? Statement 1

Statement 2

Disagree Disagree Agree

Disagree Agree Agree

A) B) C) A) Option A B) Option B C) Option C

13) In a perfectly competitive industry, the short-run supply curve for the market is the: A) marginal cost curve above the average variable cost curve. B) sum of the individual supply curves for all firms in the industry. C) marginal cost curve above the average total cost curve. 14) If private saving equals private business investment, a trade surplus implies that there is: A) no fiscal surplus or deficit. B) a fiscal surplus. C) a fiscal deficit. 15) In the long-run, after all firms in a perfectly competitive industry have adopted new

technology, the: A) price will equal minimum average total cost. B) individual firm supply will increase as demand decreases. C) price will be set where average variable cost is equal to marginal revenue.

Version 1

16) For price discrimination to work, the seller must face a market with all of the following

characteristics EXCEPT: A) a downward sloping demand curve. B) high barriers to entry. C) a way of preventing customers from purchasing the product at a lower price and reselling it at a higher price. 17) Which of the following amounts is least likely to be subtracted from gross domestic product

in order to calculate national income? A) Statistical discrepancy. B) Indirect business taxes. C) Capital consumption allowance. 18) Based on the concept of diminishing returns, as the quantity of output increases, the short-run

marginal costs of production eventually: A) rise at an increasing rate. B) fall at a decreasing rate. C) rise at a decreasing rate. 19) Manufacturing and trade sales are best described as a: A) leading indicator. B) lagging indicator. C) coincident indicator. 20) What is the relationship between price and marginal revenue for a price searcher? A) Marginal revenue = price. B) Marginal revenue < price. C) Marginal revenue > price. 21) When potential real GDP is less than actual real GDP, the economy is most likely

experiencing: A) underemployment. B) recession. C) inflation. 22) Even though the producer surplus increases under a monopoly scenario, relative to one of

perfect competition, the consumer surplus decreases by: A) an equal amount. B) a greater amount. C) a lesser amount.

Version 1

23) If a fiscal budget deficit increases, which of the following factors must also increase if all

other factors are held constant? A) Trade surplus. B) Savings. C) Investment. 24) In the dominant firm model of oligopoly, it is least likely that one firm: A) has a significant cost advantage over its competitors. B) effectively sets the price in the market. C) is the innovation leader in product development. 25) The kinked demand model assumes that below the current price, the demand curve becomes: A) more elastic because competitors will decrease their prices. B) less elastic because competitors will decrease their prices. C) less elastic because competitors will not decrease their prices. 26) Consider the following statements:

Statement 1: “When oligopoly firms cheat on price fixing agreements, the result increases economic efficiency.” Statement 2: “Monopolistic competition is inefficient because a large deadweight loss from advertising and marketing costs is a characteristic of this form of competition.” With respect to these statements: A) both are correct. B) only one is correct. C) both are incorrect.

Version 1

27) Assume that the market for paper supplies and the market for toothpicks have the following

characteristics: The Market for Paper Supplies is comprised of: A large number of independent sellers Differentiated products Low barriers to entry/exit A large number of independent sellers Homogeneous products No barriers to entry/exit A) decrease, and so will the quantity sold by Wudden Floss. B) increase, and the quantity sold by Wudden Floss will decrease. C) decrease, and Wudden Floss will sell nothing. 28) Average weekly initial claims for unemployment insurance are classified as a: A) coincident indicator. B) leading indicator. C) lagging indicator. 29) A company has estimated that the price elasticity of demand for its output is −1.1. If the

company increases the price of its product by 5%, it is most likely that: A) both total revenue and profits will decrease. B) total revenue will decrease but profits may increase. C) total revenue will increase but profits may decrease. 30) If domestic savings are insufficient to finance domestic private investment and exports are

greater than imports, it is most likely that the fiscal budget has: A) a deficit that is less than the trade surplus. B) a surplus that is greater than the trade surplus. C) a deficit that is greater than the trade surplus. 31) An economist calculates the following value:

National income + transfer payments to households − indirect business taxes − corporate income taxes − undistributed corporate profits The most appropriate term for the value she has calculated is: A) disposable income. B) GDP. C) personal income.

Version 1

32) In the short run, will an increase in the money supply increase the price level and real output? A) Only one will increase in the short run. B) Both will increase in the short run. C) Neither will increase in the short run. 33) Which of the following events is most likely to increase short-run aggregate supply (shift the

curve to the right)? A) Inflation that results in an increase in goods prices. B) An increase in government spending intended to increase real output. C) High unemployment puts downward pressure on money wages. 34) With respect to the IS-LM model, a change in the price level will shift: A) the LM curve, but not the aggregate demand curve. B) the aggregate demand curve, but not the LM curve. C) both the LM and aggregate demand curves. 35) Compared to a competitive market result, a single-price monopoly will most likely: A) adopt a marginal cost pricing strategy, which will decrease consumer surplus. B) result in lower output, deadweight loss, and less producer and consumer surplus. C) result in a higher price, less consumer surplus, and more producer surplus. 36) The spot rate for Japanese yen per UK pound is 138.78. If the UK interest rate is 1.75% and

the Japanese interest rate is 1.25%, the 6-month no-arbitrage forward rate is closest to: A) 138.10 JPY/GBP. B) 138.44 JPY/GBP. C) 138.95 JPY/GBP. 37) The spot rate for Chinese yuan per Canadian dollar is 6.4440. If the Canadian interest rate is

2.50% and the Chinese interest rate is 3.00%, the 3-month no-arbitrage forward rate is closest to: A) 6.436 CNY/CAD. B) 6.475 CNY/CAD. C) 6.452 CNY/CAD.

Version 1

38) If households are holding larger real money balances than they desire, which of the following

is least likely? A) The opportunity cost of holding money balances will decrease. B) The interest rate is higher than its equilibrium rate in the market for real money balances. C) The central bank must issue securities to absorb the excess money supply and establish equilibrium. 39) According to the quantity theory of money, if nominal GDP is $7 trillion, the price index is

150, and the money supply is $1 trillion, then the velocity of the money supply is closest to: A) 7.0. B) 10.5. C) 4.7. 40) The spot exchange rate for United States dollars per United Kingdom pound (USD/GBP) is

1.5775. If 30-day interest rates are 1.5% in the United States and 2.5% in the United Kingdom, and interest rate parity holds, the 30-day forward USD/GBP exchange rate should be: A) 1.5788. B) 1.5621. C) 1.5762. 41) Participants in foreign exchange markets that can be characterized as "real money accounts"

most likely include: A) insurance companies. B) hedge funds. C) central banks. 42) Which of the following relationships in regard to the quantity theory of money is least

accurate? A) Nominal GDP = Price × Money Supply. B) Nominal GDP = Money Supply × Velocity = Price × Real Output. C) Money × Velocity = Money Supply × Velocity. 43) In the context of the foreign exchange market, investment accounts are said to be leveraged if

they: A) buy currencies on margin. B) use derivatives. C) borrow and sell foreign currencies.

Version 1

44) If a bank needs to borrow funds from the Federal Reserve to fund a temporary shortage in

reserves, it would borrow funds at the: A) prime rate. B) discount rate. C) federal funds rate. 45) Assuming the federal government maintains a balanced budget, the most likely effects of a

tax increase on government expenditures and real GDP are: Government Expenditures

Real GDP

Increase Increase Decrease

Increase Decrease Decrease

A) B) C) A) Option A B) Option B C) Option C

46) Spot and one-month forward exchange rates are as follows:

EUR/DEF EUR/GHI EUR/JKL

Spot

1-month forward

2.5675 4.3250 7.0625

2.5925 4.2800 7.0075

Based on these exchange rates, the EUR is closest to a 1-month forward: A) premium of 1% to the GHI. B) discount of 1% to the JKL. C) premium of 1% to the DEF. 47) Frequent changes in advertised prices are one of the costs of: A) unexpected inflation only. B) both expected and unexpected inflation. C) expected inflation only.

Version 1

48) The exchange rate for Australian dollars per British pound (AUD/GBP) was 1.4800 five

years ago and is 1.6300 today. The percent change in the Australian dollar relative to the British pound is closest to: A) depreciation of 9.2%. B) appreciation of 10.1%. C) depreciation of 10.1%. 49) Which of the following statements about the demand and supply of money is most accurate?

People who are: A) buying bonds to reduce their money balances will increase the demand for bonds with an associated increase in interest rates. B) holding money when interest rates are lower will try to increase their money balances and, as a result, the supply of money increases. C) holding money when interest rates are higher will try to reduce their money balances and, as a result, the demand for money decreases. 50) The spot exchange rate for CHF/EUR is 0.8342 and the 1-year forward quotation is −0.353%.

The 1- year forward exchange rate for EUR/CHF is closest to: A) 1.2022. B) 0.8313. C) 1.2029. 51) Contractionary monetary policy is least likely to decrease consumption spending by

decreasing: A) the foreign exchange value of the currency. B) securities prices. C) expectations for economic growth. 52) Other things equal, a real exchange rate (stated as units of domestic currency per unit of

foreign currency) will decrease as a result of an increase in the: A) nominal exchange rate (domestic/foreign). B) domestic price level. C) foreign price level. 53) In the balance of payments accounts, goods and financial assets that migrants bring to a

country are included in the: A) financial account. B) capital account. C) current account.

Version 1

54) If the money interest rate is measured on the y-axis and the quantity of money is measured on

the x- axis, the money supply curve is: A) vertical. B) downward sloping to the lower right. C) upward sloping to the upper right. 55) According to the Fisher effect, which of the following interest rates includes a premium for

the expected rate of inflation? A) Neither yields on short-term government debt nor yields on long-term corporate debt. B) Both yields on short-term government debt and yields on long-term corporate debt. C) Yields on long-term corporate debt, but not yields on short-term government debt. 56) A country is experiencing a core inflation rate of 7% during a recessionary period of real

GDP growth. If the central bank has a single mandate to achieve price stability and uses inflation targeting with an acceptable range of zero to 4%, its monetary policy response is most likely to decrease: A) the foreign exchange value of the country’s currency. B) short-term interest rates. C) GDP growth in the short run. 57) In 20X5, Carthage’s merchandise imports exceeded the value of its merchandise exports. In

this case, Carthage would most likely have which of the following? A) Current account surplus. B) Balance of trade surplus. C) Capital account surplus. 58) The least likely result of import quotas and voluntary export restraints is: A) a decrease in the quantity of imports of the product. B) increased revenue for the government. C) a shift in production toward higher-cost suppliers. 59) The USD/EUR spot exchange rate is 1.3500 and 6-month forward points are −75. The 6-

month forward exchange rate is: A) 1.3575, and the USD is at a forward discount. B) 1.3425, and the USD is at a forward discount. C) 1.3425, and the USD is at a forward premium.

Version 1

60) Assume that the long-term equilibrium money market interest rate is 4% and the current

money market interest rate is 3%. At this current rate of 3%, there will be an excess: A) supply of money in the money market, and investors will tend to be net buyers of securities. B) demand for money in the money market, and investors will tend to be net buyers of securities. C) demand for money in the money market, and investors will tend to be net sellers of securities.

Version 1

Answer Key Test name: Economics 1) C

An increase in the wage rate decreases short-run aggregate supply, leading to a short-run recessionary gap. 2) B

When demand is relatively inelastic, consumers do not reduce their quantity demanded very much when the price increases. That is, a given percentage increase in price results in a smaller percentage reduction in quantity demanded. Thus, total expenditures on the good increase. "Fail to reduce the quantity demanded for the good" is inaccurate because that would only be true if demand was perfectly inelastic. 3) C

High entry barriers due to economies of scale, government licensing, resource controls, and patents prevent new firms from entering the market to exploit positive economic profit opportunities. 4) B

A chained or chain-weighted price index uses updated weights for each good and service in its market basket. A price index that is not chain-weighted, such as a Laspeyres index, is calculated using weights for each good and service in the market basket as of the index’s base period. Hedonic pricing is a technique used to adjust a price index for upward bias from quality changes of goods in its market basket. 5) C

Allocative efficiency occurs when the quantity produced maximizes the sum of consumer and producer surplus. That is, where marginal benefit equals marginal cost. Price discrimination reduces the allocative inefficiency that exists when prices are greater than marginal cost by increasing output toward the quantity where price equals marginal cost. Firms gain by selling to customers with inelastic demand while still providing goods to customers with more elastic demand. This may even cause production to take place at a level where it would not take place otherwise. 6) B

The inflation rate is the percentage change in the price index from a year earlier. 7) B 8) C

Version 1

A government budget deficit, a trade surplus, and an excess of private investment over private savings cannot all occur at the same time. If the government runs a budget deficit, the deficit must be financed by a trade deficit (exports < imports), surplus private savings (private savings > private investment), or both. 9) C

Advertising expenses are high for firms in monopolistic competition. Not only because firms need to inform consumers about the unique features of a firm’s products, but also to create or increase a perception of differences between products that are actually quite similar. Advertising costs increase average total costs, but the increase to average total cost attributable to advertising decreases as output increases because more fixed advertising dollars are being averaged over a larger quantity. If advertising increases output (sales) significantly, it can actually decrease a firm’s average total cost if there are economies of scale. 10) B

In order for effective price discrimination to occur, the seller must have a downward sloping demand curve. The seller must also have at least two identifiable groups of customers with price elasticities of demand for the product, and the seller must be able to prevent customers from reselling the product. 11) A

To maximize profit, all firms expand output until marginal revenue equals marginal cost. Price is determined from the demand curve, which is above the marginal revenue curve since a monopoly faces a downward sloping demand curve. 12) A

Walker should disagree with both statements. Price changes resulting from increases in the quality of goods, do not represent inflation. However, the Consumer Price Index is affected by biases from product quality, as well as new goods and substitution, causing it to overstate the rate of inflation. As a result, increases in wages that are based on CPI will more than compensate for actual increases in the cost of living. 13) B

The short-run supply curve for a firm is its marginal cost curve above the average variable cost curve. The short-run supply curve of the market is the sum of the supply curves for all firms in the industry. 14) B

Version 1

The fundamental relationship among saving, investment, the fiscal balance, and the trade balance is stated as: (G − T) = (S − I) − (X − M). If S = I, this equation becomes (G − T) = − (X − M), or (T − G) = (XM). In this case, if the trade balance is in surplus (exports are greater than imports), the fiscal balance must also be in surplus (taxes are greater than government spending). 15) A

After some firms in an industry adopt a technological change, the existing firms that use the old technology will experience losses and either adopt the technology or exit the industry. Long-run equilibrium with price equal to minimum average total cost for the new technology will be established. 16) B

Price discrimination is the practice of charging different consumers different prices for the same product or service. For price discrimination to work the seller must: 1) have a downward sloping demand curve, 2) have at least two identifiable groups of customers with different price elasticities of demand, 3) must be able to prevent customers in the lower-price group from reselling the product to customers in the higher-price group. 17) B

Indirect business taxes are not subtracted because they are included in national income. 18) A

The law of diminishing returns states that as more variable resources are a production process combined with a fixed input, output will eventually increase at a decreasing rate. In the short run, as the quantity produced rises, costs rise at an increasing rate. 19) C

Manufacturing and trade sales are a coincident indicator that generally reflects the current phase of the business cycle. 20) B

For a price searcher, demand is downward sloping, marginal revenue is less than price since price must be reduced to sell additional units of output. 21) C

The economy is in an inflationary phase if actual real GDP is greater than potential real GDP. When actual real GDP equals potential real GDP, the economy is said to be at full employment. The economy is in a recessionary phase if real GDP is less than potential GDP. 22) B

Version 1

The consumer surplus decreases by a greater amount than the producer surplus increases, with the difference representing a deadweight loss. 23) B

The relationship between the fiscal balance, savings, investment, and the trade balance is (G − T) = (S − I) − (X − M). An increase in a fiscal budget deficit (G − T) must be funded by an increase in savings (S), a decrease in investment (I), or a decrease in net exports (X − M), which would decrease a trade surplus or increase a trade deficit. 24) C

The dominant firm model of oligopoly is based on the assumption that one firm has a significant cost advantage which allows it to set the price in the market and control a relatively large share of the industry’s production and sales. It does not assume that the firm will be the innovation leader in product development. In fact, being more innovative is one of the factors that allow smaller competitors that work at a cost disadvantage to survive. 25) B

The kinked demand model of oligopoly behavior assumes that a firm’s competitors will not match a price increase, but will match the price of a competitor that offers a lower price. The result is a demand curve that is more elastic above the current price, but less elastic below it. 26) B

With a price-fixing agreement, producers in an oligopoly market restrict output to increase price and joint profits just as a monopoly producer does. Such agreements decrease economic efficiency. When these agreements are violated, quantity produced increases, increasing economic efficiency. Therefore Statement 1 is accurate. The efficiency of monopolistic competition is not clear. While increased opportunity cost is associated with the intensive marketing and advertising activities that are characteristic of monopolistic competition, consumers definitely benefit from these selling activities because they receive information that often enables them to make better purchasing decisions. Hence the advertising and marketing costs may be more than the efficient amount, but do not represent a deadweight loss. Therefore Statement 2 is inaccurate. 27) C

Version 1

Papyrus Company is an example of a price searcher engaged in monopolistic competition (low barriers to entry). Thus, the company faces a downward sloping demand curve and highly elastic demand. An increase in price will result in fewer units sold. Wudden Floss is an example of a price taker operating in a purely competitive market. Thus, the firm faces a horizontal demand curve and perfectly elastic demand. An increase in price will result in no units sold. In a purely competitive market, the firm must take the market price. 28) B

Initial claims for unemployment insurance are considered a leading indicator. 29) B

Price elasticity of −1.1 tells us that a 5% increase in price will reduce sales by more than 5%, so total revenue will decrease. Whether profits increase or decrease will depend on whether the cost reduction from producing less output is greater or less than the decrease in total revenue. 30) B

The fundamental relationship among saving, investment, the fiscal balance and the trade balance is expressed as (S − I) = (G − T) + (X − M). If domestic savings (S) are not sufficient to finance private investment (I), then (S − I) is negative and the sum (G − T) + (X − M) must also be negative. With exports greater than imports, (X − M) is positive so (G − T) must be negative and larger than (X − M). If (G − T) is negative, taxes (T) are greater than government spending (G) and the government has a fiscal surplus. 31) C

Personal income is calculated by adding transfer payments to national income and subtracting indirect business taxes, corporate income taxes, and undistributed corporate profits. Disposable income is personal income minus personal taxes. GDP is national income plus a capital consumption allowance and an adjustment for statistical discrepancy between the income and expenditure approaches. 32) B

In the short run, an increase in the money supply will increase aggregate demand. The new shortrun equilibrium will be at a higher price level and a greater level of real output (GDP). 33) C

Version 1

Falling money wages would cause businesses to increase (profit-maximizing) output levels at each price level for final goods and services. Changes in the price level of goods and services are represented by a movement along a short-run aggregate supply curve, not a shift in the curve. A rise in resource prices will decrease aggregate supply. An increase in government spending will shift the aggregate demand curve but not the aggregate supply curve. 34) A

Because an LM curve is constructed for a given level of the real money supply, a change in the price level (which affects the real money supply) will shift the LM curve. The aggregate demand curve is determined by changing the price level, which produces alternative LM curves. Changing price levels determines the aggregate demand curve from the intersections of alternative LM curves with the IS curve. 35) C

A firm in a monopoly position will reduce output to where MC = MR, which will increase price, decrease consumer surplus, and increase producer surplus. A marginal cost pricing strategy refers to regulation which requires a firm to set price equal to marginal cost. 36) B

The calculation is as follows:

37) C

The calculation is as follows:

38) C

If households' real money balances are larger than they desire, the interest rate (opportunity cost of holding money balances) is higher than its equilibrium rate. Households will use their undesired cash to buy securities, bidding up securities prices and reducing the interest rate until the equilibrium rate is achieved. This market process does not require any action by the central bank. 39) A

The equation of exchange is MV = PY. Nominal GDP = PY, so that MV = nominal GDP. Therefore, ($1.0 trillion)(V) = $7.0 trillion. V = $7.0 trillion / $1.0 trillion. V = 7.0.

Version 1

40) C

Forward USD/GBP = spot USD/GBP × (1 + U.S. interest rate) / (1 + UK interest rate) = 1.5775 × [(1 + 0.015/12) / (1 + 0.025/12)] = 1.5762 41) A

Real money accounts are foreign exchange buy-side investors that do not use derivatives. Many mutual funds, pension funds, and insurance companies can be classified as real money accounts. Hedge funds typically use derivatives. Central banks usually do not act as investors in foreign exchange markets but may intervene in foreign exchange markets to achieve monetary policy objectives. 42) A

The quantity theory of money holds that: Money Supply × Velocity = Nominal GDP = Price × Real Output. 43) B

Leveraged accounts in the foreign exchange market refer to investment accounts that use derivatives. 44) B

Banks are able to borrow from the Fed at the discount rate. The federal funds rate is the interest rate banks charge other banks to borrow reserves from other banks. The prime rate is the rate that commercial banks charge their best customers. 45) A

The amount of the spending program exactly offsets the amount of the tax increase, leaving the budget unaffected (balanced budget). The multiplier effect is stronger for government spending versus the tax increase. Therefore, the balanced budget multiplier will be positive. All of the government spending enters the economy as increased expenditure, whereas only a portion of the tax increase results in lessened expenditure (determined by the marginal propensity to consume), because part of the tax increase will come from the savings of the taxpayer (determined by the marginal propensity to save). 46) A

The EUR is at a forward premium to the GHI because the EUR/GHI forward rate is less than the EUR/GHI spot rate. The base currency, GHI, is at a forward discount of forward/spot − 1 = 4.2800 / 4.3250 − 1 = −1.04%. The EUR is at a forward discount to the DEF and a forward premium to the JKL.

Version 1

47) B

Inflation imposes "menu costs" on an economy as businesses must frequently change their advertised prices, regardless of whether inflation is expected or unexpected. 48) A

To correctly calculate the percentage change in AUD relative to GBP, convert the exchange rates so that AUD is the base currency: 1 / 1.4800 = 0.6757 GBP/AUD five years ago and 1 / 1.6300 = 0.6135 GBP/AUD today. The percentage change in the Australian dollar against the British pound is 0.6135 / 0.6757 − 1 = −9.2%. Note that the GBP has appreciated against the AUD by 1.6300 / 1.4800 − 1 = 10.1% over the same period. 49) C

Buying bonds would drive bond prices up and interest rates down. Selling bonds would have the opposite effect; driving bond prices down and interest rates up. When interest rates are lower, there is an excess demand for money. The supply of money is determined by the monetary authorities. 50) C

The forward rate for CHF/EUR is 0.8342 × (1 − 0.00353) = 0.8313. The 1-year forward EUR/CHF exchange rate is 1 / 0.8313 = 1.2030. 51) A

Contractionary monetary policy is likely to increase the value of the domestic currency in the foreign exchange market, which decreases foreign demand for the country's exports. Contractionary monetary policy should cause both securities prices and expectations for economic growth to decrease, each of which is likely to cause consumers to decrease spending. 52) B

An increase in the domestic price level, other things equal, will decrease a real exchange rate. Increases in the nominal exchange rate or the foreign price level, other things equal, will increase a real exchange rate. 53) B

The capital account includes goods and financial assets that migrants bring when they come to a country or take with them when they leave. 54) A

Version 1

The money supply schedule is vertical because it is not affected by changes in the interest rate but is determined by the monetary authorities such as the Federal Reserve System (Fed) in the United States. 55) B

The Fisher effect holds that all nominal interest rates include a premium for expected inflation. 56) C

If the central bank has a price stability mandate, it will most likely respond to the above-target inflation rate by decreasing the money supply, even though GDP growth is in a recessionary phase. Decreasing the money supply will result in higher short-term interest rates and appreciation of the currency, but will likely cause GDP growth to decrease further in the short run. 57) C

If a country is running a current account deficit, it must have an inflow of foreign capital, creating a surplus in the capital account. 58) B

Import quotas and voluntary export restraints, unlike tariffs, do not necessarily generate tax revenue. The other choices describe effects that result from tariffs, quotas, and VERs. 59) C

For an exchange rate quoted to four decimal places, each forward point represents 0.0001. The 6month forward exchange rate is 1.3500 − 0.0075 = 1.3425 USD/EUR. The USD is expected to appreciate against the EUR and is trading at a forward premium. 60) C

At interest rates below 4% (the long-term equilibrium rate), the quantity of money demanded exceeds the quantity of money supplied. At below-equilibrium rates, investors will sell bonds to obtain the desired extra cash. As they sell more bonds, the prices of bonds fall, and interest rates start to move back towards the 4% equilibrium.

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Which of the following statements best describes the overreaction effect? A) Low returns over a three-year period are followed by high returns over the following three years. B) High returns over a one-year period are followed by low returns over the following three years. C) High returns over a one-year period are followed by high returns over the following year. 2) Equal weighting is the most common weighting methodology for indexes of which of the

following types of assets? A) Hedge funds. B) Equities. C) Fixed income securities. 3) Which of the following option positions is said to be a long position? A) Writer of a put option. B) Buyer of a put option. C) Writer of a call option. 4) An investor bought a stock on margin. The margin requirement was 60%, the current price of

the stock is $80, and the stock price was $50 one year ago. If margin interest is 5%, how much equity did the investor have in the investment at year-end? A) 73.8%. B) 60.6%. C) 67.7%. 5) Peg Fisk, CFA, states that two of the objectives of market regulation which CFA Institute

attempts to address are minimum standards of competence among investment professionals and ease of performance evaluation for investors. Fisk is accurate with regard to: A) only one of these objectives B) both of these objectives. C) neither of these objectives.

Version 1

6) The idea that uninformed traders, when faced with unclear information, observe the actions

of informed traders to make decisions, is referred to as: A) narrow framing. B) herding behavior. C) information cascades. 7) Which of the following statements least likely describes the role of a portfolio manager in

perfectly efficient markets? Portfolio managers should: A) quantify client's risk tolerance, communicate portfolio policies and strategies, and maintain a strict buy and hold policy avoiding any changes in the portfolio to minimize transaction costs. B) construct diversified portfolios that include international securities to eliminate unsystematic risk. C) construct a portfolio that includes financial and real assets. 8) Which of the following conditions is most likely necessary for capital to be allocated to its

most valuable uses? A) There are no barriers to the flow of complete information to the financial markets. B) Investors are well informed about the risk and return of various investments. C) Financial markets are frictionless (i.e., free of taxes or transactions costs). 9) The value of a total return index: A) may increase at either a faster or slower rate than the value of a price return index

with the same constituent securities and weights. B) can be calculated by multiplying the beginning value by the geometrically linked series of periodic total returns. C) is determined by the price changes of the securities that constitute the index. 10) Which of the following statements about indexes is CORRECT? A) An equal weighted index assumes a proportionate market value investment in each

company in the index. B) A market weighted series must adjust the denominator to reflect stock splits in the sample over time. C) A price-weighted index assumes an equal number of shares (one of each stock) represented in the index.

Version 1

11) If the momentum effect persists over time, it would provide evidence against which of the

following forms of market efficiency? A) Weak form only. B) Both weak form and semi strong form. C) Semi strong form only. 12) Which of the following statements concerning market efficiency is least accurate? A) Tests of the semi-strong form of the EMH require that security returns be risk-

adjusted using a market model. B) Market efficiency assumes that individual market participants correctly estimate asset prices. C) If weak-form market efficiency holds, technical analysis cannot be used to earn abnormal returns over the long-run. 13) An analyst with Guffman Investments has developed a stock selection model based on

earnings announcements made by companies with high P/E stocks. The model predicts that investing in companies with P/E ratios twice that of their industry average that make positive earnings announcements will generate significant excess return. If the analyst has consistently made superior risk-adjusted returns using this strategy, which form of the efficient market hypothesis has been violated? A) Strong, semi strong, and weak forms. B) Weak form only. C) Semi strong and strong forms only. 14) A stock's price currently is $100. An analyst forecasts the following for the stock:

The normalized trailing price earnings (P/E) ratio will be 12×. The stock is expected to pay a $5 dividend this coming year on projected earnings of $10 per share. If the analyst were to buy and hold the stock for the year, the projected rate of return based on these forecasts is closest to: A) 15%. B) 25%. C) 20%.

Version 1

15) A firm has a constant growth rate of 7% and just paid a dividend of $6.25. If the required rate

of return is 12%, what will the stock sell for two years from now based on the dividend discount model? A) $133.75. B) $149.80. C) $153.13. 16) Which of the following industries is most likely to operate in a fragmented market? A) Pharmaceuticals. B) Oil services. C) Confections. 17) When constructing a peer group of firms, an analyst should least appropriately consider the

firms’: A) industry classification. B) cost structures. C) business cycle sensitivity. 18) In a period when U.S. equity prices are increasing and the U.S. dollar is depreciating, which

of the following investors in U.S. equities is most likely to earn the highest return in the investor's local currency? A) U.S. investor who reinvests dividends. B) Non-U.S. investor who reinvests dividends. C) Non-U.S. investor who does not reinvest dividends. 19) Assume a company has earnings per share of $5 and pays out 40% in dividends. The

earnings growth rate for the next 3 years will be 20%. At the end of the third year the company will start paying out 100% of earnings in dividends and earnings will increase at an annual rate of 5% thereafter. If a 12% rate of return is required, the value of the company is closest to: A) $102.80. B) $92.90. C) $55.70.

Version 1

20) Given the following estimated financial results for the next period, value the stock of

FishnChips, Incorporated, using the infinite period dividend discount model (DDM). Sales of $1,000,000. Earnings of $150,000. Total assets of $800,000. Equity of $400,000. Dividend payout ratio of 60.0%. Average shares outstanding of 75,000. Real risk free interest rate of 4.0%. Expected inflation rate of 3.0%. Expected market return of 13.0%. Stock Beta at 2.1. The per share value of FishnChips stock is approximately: (Note: Carry calculations out to at least 3 decimal places.) A) $17.91. B) $26.86. C) $30.89. 21) Because of dividend displacement of earnings, the net effect on firm value of increasing the

dividend payout ratio is: A) to increase firm value. B) indeterminate. C) to decrease firm value. 22) The experience curve, which illustrates the cost per unit relative to output: A) slopes upward. B) slopes downward. C) slopes upward in the early years and downward in the later years. 23) Which of the following is least likely a reason the price to cash flow (P/CF) model has grown

in popularity? A) CFs are used extensively in valuation models. B) CFs are more easily estimated than future dividends. C) CFs are generally more difficult to manipulate than earnings. CFs are not easier to estimate than dividends.

Version 1

24) Declining prices that result from the development of substitute products are most likely to

characterize an industry in the: A) shakeout stage. B) mature stage. C) decline stage. 25) Use the following information and the multi-period dividend discount model to find the value

of Computech’s common stock. Last year’s dividend was $1.62. The dividend is expected to grow at 12% for three years. The growth rate of dividends after three years is expected to stabilize at 4%. The required return for Computech’s common stock is 15%. Which of the following statements about Computech's stock is least accurate? A) At the end of two years, Computech's stock will sell for $20.69. B) The dividend at the end of year three is expected to be $2.28. C) Computech's stock is currently worth $17.46. 26) What value would be placed on a stock that currently pays no dividend but is expected to

start paying a $1 dividend five years from now? Once the stock starts paying dividends, the dividend is expected to grow at a 5 percent annual rate. The appropriate discount rate is 12 percent. A) $9.08. B) $14.29. C) $8.11. 27) Which of the following is least likely an advantage of using price/sales (P/S) multiple? A) P/S multiples provide a meaningful framework for evaluating distressed firms. B) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in

valuation analysis. C) P/S multiples are more reliable because sales data cannot be distorted by management. 28) Industry analysis is most likely to provide an analyst with insight about a company's: A) pricing power. B) financial performance. C) competitive strategy.

Version 1

29) Yong Kim, CFA, buys a preferred stock that has a 6% dividend yield (defined as the ratio of

the preferred dividend to the market price of the preferred stock). One year later, Kim sells the stock when it is selling at a 5% dividend yield. The preferred stock pays a fixed annual dividend, which Kim received right before selling. What rate of return did Kim realize on his investment? A) 26%. B) 14%. C) 20%. 30) A conglomerate is in the following lines of business, with segment revenue as a percentage

of total revenue: 30% banking, 30% automobiles, 25% apparel, and 15% heavy machinery. Based on the Global Industry Classification Standard, the sector classification for this company is most likely: A) industrials. B) financial services. C) consumer discretionary.

Version 1

Answer Key Test name: Equity Investments 1) A

The overreaction effect refers to stocks with poor returns over three to five-year periods that had higher subsequent performance than stocks with high returns in the prior period. The result is attributed to overreaction in stock prices that reverses over longer periods of time. Stocks with high previous short- term returns that have high subsequent returns show a momentum effect. 2) A

Most hedge fund indexes are equal-weighted. Equity and fixed income indexes are predominately market capitalization weighted. 3) B

The buyer of an option (either a call or put) is said to be long the option and the writer of an option is said to be short the option. Note that with put options, the long (put option holder) benefits when the price of the underlying asset decreases, while the short (put option writer) benefits when the price of the underlying asset increases. We say that a put buyer is long the option but has short exposure to the underlying asset price. 4) A

Margin debt = 40% × $50 = $20; Interest = $20 × 0.05 = $1. Equity % = [Value − (margin debt + interest)] / Value $80 − $21 / $80 = 73.8% 5) B

CFA Institute attempts to address both of these objectives of market regulation. The CFA Program is part of the effort to encourage minimum standards of competency among finance professionals. Global Investment Performance Standards are part of the effort to make performance evaluation easier for investors. 6) C

“Information cascades” refers to uninformed traders watching the actions of informed traders when making investment decisions. Herding behavior is when trading occurs in clusters, not necessarily driven by information. Narrow framing refers to investors viewing events in isolation. 7) A

Version 1

A portfolio manager should quantify each client's risk tolerance and communicate portfolio policies and strategies. However, portfolio managers should monitor client's needs and changing circumstances and make appropriate changes to the portfolio. Adhering to a strict buy and hold policy would not be in the client's best interest. Portfolios need to be rebalanced and changed to meet client’s changing needs. 8) B

Capital will flow to its most valuable uses if markets function well and investors are well informed about the risk and return characteristics of various investments. Allocation of capital to its most valuable uses does not require that all investors have complete information or that financial markets are frictionless. 9) B

The value of a total return index can be calculated by multiplying the beginning value by the geometrically linked series of index total returns. The value of a total return index includes both the price changes of the securities that constitute the index and any cash flows from the securities (dividends, interest, and other distributions). A total return index cannot increase at a slower rate (or decrease at a faster rate) than an otherwise identical price return index because cash flows from the securities cannot be negative. 10) C

The descriptions of value weighted and unweighted indexes are switched. The denominator of a price- weighted index must be adjusted to reflect stock splits and changes in the sample over time. A market value-weighted series assumes you make a proportionate market value investment in each company in the index. 11) B

The momentum effect suggests it is possible to earn abnormal returns using market data. All three forms of market efficiency (weak form, semi strong form, and strong form) assume that market prices fully reflect market data. 12) B

Market efficiency does not assume that individual market participants correctly estimate asset prices, but does assume that their estimates are unbiased. That is, some agents will over-estimate and some will under-estimate, but they will be correct, on average. 13) C

Version 1

The semi strong form of EMH states that security prices rapidly adjust to reflect all publicly available information. If the analyst can use his model, which is based on publicly available information, to earn above average returns, the semi strong form of the EMH has been violated. If the semi strong form of EMH is violated, the strong form of EMH is also violated. 14) B

The forecast year-end price, P, is: P = EPS × (P/E) = 10(12) = 120

15) C

16) B

Most areas of the oil services industry are characterized by many small competitors. The confections and pharmaceutical industries each have a small number of very large firms. 17) C

A peer group should consist of firms that are alike in their principal lines of business, along with other similarities such as cost structures and access to capital. Firms can be similar in business cycle sensitivity but dissimilar in terms of their business activities (e.g., a firm in the home building industry and a firm in the heavy equipment manufacturing industry). 18) A

Sources of return on equity securities include price appreciation or depreciation, dividend income, and foreign exchange gains or losses for investors outside the country. In an increasing equity market, reinvesting dividends is likely to increase returns compared to not reinvesting dividends. If the currency is depreciating, investors from outside the country will experience foreign exchange losses that decrease their returns. 19) A

Version 1

First, calculate the dividends in years 0 through 3:(We need D3 to calculate the value in Year 2) D0 = (0.4)(5) = 2 D1 = (2)(1.2) = 2.40 D2 = (2.4)(1.2) = 2.88 D3 = E3 = 5(1.2)3 = 8.64 BecauseD3 will grow at a constant rate, we can use it to estimate a terminal value for the stock at t = 2: P2 = D3 / (k − g) = 8.64 / (0.12 − 0.05) = $123.43 Present value of the cash flows = value of stock =2.4 / (1.12)1 + 2.88 / (1.12)2 + 123.43 / (1.12)2 = 102.83 20) B

Version 1

Here, we are given all the inputs we need. Use the following steps to calculate the value of the stock: First, expand the infinite period DDM: DDM formula:P0 = D1 / (ke − g) D1 = (Earnings × Payout ratio) / average number of shares outstanding = ($150,000 × 0.60) / 75,000 = $1.20 ke = nominal risk free rate + [beta × (expected market return − nominal risk free rate)] Note: Nominal risk-free rate = (1 + real risk free rate) × (1 + expected inflation) − 1 = (1.04) × (1.03) − 1 = 0.0712, or 7.12%. ke = 7.12% + [2.1 × (13.0% – 7.12%)] = 0.19468 g = (retention rate × ROE) Retention = (1 − Payout) = 1 − 0.60 = 0.40. ROE = (net income / sales)(sales / total assets)(total assets / equity) = (150,000 / 1,000,000)(1,000,000 / 800,000)(800,000 / 400,000) = 0.375 g = 0.375 × 0.40 = 0.15 Then, calculate:P0 = D1 / (ke − g) = $1.20 / (0.19468 − 0.15) = 26.86. 21) B

Version 1

The net effect on firm value of increasing the dividend payout ratio is ambiguous because the positive effect of larger dividends may be offset by a negative effect on the firm's sustainable growth rate. If increasing the payout ratio always increased firm value, all firms would have 100% payout ratios. 22) B

The experience curve, which shows the cost per unit relative to output, slopes downward because of increases in productivity and economies of scale, especially in industries with high fixed costs. 23) B 24) C

The decline stage of the industry life cycle is often characterized by declining prices as substitute products or global competition emerge, or as a result of decreasing demand due to societal changes. 25) C

The dividends for years 1, 2, and 3 are expected to be ($1.62)(1.12) = $1.81; ($1.81)(1.12) = $2.03; and ($2.03)(1.12) = $2.27. At the end of year 2, the stock should sell for $2.27 / (0.15 − 0.04) = $20.64. The stock should sell currently for ($20.64 + $2.03) / (1.15)2 + ($1.81) / (1.15) = $18.71. 26) A

P4 = D5/(k − g) = 1/(.12 − .05) = 14.29 P0 = [FV = 14.29; n = 4; i = 12] = $9.08. 27) C

Accounting data on sales is used to calculate the P/S multiple. The P/S multiple is thought to be more reliable because sales figures are not as easy to manipulate as the earnings and book value, both of which are significantly affected by accounting conventions. However, it is not true that "sales data cannot be distorted by management" because aggressive revenue recognition practices can influence reported sales. 28) A

Industry analysis provides a framework for an analyst to understand a firm in relation to its competitive environment, which determines how much pricing power a firm has. Competitive strategy and financial performance are aspects of company analysis. 29) A

Version 1

The dividend can be of any size. Suppose it is $1.00. The purchase price is 1.00 / 0.06 = 16.667. The sale price is 1.00 / 0.05 = 20. Kim pays 16.667 and receives 20.00 plus a 1.00 dividend one year later. The rate of return is [(20 + 1) / 16.667] − 1 = 26%. 30) C

Automobiles and apparel are classified as consumer discretionary; banking is classified as financial services; and heavy machinery is classified as industrials. Based on revenues, a majority of the firm’s sales (55%) are derived from the consumer discretionary sector.

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) An analyst finds a stock that has had a low beta given its historical return, but its total risk has been commensurate with its return. When writing a research report about the stock for clients with well- diversified portfolios, according to Standard V(B), Communication with Clients and Prospective Clients, the analyst needs to mention: A) the relationship of the historical beta and return only. B) the relationship of the historical total risk to return only. C) both the historical beta and total risk and return. 2) Jan Hirsh, CFA, is employed as manager of a college endowment fund. The college’s board

of directors has recently voted to consider divesting from companies located in a country that has a poor civil rights record. Hirsh has personal investments in several firms in the country. Hirsh needs to: A) disclose her ownership in the stocks to her supervisor only. B) do nothing since the board has not made a decision yet. C) disclose her ownership in the stocks to both her supervisor and the board. 3) An analyst meets with a new client. During the meeting, the analyst sees that the new client’s

portfolio is heavily invested in one over-the-counter stock. The analyst has been following the stock and thinks it will perform well in the long run. The analyst arranges through a brokerage firm to simultaneously sell a large number of shares of the stock via a series of cross trades from the new client’s portfolio to various existing clients. He arranges the trades to be executed at a price that approximates the current market price. This action is: A) not in violation of the Standards. B) a violation of Standard III(B), Fair Dealing. C) a violation of Standard III(A), Loyalty, Prudence, and Care. 4) Carol Hull, CFA, is an investment advisor whose prospective client, Frank Peters, presents

special requirements. To construct an investment policy statement for Peters, Hull inquires about Peters’ investment experience, risk and return objectives, and financial constraints. Peters states that he has a great deal of investment experience in the capital markets and does not wish to answer questions about his tolerance for risk or his other holdings. Under Standard III(C), Suitability, Hull: A) may accept Peters’ account but may only manage his portfolio to a benchmark or index. B) must decline to enter into an advisory relationship with Peters. C) is permitted to manage Peters’ account without any knowledge of his risk preferences.

Version 1

5) Michael Malone, CFA, is an investment analyst for a large brokerage firm in New York who

covers the airlines industry. After hours in his personal time, Malone maintains an online blog on which he expresses his personal opinions about various investment opportunities, including, but not limited to, the airlines industry. On his blog, he posts a very negative investment opinion about WestAir stock. Malone knows that WestAir's stock will be downgraded to a “sell” by his firm next week. Malone has most likely violated: A) violated Standard IV(A) Loyalty. B) Standard VI(B) Priority of Transactions. C) violated Standard II(A) Material Nonpublic Information. 6) Which of the following actions would be a violation of the Standard VII(A) Conduct as

Participants in CFA Institute Programs? A) Misrepresenting information on the Professional Conduct Statement. B) Using the CFA designation without submitting a Professional Conduct Statement and paying annual dues. C) Exaggerating the implications of holding the CFA designation. 7) Which of the following statements is least accurate regarding being a part of Standard III(B),

Fair Dealing? A) At the same time notify clients for whom an investment is suitable of a new investment recommendation. B) Shorten the time between decision and dissemination. C) Maintain a list of clients and their holdings. 8) Francisco Perez, CFA, CPA, is a portfolio manager for an investment advisory firm. Due to

the prominence of his position, he is often invited to attend free marketing and educational events hosted by firms which seek to inform the investment community about their investment processes. One such firm, Unlimited Horizons, has invited Perez to attend free educational events which qualify for Continuing Education credits which could help Perez maintain his CPA designation. Perez should most likely: A) decline to attend the event as it could result in a violation of Standard I(A) "Knowledge of the Law." B) accept the invitation as no cash compensation is involved and the primary intent is to educate and inform the investment community. C) decline to attend the event as it could result in a violation of Standard I(B) "Independence and Objectivity."

Version 1

9) Lucy Ackert and Chris Brown prepared the following information to be included in the

promotional materials of their employer, Lofton Securities. Lucy Ackert is one of five CFAs at Lofton Securities. She satisfied all requirements for the CFA designation in 1998. Chris Brown holds a CFA Level I designation, which he passed in 2001. He is registered to take the next scheduled Level II examination. Are the promotional materials prepared by Ackert and Brown fully consistent with the Standards of Professional Conduct? A) Ackert: No. Brown: Yes. B) Ackert: Yes. Brown: No. C) Ackert: No. Brown: No. 10) Victor Logan is a portfolio manager for McCoy Advisors, and Jack Brisco is the Director of

Research for McCoy. Brisco has developed a proprietary model that has been thoroughly researched and is known throughout the industry as the McCoy model. The model is purely quantitative and screens stocks into buy, hold, and sell categories. The basic philosophy of the model is thoroughly explained to clients. Brisco frequently alters the model based on rigorous research—an aspect that is well explained to clients, although the specific alterations are not continually disclosed. Portfolio managers then make specific sector and security holding decisions, purchasing only securities that are indicated as "buys" by the model. Logan has conducted very thorough research on his own, using the same process that Brisco uses to validate his findings. Logan feels the model is missing some key elements that would further reduce the list of acceptable securities to purchase, however, Brisco has refused to look at Logan's research. Frustrated by this, Logan applies his own version of the model, with the justification that he is still only purchasing securities on the buy list. Because of the conflict with Brisco, he does not disclose the use of the model to anyone at McCoy or to clients. Which of the following statements regarding Logan and Brisco is CORRECT? Logan is: A) not violating the Standards by applying his version of the model, but is violating the Standards by not disclosing it to clients. Brisco is not violating the Standards. B) violating the Standards by applying his version of the model and by not disclosing it to clients. Brisco is violating the Standards by failing to consider Logan's research. C) violating the Standards by applying his version of the model and by not disclosing it to clients. Brisco is not violating the Standards.

Version 1

11) Sometimes a CFA Institute member simply feels a law has been violated by his firm, and

sometimes the member knows a law has been violated. Which of the following pairs of guidelines is CORRECT with respect to the first step a member should take in each case? The member should first contact: A) the firm's counsel if he feels a law has been violated and the SEC if he knows a law has been violated. B) his supervisor in the firm if he feels a law has been violated and contact the firm's counsel if he knows a law has been violated. C) the firm's counsel if he feels a law has been violated and contact his supervisor if he knows a law has been violated. 12) Amanda Brad, CFA, is a security analyst at UpTrend, Incorporated During a routine visit to a

beauty salon, she learns that a major cosmetic company, Lorean, is expected to present a revolutionary formula for facial cream. Brad buys Lorean stock for her portfolio and prepares a special report on the company. Brad also makes a call to Hillary Lang, another security analyst at UpTrend, to inform her about the news. Lang starts trading on her clients’ portfolios. Brad’s report states that given the on-going research activity at Lorean within the last months, investors can expect some successful new products and a sharp increase in the price of the stock. Lang’s actions: A) violate the Standard of Objectivity and Independence. B) violate the Standards because she trades on inside information. C) violate the Standard of Fair Dealing. 13) An analyst preparing a report needs to cite which of the following? A) A recent quote from the Federal Reserve Chairman. B) The individual who developed a chart from the same firm. C) Estimates of betas provided by Standard & Poor's.

Version 1

14) Sue Parsons, CFA, works full-time as an investment advisor for the Malloy Group, an asset

management firm. To help pay for her children’s college expenses, Parsons wants to engage in independent practice in which she would advise individual clients on their portfolios. She would conduct these investment activities only on weekends. She is currently only in the preparation stage and has not started independent practice yet. Which of the following statements about Standard IV(A), Loyalty to Employer, is most accurate? Standard IV(A): A) does not require Parsons to notify Malloy of preparing to undertake independent practice under the current conditions. B) requires Parsons to obtain written consent from both Malloy and the persons from whom she undertakes independent practice. C) requires Parsons to notify Malloy in writing about her intention to undertake an independent practice. 15) A CFO who is a CFA Institute member is careful to make his press releases—some of them

containing material and previously undisclosed information—clear and understandable to his readers. While writing a new release, he often has his current intern proofread rough drafts. He also sends electronic copies to his brother, an English teacher, to get suggestions concerning style and grammar. With respect to Standard II(A), Material Nonpublic Information, the CFO is: A) not in violation of the Standard. B) violating the standard by either showing the pre-release version to his intern or sending it to his brother. C) only in violation by e-mailing the pre-release version to his brother but not the intern, because the intern is in essence an employee of the firm. 16) An analyst who is a CFA Institute member receives an invitation from a business associate’s

firm to spend the weekend in a high-quality resort. In order to abide by the Standards, the analyst should (may): A) do both of the actions listed here. B) obtain written consent from his supervisor if the offer is contingent on achieving a target investment return. C) refuse the invitation if the associate is from a firm he analyzes for his employer.

Version 1

17) One year ago, Karen Jason left the employment as a portfolio manager of Howe Advisors.

The departure was contentious and both parties threatened legal action. As a result, both parties signed a settlement in which Jason was paid a pro rated bonus, but agreed not to work on the portfolios of any existing Howe client for two years. The terms of the agreement were that both parties agreed to keep all aspects of the agreement confidential, including the fact that there was hostility surrounding the departure. Jason now works for Torre Advisors, who has the Stein Company as a new client. At the time Jason left Howe, Stein was a client of Howe, although Jason did not personally work on the Stein portfolio. Jason's supervisor at Torre wants Jason to work on the Stein portfolio. Jason should: A) inform her supervisor that she cannot work on the portfolio because of a legal agreement, but cannot tell him why. B) work on the portfolio because she did not personally work on the portfolio when she was at Howe. C) inform her supervisor that she cannot work on the portfolio because of a non-compete agreement. 18) Nick O'Donnell, CFA, unsuspectingly joins the research team at Wickett & Company, an

investment banking firm controlled by organized crime. None of the managers at Wickett are CFA Institute members. Because of his tenuous situation at Wickett, O'Donnell begins making preparations for independent practice. He knows he will be terminated if he informs management at Wickett that he is preparing to leave. Consequently, he determines that "if he can just hang on for one year, he will likely have a client base sufficient for him to strike out on his own." This action is: A) a violation of his duty to disclose conflicts to his employer. B) not a violation of his duty to employer. C) a violation of his fiduciary duties. 19) Gordon McKinney, CFA, works in the trust department of a bank. The bank's trust account

holds a large block of a particular company. McKinney learns that this company is going to buy back one million shares at a 15% premium to the market price on a first-come-firstserved basis. McKinney immediately tells his mother-in-law to tender her shares but waits until the end of the day to tender the trust's shares. McKinney has most likely violated: A) Standard VI(B), Priority of Transactions. B) Standard IV(A), Loyalty to Employer. C) Standard II(A), Material Nonpublic Information.

Version 1

20) A stockbroker who is a member of CFA Institute has a part-time housekeeper who also

works for the CEO of Festival, Inc. One day the housekeeper mentions to the broker that she saw the CEO of Festival having a conversation at his home with John Tater, who is a nationally known corporate lawyer and consultant. The stockbroker is restricted from trading on this information: A) for both of the reasons listed here. B) only if the broker knows that the meeting is non-public information. C) if the housekeeper says the meeting concerned a tender offer and the broker knows that it is non-public information. 21) In accordance with Standard III (A) Loyalty, Prudence and Care, which of the following

statements is not a required or recommended action? A) Submit to clients, at least quarterly, itemized statements detailing all of the period’s transactions. B) Vote all proxies on behalf of clients in a responsible manner. C) Utilize client brokerage to the sole benefit of the client. 22) Regarding (1) not voting all client proxies, and (2) using a directed brokerage arrangement, a

member would violate the Standards by: A) engaging in neither of these practices. B) using a directed brokerage arrangement. C) not voting all proxies for client stocks. 23) Denise Weaver is a portfolio manager who manages a mutual fund and has pension clients.

When Weaver receives a proxy for stock in the mutual fund, she gives it to Susan Griffith, her administrative assistant, to complete. When the proxy is for a stock owned in a pension plan, she asks Griffith to send the proxy on to the sponsor of the pension fund. Weaver has: A) violated the Standards by her policy on mutual fund and pension fund proxies. B) violated the Standards by her policy on mutual fund proxies, but not her policy on pension fund proxies. C) not violated the Standards.

Version 1

24) Liam McCoy has lunch with a wealthy client whose portfolio he manages. McCoy advises

the client to double his current position in the JKM Corporation due to an anticipated increase in sales. In accordance with Standard (V) Investment Analysis, Recommendations and Actions, when McCoy returns to his office he should: A) document the details of the conversation with the client with regard to his investment recommendation. B) verify the suitability of the investment recommendation before placing the client’s order. C) identify other clients for whom JKM may be a suitable investment and notify them immediately of his recommendation. 25) Rhonda Meyer, CFA, is preparing a research report on Moon Ventures, Incorporated In the

course of her research she learns the following: Moon had its credit rating downgraded by a prominent rating agency 3 years ago due to sales pressure in the industry. The rating was restored 3 months later when the pressure resolved. Moon’s insider trading has been substantial over the last 3 months. Holdings of Moon shares by officers, directors, and key employees were reduced by 50% during that period. In Meyer’s detailed report making a buy recommendation for Moon, both the credit rating downgrade and the insider trading were omitted from the report. Meyer has: A) not violated the Code and Standards in her report. B) violated the Code and Standards by not including the insider trading information in her report. C) violated the Code and Standards by not including the insider trading information and by not including the credit rating downgrade in her report. 26) Member compliance on issues relating to corporate governance or to soft dollars is primarily

addressed by the Standard concerning: A) Disclosure of Conflicts to Clients and Prospects. B) Loyalty, Prudence, and Care. C) Disclosure of Referral Fees.

Version 1

27) Steve Jones is a portfolio manager for Gregg Advisors. Gregg has developed a proprietary

model that has been thoroughly researched and is known throughout the industry as the Gregg model. The model is purely quantitative and screens stocks into buy, hold, and sell categories. The basic philosophy of the model is thoroughly explained to clients. The director of research frequently alters the model based on rigorous research—an aspect that is well explained to clients, although the specific alterations are not continually disclosed. Portfolio managers then make specific sector and security holding decisions, purchasing only securities that are indicated as "buys" by the model. Jones thoroughly understands the model and uses it with all of his clients. Jones is: A) violating the Standards in purchasing stocks without a thorough research basis and in not disclosing all alterations of the model to clients. B) not violating the Standards either in purchasing stocks without a thorough research basis or in not disclosing all alterations of the model to clients. C) violating the Standards in not disclosing all alterations of the model to clients, but not in purchasing stocks without a thorough research basis. 28) A code of ethics: A) provides the public with assurance of a minimum level of ethical behavior. B) should not be used for marketing purposes. C) may be rules-based or principles-based. 29) Lynne Jennings is a chemical industry research analyst for a large brokerage company. That

industry is currently seeing an increase in mergers and acquisitions. While flying through Chicago, Jennings sees several senior officers who she knows are from the largest and fourth largest chemical companies walk into a conference room. She concludes that negotiations for an acquisition might be taking place. Jennings: A) may not act or cause others to act on this information. B) should inform her compliance officer that she has material nonpublic information on firms she covers. C) may use this information to support an investment recommendation.

Version 1

30) Joni Black, CFA, works for a portfolio management firm. Black is a partner of the firm and is

primarily responsible for managing several large pension plans. Black has just finished a research report in which she recommends Zeta Corporation as a “Strong Buy.” Her rating is based on solid management in a growing and expanding industry. She just handed the report to the marketing department of the firm for immediate dissemination. Upon returning to her desk she notices a news flash by CNN reporting that management for Zeta Corporation is retiring. Black wishes she did not recommend Zeta Corporation as a “Strong Buy,” but believes the corporation is still a good investment regardless of the management. What course of action for Black is best? Black: A) should revise the recommendation based on this new information. B) should report the new information to her immediate supervisor so that they can determine whether or not the marketing department should send out the report as written. C) may send out the report as written as long as a follow up is disseminated within a reasonable amount of time reflecting the changes in management. 31) Recommended procedures to comply with the Standard concerning priority of transactions

are least likely to include: A) limited front-running by employees. B) disclosure to clients of the firm’s policies in regard to personal investing. C) blackout periods. 32) An analyst finds a stock with historical returns that are not correlated with interest rate

changes. The analyst writes a report for his clients that have large allocations in fixed-income instruments and emphasizes the observed lack of correlation. He feels the stock would be of little value to investors whose portfolios are composed primarily of equities. The clients with allocations of fixed income instruments are the only clients to see the report. According to Standard V(B), Communication with Clients and Prospective Clients, the analyst has: A) not violated the Standard. B) violated the Standard concerning fair dealings with all clients. C) violated the article in the Standard concerning facts and opinions.

Version 1

33) Patricia Hoolihan is an individual investment advisor who uses mutual funds for her clients.

She typically chooses funds from a list of 40 funds that she has thoroughly researched. The Burns, a married couple that are a client, asked her to consider the Hawkeye fund for their portfolio. Hoolihan had not previously considered the fund because when she first conducted her research three years ago, Hawkeye was too small to be considered. However, the fund has now grown in value, and cursory research uncovers no fundamental flaws with the fund. She puts the fund in the Burns' portfolio but not in any of her other clients' portfolios. The fund ends up being the best performing fund on her list. Hoolihan has: A) violated the Standards by not having a reasonable and adequate basis for making the recommendation. B) not violated the Standards. C) violated the Standards by not dealing fairly with clients. 34) Which of the following statements about a code of ethics is most accurate? A code of ethics: A) must include rules-based standards of conduct. B) does not need to include standards of conduct. C) must include principles-based standards of conduct. 35) An analyst has found an investment with what appears to be a great return-to-risk ratio. The

analyst double-checks the data for accuracy, keeps careful records, and is careful to not make any misrepresentations as he simultaneously sends an e-mail to all his clients with a “buy” recommendation. According to Standard V(A), Diligence and Reasonable Basis, the analyst has: A) fulfilled all obligations. B) violated the Standard if he does not verify whether the investment is appropriate for all the clients. C) violated the Standard by communicating the recommendation via e-mail. 36) Abner Flome, CFA, is writing a research report on Paulsen Group, an investment advisory

firm. Flome’s brother-in-law holds shares of Paulsen stock. Flome has recently interviewed for a position with Paulsen and expects a second interview. According to the Standards, Flome’s most appropriate action is to disclose in the research report: A) his brother-in-law’s holding of Paulsen stock and that he is being considered for a job at Paulsen. B) that he is being considered for a job at Paulsen. C) his brother-in-law’s holding of Paulsen stock.

Version 1

37) Lance Tuipulotu, CFA, manages investments for 400 individuals and families and often finds

his resources stretched. When his largest investors petition him to include a 5% to 7% allocation of noninvestment-grade bonds in their portfolios, he decides he needs additional help to meet the request. He considers various independent advisors to use as submanagers, but determines that the most qualified advisors would be too expensive. Reasoning that a lower-cost provider would enable him to pass the savings along to his clients, he chooses that provider to invest the new bond allocation. Tuipulotu has violated: A) Both Standard III(C) Suitability and Standard V(A) Diligence and Reasonable Basis. B) Standard III(C) Suitability by failing to consider the appropriateness of the noninvestment-grade bonds. C) Standard V(A) Diligence and Reasonable Basis by letting fee structure determine the selection of the submanager. 38) Cynthia Abbott, a CFA charterholder, is preparing a research report on Boswell Company for

her employer, Capital Asset Management. Bob Carter, president of Boswell, invites Abbott and several other analysts to visit his company and offers to pay her transportation and lodging. Abbott pays for her own transportation and lodging, but while visiting the company, accepts an item of small value from Carter. Abbott does not disclose this gift to her supervisor at Capital when she returns. In the course of the company visit, Abbott overhears a conversation between Carter and his chief financial officer that the company’s earnings per share (EPS) are expected to be $1.10 for the next quarter. Abbott was surprised that this EPS is substantially above her initial earnings estimate of $0.70 per share. Without further investigation, Abbott decides to include the $1.10 EPS in her research report on Boswell. Using the high EPS positively affects her recommendation of Boswell. Which of the following statements about whether Abbott violated Standard V(A), Diligence and Reasonable Basis and Standard I(B), Independence and Objectivity is CORRECT? Abbott: A) violated Standard V(A) but she did not violate Standard I(B). B) did not violate Standard V(A) but she violated Standard I(B). C) violated both Standard V(A) and Standard I(B).

Version 1

39) Ken James has been an independent financial advisor for 15 years. He received his CFA

Charter in 1993, but did not feel it helped his business, so he let his dues lapse this year. He still has several hundred business cards with the CFA designation printed on them. His promotional materials state that he received his CFA designation in 1993. James: A) must cease distributing the cards with the CFA designation, but can continue to use the existing promotional materials. B) must cease distributing the cards with the CFA designation and the existing promotional materials. C) can continue to use the existing promotional materials, and can use the cards until his supply runs out—his new cards cannot have the designation. 40) An investment advisor goes straight from a research seminar to a meeting with a prospective

new client with whom she has never been in contact. The advisor is very excited about the information she just received in the seminar and begins showing the prospect the new ideas her firm is coming up with. This is most likely a violation of: A) both of these. B) Standard III(C), Suitability. C) Standard III(B), Fair Dealing. 41) Lee Hurst, CFA, is an equity research analyst who has recently left a large firm to start

independent practice. He is able to re-create several of his previous recommendation reports, based on his clear recollection of supporting documentation he compiled at his previous employer. He publishes the reports and obtains several new clients. Hurst is most likely: A) in violation of Standard V(C) Record Retention. B) in violation of Standard V(A) Diligence and Reasonable Basis. C) not in violation of any Standard. 42) Martin Tripp, CFA, is vice-president of the equity department at Walker Financial, a large

money management firm. Of the twenty analysts in his department for whom he has supervisory responsibility, eight are subject to CFA Institute Standards of Professional Conduct. Tripp believes that he cannot personally evaluate the conduct of the twenty analysts on a continuing basis. Therefore, he plans to delegate some of his supervisory duties to Sarah Green, who is subject to the Standards, and some to Bob Brown, who is not subject to the Standards. According to CFA Institute Standards of Professional Conduct, which of the following statements about Tripp's ability to delegate supervisory duties is most accurate? A) Tripp may delegate some or all of his supervisory duties only to Green because she is subject to the Standards. B) Tripp may not delegate any of his supervisory duties to either Green or Brown. C) Tripp may delegate some or all of his supervisory duties to Brown, even though Brown is not subject to the Standards.

Version 1

43) Andy Rock, CFA, is an analyst at Best Trade Company The company is going to announce a

sell recommendation on Biomed stock in one hour. Rock was a member of the team who reached the decision on Biomed. Rock’s wife has an account at Best Trade Comapany that contains Biomed stock. According to the Code and Standards, trading on Rock’s wife’s account can begin: A) only after the recommendation is announced to the general public. B) as soon as the information is disseminated to all clients. C) only after Rock, as a beneficial owner, has given an appropriate amount of time for clients and his employer to act. 44) Jacob Allen, CFA, decides he could make more money if he started his own company. Which

of the following steps would most likely violate Standard IV(A) Loyalty? A) Using his notes from prior research of a firm in a creating a new research report on the firm, after leaving his current employer. B) Soliciting, without written permission from his current employer, the business of former clients after he leaves his current employer. C) Renting space for his new company and interviewing several candidates for the position of manager at the new company. 45) An analyst has several groups of clients who are categorized according to their specific

needs. Compared to research reports distributed to all of the clients, reports for a specific group: A) may generally exclude more basic facts. B) will not be allowed because it violates the Standard III(B), Fair Dealing. C) will definitely include more basic facts. 46) Ron Vasquez is registered to sit for the Level II CFA exam. Unfortunately, Vasquez has

failed the exam the past two years. In his frustration, Vasquez posted the following comment on a popular internet bulletin board: “I believe that CFA Institute is intentionally limiting the number of charterholders in order to increase its cash flow by continuing to fail candidates. Just look at the pass rates.” Which of the following statements regarding Vasquez’s conduct is most accurate? Vasquez is: A) in violation of both Standard I(D) Misconduct and Standard VII(A) Conduct as Participants in CFA Institute Programs. B) not in violation of Standard I(D) Misconduct or Standard VII(A) Conduct as Participants in CFA Institute Programs C) in violation of Standard VII(A) Conduct as Participants in CFA Institute Programs, but not in violation of Standard I(D) Misconduct.

Version 1

47) Judy Gonzales is a portfolio manager with Brenly Capital and works on Johnson Company's

account. Brenly has a policy against accepting gifts over $25 from clients. The Johnson portfolio has a fantastic year, and in appreciation, the pension fund manager sent Gonzales a rare bottle of wine. Gonzales should: A) inform her supervisor in writing that she received additional compensation in the form of the wine. B) return the bottle to the client explaining Brenly's policy. C) present the bottle of wine to her supervisor. 48) Rey Sanchez, CFA, covers the specialty chemical industry for Rock Advisory Associates.

Until today he has had a buy recommendation on ChemStar, and many of the firm’s customers have purchased shares based upon his recommendation. The firm’s client accounts are divided into two fundamental categories: trading and buy-and-hold accounts. The firm holds discretionary trading authority over the trading accounts, but not the buy-and-hold accounts. Sanchez has recently come to believe that the fundamentals are changing for the worse at ChemStar, and is preparing a sell recommendation. He calls a meeting of the firm’s portfolio managers with accounts holding ChemStar and tells them of the pending release of the sell recommendation. On this basis, the portfolio managers sell all positions in the discretionary accounts but not in the buy-and-hold accounts. Sanchez completes and mails the report to all clients two days later, and, shortly thereafter, many of the buy-and-hold accounts sell their ChemStar positions. With regard to these actions, Sanchez is: A) not in violation of the Standard on Fair Dealing; the portfolio managers are in violation of the Standard on Fair Dealing. B) in violation of the Standard on Fair Dealing; the portfolio managers are in violation of the Standard on Fair Dealing. C) in violation of the Standard on Fair Dealing; the portfolio managers are not in violation of the Standard on Fair Dealing.

Version 1

49) Steve Phillips is the new director of equity research for a brokerage company. He receives a

call from a reporter at the Financial News, a weekly publication that comes out on Mondays. The reporter explains the relationship she had with his predecessor. They would share information that they both learned on stocks—the former director would benefit the company's clients by news he obtained from the reporter in exchange for information he gave to her. The former director could ask her not to publish any information he gave her until after a certain date, ensuring that the brokerage clients would be informed before the publication date. After the conversation, Phillips called the former director, who confirmed that the reporter was trustworthy with respect to honoring the agreement for delaying publication until clients have been informed. Philips should: A) only disclose research that has already been disseminated to clients, as long as the reporter is providing valuable information of her own. B) disclose research not yet disclosed to clients, as long as the reporter promises not to publish the information until after all clients have received the research, and the reporter provides valuable information of her own. C) not disclose any research even after it has been disseminated to clients regardless of the value of the information that the reporter may have. 50) Preston Partners is an investment management firm that adopted the Code and Standards as

part of its policy manual. Gerald Smithson, CFA, has recently added the stock of Utah Biochemical Company and Norgood PLC to all his client's investment portfolios. Shortly afterwards Utah Biochemical and Norgood announced a merger that increased the share price of both companies. Smithson contends he saw the president of Utah Biochemical dining with the chairman of Norgood, but did not overhear their conversation. Smithson researched both companies extensively and determined that each company was a good investment. He put in a block trade for shares in each company. Preston's policies were not clear in this area as he allocated the shares by starting with his largest client accounts and working down to the small accounts. Some of Smithson's clients were very conservative personal trust accounts, others were pension funds who had aggressive investment objectives. Which standard was NOT broken? A) Standard III(C)—Suitability. B) Standard V(A)—Diligence and Reasonable Basis. C) Standard IV(C)—Responsibilities of Supervisors.

Version 1

51) Jason Blackwell, CFA, works as an investment manager for Mega Capital, a large

multinational brokerage firm. Mega Capital is based in a country whose applicable law is stricter than the CFA Institute Code and Standards, but does business with clients in a country whose applicable law is less strict than the Code and Standards. Blackwell decides to follow the requirements of the Code and Standards for clients in the less strict country, which is sufficient to also comply with that less-strict country’s local laws. While Blackwell is still employed at Mega, Lego Associates verbally asks Blackwell to review client portfolios during evenings and weekends for a fee. Blackwell gets written consent from his immediate supervisor at Mega to undertake this independent activity for a one-month trial basis. Which of the following statements about Blackwell’s actions involving Standard I, Professionalism, and Standard IV(A), Loyalty is most accurate? Blackwell: A) violated Standard I but did not violate Standard IV(A). B) violated both Standard I and Standard IV(A). C) did not violate either Standard I or Standard IV(A). 52) Which of the following statements regarding allocating trades is CORRECT? It is

permissible under the Standards to allocate trades: A) on a pro-rata basis over all suitable accounts. B) based upon any method the firm deems suitable so long as the allocation procedure has been disclosed to all clients. C) based upon compensation arrangements. 53) Paul Drake is employed by a company to provide investment advice to participants in the

firm's 401(k) plan. Company stock is one of the investment options in the plan. Drake feels that the stock is too risky for employees to own in their 401(k) plan and starts advising them to pull out of the stock. The Treasurer of the company calls Drake and tells him that he will be fired if he continues making such advice because he is violating his fiduciary duty to the company. Drake should: A) continue to advise employees to sell their stock. B) make sell recommendations but point out that the company Treasurer has a differing and valid point of view. C) tell employees that he cannot provide advice on company stock because of a conflict of interest.

Version 1

54) Paul Thomas, CFA, is designing a new layout for research reports his firm writes and issues

on individual stocks. In his design, Thomas includes a stock chart on the first page of each report. He does not reference that the charts are copied from the Standard & Poor's web site. Thomas has: A) violated CFA Institute Standards of Professional Conduct because he did not state the source of the charts. B) violated CFA Institute Standards of Professional Conduct because he did not make sure that the information in these charts is accurate. C) not violated CFA Institute Standards of Professional Conduct because these charts are widely available over the Internet. 55) Klaus Gerber, CFA, is a regular contributor to the Internet site WizeGuy. This past week

Gerber has been incorrectly quoted as recommending that investors buy shares in Bradford, Incorporated. He is unaware that this message has been placed on the site as the quote was placed as a prank by an unknown source. This is the third time this has happened over the past month and each time the stock being mentioned moved in price according to the buy or sell recommendation. Fritz Fox, CFA, maintains and updates the WizeGuy site and has learned how to determine if the quotes being attributed to Gerber are actually valid. Several days later, he observes an investment recommendation, posted on the site, to buy Gresham, Incorporated. The investment recommendation is purported to be from Gerber, but Fox actually knows it to be bogus. He immediately sells 1,000 Gresham short and e-mails Gerber to inform him of the bogus recommendation. Gerber immediately issues a rebuttal, and Gresham falls by 14%. Fox's action is: A) not in violation of the Code and Standards. B) a violation of the Standard concerning use of material nonpublic information. C) a violation of the Standard concerning fiduciary duties.

Version 1

56) Caroline Turner, an analyst for Lansing Asset Management, just completed an investment

report in which she recommends changing a “buy” to a “sell” for Gallup Company. Her supervisor at Lansing approves of the change in recommendation. Turner wonders about whether she needs to disseminate this investment recommendation to Lansing’s clients and if so, how to distribute this information. According to CFA Institute Standards of Professional Conduct, Turner is: A) not required to disseminate the change of recommendation from a buy to a sell because the change is not material. B) required to disseminate the change in a prior investment recommendation to all clients and customers on a uniform basis. C) required to design an equitable system to disseminate the change in a prior investment recommendation. 57) Fern Baldwin, CFA, as a representative for Fernholz Investment Management, is

compensated by a base salary plus a percentage of fees generated. In addition, she receives a quarterly performance bonus on a particular client’s fee if the client’s account increases in value by more than 2 points over a benchmark index. Baldwin had a meeting with a prospect in which she described the firm’s investment approach but did not disclose her base salary, percentage fee, or bonus. Baldwin has: A) not violated the Standards because there is no conflict of interest with a potential prospect in the employment arrangements. B) violated the Standards by not disclosing her salary, fee percentage, and performance bonus. C) violated the Standards by not disclosing her performance bonus. 58) The CFA Institute Professional Conduct Program may impose sanctions on: A) CFA charterholders, member firms, and candidates for the CFA designation. B) CFA charterholders and candidates for the CFA designation. C) CFA charterholders only. 59) An analyst belongs to a nationally recognized charitable organization, which requires dues

for membership. The analyst has worked out a deal where he provides money management advice in lieu of paying dues. Which of the following must the analyst do? A) Must treat the charitable organization as his employer. B) Resign from the position because the relationship is a conflict with the Standards. C) Nothing since he is not an employee of the charitable organization.

Version 1

60) Bjorn Sandvik, CFA, completes a research report with a buy recommendation for Acorn

Properties. In the early afternoon, Sandvik e-mails this recommendation to his clients who had responded to his request that they provide Sandvik with their e-mail addresses. Later that afternoon, the printed recommendation is forwarded to the postal service for normal delivery to all customers, who receive the mailing 1 to 3 days later. Sandvik has: A) violated the Code and Standards by sending the e-mail recommendation to only some of his clients. B) not violated the Code and Standards because he acted fairly in disseminating research information to his clients. C) violated the Code and Standards by sending the e-mail recommendation in advance of the printed report. 61) A profession is most accurately described as an occupational group that requires its members

to: A) put client interests first. B) have specialized expert knowledge. C) abide by a code of ethical conduct. 62) Which of the following is least likely to be a reason for imposing a suspension on a member

or candidate? A) Discussing a question from the CFA exams on social media. B) Misdemeanor charge for possession of narcotics. C) Failing to return the annual professional conduct statement. 63) John Hill, CFA, has been working for Advisors, Incorporated, for eight years. Hill is about to

start his own money management business and has given his two-week notice of his resignation from Advisors. A few days before his resignation takes effect, a former client of Advisors calls Hill at his home about his new firm. The former client says that he is very happy that Hill is leaving Advisors because now he and Hill can resume a professional relationship. The client says that he would never become a client of Advisors again. Hill promises to call the client back after he has left Advisors. Hill does not tell his employer about the call. Hill has most likely: A) not violated the Standards. B) violated the Standard concerning loyalty to employer. C) violated the Standard concerning disclosure of conflicts.

Version 1

64) Nancy McCoy, CFA, is preparing a report on Gourmet Food Mart. As part of her research,

she contacts the company’s contractors, suppliers, and competitors. McCoy is told by the CEO of a major produce vendor that he is about to file a lawsuit against Gourmet Food Mart, seeking significant damages. McCoy incorporates this information into her research report, which projects a decline in profitability for Gourmet Food Mart due to the impending litigation. According to the CFA Institute Standards of Professional Conduct, McCoy: A) has not violated any Standard. B) has violated the Standards by disseminating confidential information. C) has violated the Standards by utilizing material nonpublic information. 65) The following information pertains to the Galaxy Trust, a trust established by Stephen P.

House and managed by Gamma Investment LLC: At the time the trust was established House provided $5 million in cash to fund the trust, but Gamma was aware that 93% of his personal assets were in the form of Oracle stock. Gamma has been asked to view his funds and the trust as a single entity for planning purposes, since House’s will stipulates that all of his estate will pass to the trust upon his death. The investment policy statement, developed in September 1996, stipulates that the trust should maintain a short position in Oracle stock and use the proceeds to diversify the trust more adequately. House was able to sell all of his Oracle shares back to the corporation in January 1999 for cash. The policy statement redrawn in September 1999 continues to stipulate that the trust hold a short position in Oracle stock. House has given the portfolio manager in charge of the trust an all expenses paid vacation package anywhere in the world each year at Christmas. The portfolio manager has reported this fact in writing to his immediate supervisor at Gamma. Which of the following is most correct? The investment manager is: A) in violation of the Code and Standards by not properly updating the investment policy statement in light of the change in the circumstances but is not in violation with regard to the acceptance of the gift from House. B) in violation of the Code and Standards by not properly updating the investment policy statement in light of the change in the circumstances and is in violation with regard to the acceptance of the gift from House. C) not in violation of the Code and Standards for not properly updating the investment policy statement in light of the change in the circumstances and is not in violation with regard to the acceptance of the gift from House.

Version 1

66) Bob Hatfield, CFA, has his own money management firm with two clients. The accounts of

the two clients are equal in value. It is Hatfield’s opinion that interest rates will fall in the near future. Based upon this, Hatfield begins increasing the bond allocation of each portfolio. In order to comply with Standard V(B), Communication with Clients and Prospective Clients, the analyst needs to: A) inform the clients of the change and tell them it is based upon an opinion and not a fact. B) perform both of these functions. C) make sure that the change is identical for both clients. 67) Bill Valley has been working for Advisors, Incorporated, for several years, and he just joined

CFA Institute. Valley’s sister just received a large bonus in the form of stock options in Zephyr, Incorporated. Valley’s sister knows nothing about financial assets and offers Valley a week at her holiday home each year in exchange for Valley monitoring Zephyr and the value of her stock options. In order to comply with the Code and Standards, Valley needs to inform Advisors of: A) both the use of the holiday home and his sister's options. B) the compensation in the form of the use of the holiday home only. C) nothing since no money is involved and it is a favor for a family member. 68) Roger Smith, CFA, has been invited to join a group of analysts in touring the riverboats of

River Casino Corporation. For the tour, River Casino has arranged chartered flights from casino to casino since commercial flight schedules are not practical for the group’s time schedule. River Casino has also arranged to pay for the analysts’ lodging for the three nights of the tour. According to CFA Institute Standards of Professional Conduct, Smith: A) is required to pay for his flight and lodging. B) may accept the arrangements as they are. C) may accept the flight but is required to pay for his lodging.

Version 1

69) Fred Dean, CFA, has just taken a job as trader for LPC. One of his first assignments is to

execute the purchase of a block of East Street Industries. While working with East Street on an assignment for his previous employer, he learned that East Street’s sales have weakened and will likely be significantly below the LPC analyst’s estimate, but no public announcement of this has been made. Which of the following actions would be the most appropriate for Dean to take according to the Standards? A) Contact East Street’s management and urge them to make the information public and make the trade if they refuse. B) Post the information about the drop in sales on an internet bulletin board to achieve public dissemination and inform his supervisor of the posting. C) Request that the firm place East Street’s stock on a restricted list and decline to make any trades of the company’s stock. 70) Graham Carson, CFA, is an investment advisor to Ron Grayson, a client with moderate risk

tolerance and an investment horizon of 15 years. Grayson calls Carson to complain about two stocks in his account that have performed poorly. He feels that one stock was too risky for him as it paid no dividend and had a beta of 1.4. The other stock had a beta of 0.9 and paid a dividend of 3%, but financial regulators have indicated that the firm’s reported earnings were incorrectly stated. Based on this information, Carson has most likely: A) not violated the Standards. B) violated both the Standard on suitability and the Standard on diligence and reasonable basis. C) violated only the Standard on suitability. 71) Fran Lester, CFA, works for a broker based in a country in which participation in any IPO is

permitted with her employer’s permission. She lives and works in a country that has no restrictions on her participation in IPOs. If Lester’s firm is distributing shares of an oversubscribed IPO through the office Lester works in, can Lester receive shares in the IPO? A) Yes, because the applicable law is that of her home country. B) No, not under any circumstances. C) Yes, but she must obtain permission from her employer. 72) Recommended procedures to comply with the Standard related to fair dealing are most likely

to include: A) publishing personnel guidelines for pre-dissemination that prohibit those who know about a pending recommendation from discussing or acting on it. B) simultaneously informing all investment representatives in the firm about pending recommendation changes. C) requiring investment committee approval for all recommendation changes.

Version 1

Answer Key Test name: Ethical and Professional Standards 1) A

Using reasonable judgment, an analyst may exclude certain factors from research reports. Since the report will be delivered to clients with well-diversified portfolios, total risk is not as important as beta. Given that the total risk has been only commensurate with historical return, furthermore, then the analyst is not negligent by not mentioning it. 2) B

From the given information, there is no conflict of interest and no violation of Standard VI(A), Disclosure of Conflicts. A conflict could arise if the board were to ask Hirsh what the effect on the college’s endowment would be if they were to divest. At that time she would have to reveal her ownership in the stocks to make known the possible conflict of interest. 3) A

There is no violation. It is in the best interest of the client to be diversified and selling via a series of cross trades will likely reduce price impact costs when compared to selling directly into the market. The analyst appears to have reasonable basis for putting the securities in the accounts of other clients. 4) C

Hull would not violate Standard III(C), Suitability, by managing Peters’ account without knowledge of his risk preferences. She made a reasonable inquiry into Peters’ investment experience, risk and return objectives, and financial constraints, as the Standard requires. If a client chooses not to provide some of this information, the member or candidate can only be responsible for assessing the suitability of investments based on the information the client does provide. 5) A

By expressing his investment analysis on his personal blog ahead of his employer, Malone deprived his employer of the benefits of his skills and abilities and therefore violated Standard IV(A) Loyalty. Malone did not possess material nonpublic information about WestAir and no transactions have taken place. 6) A

Version 1

Misrepresenting information on the Professional Conduct Statement is a direct violation of Standard VII(A) Conduct as Participants in CFA Institute Programs. The other choices are violations of Standard VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program. 7) A

All of these are part of Standard III(B) except notifying clients at the same time. Standard III(B) states that clients for whom the investment is suitable should be notified at approximately the same time. 8) C

Perez should decline the invitation as it creates the impression of lack of independence. If he does not accept the free continuing education courses, he would have to pay for them some other way so the free courses are a form of compensation. Nothing in the vignette suggests the free classes are illegal. 9) C

Neither statement is fully consistent with Standard VII(B), Reference to CFA Institute, the CFA Designation, and the CFA Program. The CFA designation must always be used as an adjective and never as a noun as Ackert used in her promotional description. Correct use of the CFA designation would be: “Lucy Ackert is one of five CFA charterholders at Lofton Securities.” No designation exists for someone who has passed Level I of the CFA examination. Thus, Brown’s statement saying that he “holds a CFA Level I designation” represents incorrect use. A correct statement would be: “Chris Brown passed Level I of the CFA examination in 2001.” 10) A

Because the research is thoroughly conducted, and Logan has authority to make individual security selection decisions, Logan is not violating the Standards by applying his model. However, Logan is violating the Standard on communication with clients and prospective clients by excluding relevant factors of the investment process. The use of his model is an important aspect of the investment process and should be disclosed to clients. Brisco is not violating the Standards by not considering Logan’s research. 11) C

Standard I(A) says that when a member feels a law has been broken, the member should seek advice from the firm’s counsel. If the member feels the advice is unbiased and competent, the member should follow it. If the member knows a law has been violated, the member should contact a supervisor. 12) C

Version 1

Lang violates Standard III(B), Fair Dealing, which imposes the requirement to start trading on the clients’ portfolios only after the information is disseminated to all clients. We don't know if the information is non-public which would make it insider information if it were. 13) A

Statistics provided by a recognized agency, such as Standard and Poor’s, do not need to be cited. Charts, quotes, and algorithms developed by the firm would need to be cited when they are used but the individual(s) who developed the materials within the firm do not need to be cited. 14) A

Standard IV(A), Loyalty to Employer, requires that Parsons obtain written consent only from her employer before she undertakes independent practice that could result in compensation or other benefit in competition with Malloy. It is not required to get permission from your employer when only preparing to go into independent practice. 15) B

Standard II(A), Material Nonpublic Information, says that a member must be careful about handling material non-public information. As a member of CFA Institute, the CFO must limit the people who see important information before it is released. It would not be appropriate to involve an intern or a relative in the process. 16) A

According to Standard I(B) Independence and Objectivity, the analyst should refuse the invitation if it is from a firm the analyst covers for his employer. The analyst can accept the invitation if it is from a client but the analyst must get written consent from his employer if the offer is contingent on future performance, to comply with Standard IV(B) Additional Compensation Arrangements. 17) A

Jason must inform her supervisor of the conflict, but she cannot violate the terms of the confidentiality agreement and she cannot work on the portfolio. 18) B

O’Donnell is required to obtain consent from his employer if he is attempting to practice in competition with his employer. Merely undertaking preparations to leave, which do not violate a duty, is not a violation of the Code and Standards. 19) A

Version 1

Standard VI(B), Priority of Transactions, applies. If an analyst decides to make a recommendation about the purchase or sale of a security, he must give his customers or employer adequate opportunity to act on this recommendation before acting on his own behalf. Personal transactions include those made for the member's own account and family accounts. Here, McKinney violated Standard VI(B) by acting on his mother-in-law's behalf and then waiting until the end of the day to act on his employer's behalf. Explanations for other responses: Standard IV(A), Loyalty to Employer, does not apply. This standard concerns a member competing with his/her employer (independent practice), for example a member who engages in outside consulting. Standard II(A), Material Nonpublic Information, does not apply. The question does not indicate that the information is not public. 20) C

Standard II(A), Material Nonpublic Information, states “a member cannot trade or cause others to trade in a security while the member possesses material nonpublic information” A tender offer would certainly be material nonpublic information. Knowing that the meeting took place, and nothing else, does not restrict the broker. A reasonable investor would need to know more to determine if the information was material. 21) B

Because of the time and expense involved in voting a proxy, Members and Candidates are not required to vote every proxy. A cost benefit analysis can be performed to determine if it is necessary to vote a proxy. Standard III(A) requires that client brokerage be used to benefit the client. Quarterly statements to clients are recommended. 22) A

Proxies have economic value to the client. To comply with Standard III(A) Loyalty, Prudence, and Care, the analyst is obligated to vote proxies in an informed and responsible manner. A cost benefit analysis may show that voting all proxies may not benefit the client, so voting proxies may not be necessary in all instances. Directed brokerage occurs when the client requests that a portion of the client's brokerage be used to purchase services that directly benefit the client. Although this may prevent best execution, it does not violate the Standards as it was directed by the client, not the brokerage firm. 23) A

Version 1

Proxies should be taken seriously, and although it is likely that Griffith can understand some of the issues, it is likely that she is not capable of making responsible decisions on all potential proxy issues. Proxies for a pension plan should be voted in the best interests of the beneficiaries, not the plan sponsor. The sponsor's interests will not always be the same as the beneficiary's interest. 24) A

Standard V(C) Record Retention requires that Members and Candidates document all recommendation and communications with clients. McCoy should document the details of the conversation, including any resulting investment decisions and/or actions. The suitability of the investment should have already been considered before the recommendation and McCoy should not execute the order until the client instructs him to. Identifying other clients for this investment would fall under Standard III(B) Fair Dealing. 25) B

Standard V(B), Communication with Clients and Prospective Clients, requires analysts to use reasonable judgment regarding the inclusion or exclusion of relevant factors in their research reports. It would not be unreasonable to exclude the temporary credit downgrade from 3 years earlier. 26) B

Fiduciary duty on issues relating to corporate governance or to soft dollars is primarily addressed by Standard III(A), Loyalty, Prudence, and Care. 27) B

Jones and Gregg are using reasonable judgment in not continually disclosing all of the alterations of the model. It is acceptable to use a pure quantitative model as a sole basis for purchasing stocks, as long as it is thoroughly researched. 28) C

A code of ethics may be rules-based or principles-based. There can be no assurance that none of a group or professionals will violate a code of ethics. There is no requirement that a group of professionals agreeing to a code of ethics cannot be held out to the public as a positive thing for clients. 29) C

The fact that the company officers met is not material nonpublic information. As long as she bases her investment recommendation on her own independent research, Jennings will not violate any Standards if she uses this additional information to support it. 30) A

Version 1

This question is related to Standard V(B) which states that CFA Institute members should use reasonable judgment regarding the inclusion or exclusion of relevant factors in research reports. The change in management was a relevant factor and must be disclosed before dissemination. 31) A

Standard VI(B) Priority of Transactions. Front-running is the purchase or sale of securities in advance of client trades to take advantage of knowledge of client activity and should be completely prohibited, not simply limited. Blackout periods and pre-clearance of employee trades are ways of accomplishing this. 32) A

Recommending a stock whose return is uncorrelated with interest rate changes is appropriate for the clients described in the problem. Emphasizing the lack of correlation is appropriate as long as the analyst makes no guarantees concerning the relationship in the future. Reporting historical correlation is a presentation of fact, and is not in violation. The analyst is free to show the report only to investors for whom the investment is appropriate. 33) A

Despite the fact the addition of the fund was successful, Hoolihan acted improperly in not conducting the same degree of research as she did for the other funds on her list. 34) B

A code of ethics may include standards of conduct, but does not require them. 35) A

If the analyst had been an investment manager, it would have been inappropriate for him to make a blanket recommendation for all of his clients without considering the unique needs of each. However, the analyst is merely stating that given the qualities of the investment, it is an attractive buy. He has kept adequate records, and made fair disclosure of his rating decision. 36) B

The possibility of employment with Paulsen creates a potential conflict of interest which Flome must disclose. Standard VI(A) Disclosure of Conflicts does not require disclosure of his brotherin-law’s ownership of Paulsen stock. 37) A

Both Standard III(C) Suitability and Standard V(A) Diligence and Reasonable Basis were violated. Tuipulotu must perform a full IPS review to determine the appropriateness of the new portfolio allocations. Submanagers should not be selected by cost structure alone, as the quality and appropriateness of the submanager is Tuipulotu’s responsibility.

Version 1

38) A

Abbott violated Standard V(A), Diligence and Reasonable Basis, because she did not have a reasonable and adequate basis to support the $1.10 EPS without further investigation. By including the $1.10 EPS in her report, she did not exercise diligence and thoroughness to ensure that any research report finding is accurate. If Abbott suspects that any information in a source is not accurate, she should refrain from relying on that information. Abbott did not violate Standard I(B), Independence and Objectivity, because the gift from Carter would not reasonably be expected to compromise her independent judgment. 39) A

Use of the CFA designation must be stopped immediately, however, the receipt of the Charter is a matter of fact. 40) A

It is a violation of Standard III(B) because the advisor should act first on behalf of existing clients whose needs and characteristics she already knows. It is a violation of Standard III(C) because she has never met the prospect and does not know if the new ideas are appropriate for the prospect. Thus, “both of these” is the best response. 41) A

Hurst is most likely in violation of Standard V(C) Record Retention because the supporting documentation is unavailable. He needs to recreate the supporting records based on information gathered through public sources or the covered company. He may have a reasonable basis for his recommendations and have been diligent in his analysis, but must reconstruct the records of this analysis before issuing the reports. 42) C

Standard IV(C) Responsibilities of Supervisors permits Tripp to delegate supervisory duties to Green, Brown, or both, but such delegation does not relieve Tripp of his supervisory responsibility. 43) B

Version 1

Family accounts that are client accounts should be treated like any other firm account and should neither be given special treatment nor be disadvantaged because of an existing family relationship with the member or candidate. Members or candidates may undertake transactions in accounts for which they are a beneficial owner only after their clients and employers have had adequate opportunity to act on the recommendation. Personal transactions include those made for the member or candidate's own account, for family (including spouse, children, and other immediate family members) accounts, and for accounts in which the member or candidate has a direct or indirect pecuniary interest, such as a trust or retirement account. It could be argued that Rock is a beneficial owner of his wife's account and the reason why his wife's account should be treated like any other client account is because it does not state that Rock makes the trades in his wife's account. From that we are to infer that another person other than Rock is managing his wife's account thus she should be treated like any other client. 44) A

Allen’s notes from his research are employer records and even though he prepared them, it is a violation to take them from his employer without permission. Soliciting former clients’ business is not, in itself, a violation as long has Allen has not misappropriated client information from his former employer. Preparations to start a new business are not necessarily a violation of the Standard, although soliciting current clients or recruiting other firm personnel for the new venture, before formally leaving his employer, would be violations of the Standards. 45) A

According to Standard V(B), an analyst can use reasonable judgment regarding the exclusion of some facts and should include more basic facts for reports to wider audiences. The key issue is that analysts should tailor their reports to the intended audience. 46) B

Standard VII(A) Conduct as Participants in CFA Institute Programs does not prohibit expressing opinions about the program or the CFA Institute. Thus, Vasquez is not in violation. Nothing in the facts indicates a violation of Standard I(D, Misconduct. Standard I(D) deals with professional conduct involving dishonesty, fraud, or deceit. 47) B

By not returning the bottle she would be violating the Standard on disclosure of conflicts to the employer, which states that employees must comply with prohibitions imposed by their employer. 48) B

Version 1

Sanchez is in violation of the Standard III(B), Fair Dealing, since he has disseminated his recommendation preferentially to the portfolio managers in advance of making the report available to all clients who hold shares of ChemStar. The portfolio managers are in violation of the Standard since they are effectively giving preferential treatment to the trading accounts over the buy-and-hold accounts in the placement of orders based upon the change in recommendation. 49) A

In no case should information be disclosed to a reporter before all clients are provided with the research—doing so will violate the Standard on fair dealing. However, once clients have been informed, there is no violation in releasing the information to the reporter, and in doing so Phillips might obtain information that can further help his clients. 50) B

Standard V(A)—Diligence and Reasonable Basis was not broken because Smithson conducted thorough and diligent research. Standard III(C)—Suitability, Smithson failed to consider the needs of his conservative and aggressive clients. Standard IV(C)—Responsibilities of Supervisors, Preston Partners didn't have policies explaining how to allocate shares among clients. 51) A

Blackwell violated Standard I, Professionalism. Jameson must comply with the strictest requirements among the laws of the country where his firm is based, the CFA Institute Code and Standards, and the laws of the country where he is doing business. Because the applicable laws in Mega Capital’s home country are stricter than the Code and Standards, Jameson must additionally adhere to that more strict law. 52) A

It is permissible to allocate trades on a pro-rata basis over all suitable accounts. It is not permissible to base allocations upon compensation arrangements. Any method is not necessarily suitable, and disclosure does not absolve the member from ensuring that the allocation is necessarily fair. 53) A

Although Drake is paid by the company, his fiduciary duty is to the plan participants. His advice cannot be compromised by business considerations, otherwise he will be violating the Standard on loyalty, prudence, and care. 54) A

Version 1

Standard I(C) Misrepresentation. Members should not copy or use material prepared by others without acknowledging and identifying the source of such material. Using charts and graphs without stating their source is a violation of the Standard. Data from recognized statistical reporting services may be used without attribution, but charts, analysis, and other such creative content may not. 55) B

Even though the information is false, this fact is known only to Fox and is thus nonpublic information. Since such recommendations have in the past had a significant effect on the price of the security in question, the information is clearly material. Fox is in violation of Standard II(A) Material Nonpublic Information. 56) C

Standard III(B) – Fair Dealing requires dealing fairly and objectively with all clients and prospects when disseminating material changes in prior investment recommendations. Note that the standard requires the dissemination be fair, but not necessarily equal due to the impossibility of contacting all clients simultaneously. A change of recommendation from “buy” to “sell” is generally material. 57) C

Standard VI(A) requires members to disclose all matters that could reasonably be expected to impair the member’s ability to make unbiased and objective recommendations. Compensation based on a percentage of fees generated does not create an inherent bias. If, however, a performance bonus is paid for investment results, it may unduly encourage the manager to take more risk than is proper and prudent, and so the existence of the bonus opportunity must be disclosed to the client. 58) B

The CFA Institute Professional Conduct Program may impose sanctions on CFA charterholders and candidates for the CFA designation. Firms are not members of CFA Institute. 59) A

An employee/employer relationship does not necessarily mean monetary compensation for services. If the analyst is performing services for the organization, then the analyst must treat the position as if he were an employee. 60) B

Version 1

Standard III(B) Fair Dealing requires that members deal fairly with all clients in disseminating investment recommendations. It does not require uniform or equal treatment. Sandvik’s approach in sending e-mail correspondence to those of his clients who had given him their e-mail addresses, having made the request to all of his clients, and sending regular mail correspondence the same day, is fair to all of his clients. 61) B

A profession is an occupational group (e.g., doctors or lawyers) that has requirements of specialized expert knowledge, and often a focus on ethical behavior and service to the larger community or society. While many professions require their members to put clients first or encourage them to serve the wider community, these are not defining characteristics of a profession. 62) B

A misdemeanor charge not related to professional conduct is not grounds for a suspension. The other choices are violations of the Code and Standards and may result in CFA Institute imposing a suspension of membership or participation. 63) A

Based on the information here, Hill has done nothing wrong. He took a call at his home, presumably on his own time, and the client made it clear that he would never be a client of Advisors. Therefore, there was no breach of loyalty to Advisors by Hill, nor is there a conflict of interest. 64) C

According to Standard II(A) Material Nonpublic Information, an analyst must not act or cause others to act on material nonpublic information. The information is material to the company’s future profitability, and is nonpublic because the lawsuit has not yet been filed and is not yet a matter of public record. 65) A

The investment manager is in violation of the Standard requiring him to make a reasonable inquiry into the client’s financial situation and update the investment policy statement since such a dramatic change in the client’s circumstances would undoubtedly alter the investment policy statement and would probably eliminate the need to hold a short position in Oracle. The investment manager is not in violation of the Standard concerning additional compensation, since the gift has been reported to his supervisor and has come from a client. If there was a failure to report such a gift, if the firm had a rule in place against the acceptance of gifts from clients, or if the gift had come from a non-client, there would be a violation of the standard.

Version 1

66) A

According to Standard V(B), the analyst must inform the clients of the change and tell them it is based upon an opinion and not a fact. Making an identical change in two portfolios may be a violation of this standard if the needs of the clients are not identical. 67) A

According to Standard IV(A), Loyalty to Employer, Valley must inform Advisors of his outside consultation even if it is not for monetary compensation. According to Standard VI(A), Disclosure of Conflicts, Valley must also disclose possible conflicts of interest, and his sister’s position qualifies. 68) B

Because the itinerary required charter flights due to a lack of commercial transportation, River Casino can appropriately provide them. While Standard I(B) Independence and Objectivity recommends that members pay their own room costs, it is not required and it is not unusual for members to accept accommodations. 69) A

Standard II(A) Material Nonpublic Information requires that members and candidates who possess material nonpublic information not act or cause others to act on the information. Refusing the trade would violate this Standard because it would be acting or causing others to act on the nonpublic information. Dean should seek to have East Street make the information public. If East Street does not do so, Dean must act as he would have acted if he did not possess the information. Refusing to make the trade he was instructed to make would be “acting” on the information in this case. The obligation here is to the integrity of financial markets. 70) A

Carson has not violated either Standard based on the information given. The suitability of an investment is to be determined based on the risk and return characteristics of the portfolio and not on the risk and return characteristics of each individual security. The fact that a security does not pay a dividend and has a beta higher than the market is not enough to determine its suitability in a portfolio context. The fact that regulators have called previously reported earnings into question does not necessarily mean that Carson’s analysis was not diligent or that he did not have a reasonable basis for his selection of this security. 71) B

Version 1

Standard I(A) Knowledge of the Law requires members and candidates to comply with the strictest requirement among the law where they reside, the law in the area where they do business, and the Code and Standards. In this case, the Code and Standards is the strictest. Standard III(B) Fair Dealing prohibits members and candidates from withholding shares in oversubscribed IPOs from clients for their own benefit. 72) A

Recommended procedures for compliance with Standard III(B) Fair Dealing include limiting the number of people in the firm who know that a change in recommendation will be made. Requiring investment committee approval for all recommendation changes is not among the recommended procedures.

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Which of the following is a company least likely required to present according to International Accounting Standard (IAS) No. 1? A) Statement of changes in owners’ equity. B) A summary of accounting policies. C) Disclosures of material events. 2) According to IFRS guidance for management’s commentary, addressing the company’s key

relationships is: A) neither recommended nor required. B) required. C) recommended. 3) Selected information from Able Company’s financial activities is as follows:

Net Income was $720,000. 1,000,000 shares of common stock were outstanding on January 1. 1,000 shares of 8%, $1,000 par value preferred shares were outstanding on January 1. The tax rate was 40%. The average market price per share for the year was $20. 6,000 shares of 3%, $500 par value preferred shares, convertible into common shares at a rate of 40 common shares for each preferred share, were outstanding for the entire year. Able’s basic and diluted earnings per share (EPS) are closest to:

A) B) C)

Basic EPS

Diluted EPS

$0.64 $0.55 $0.55

$0.64 $0.52 $0.55

A) Option A B) Option B C) Option C

Version 1

4) A company has the following sequence of events regarding their stock:

One million shares outstanding at the beginning of the year. On June 30th, they declared and issued a 10% stock dividend. On September 30th, they sold 400,000 shares of common stock at par. Basic earnings per share at year-end will be computed on how many shares? A) 1,200,000. B) 1,000,000. C) 1,100,000. 5) Books Forever, Incorporated, uses short-term bank debt to buy inventory. Assuming an

initial current ratio that is greater than 1, and an initial quick (or acid test) ratio that is less than 1, what is the effect of these transactions on the current ratio and the quick ratio? A) Both ratios will decrease. B) Neither ratio will decrease. C) Only one ratio will decrease. 6) David Chance, CFA, is analyzing Grow Corporation. Chance gathers the following

information: Net cash provided by operating activities Net cash used for fixed capital investments Cash paid for interest Income before tax Income tax expense Net income

$ 3,500 $ 727 $ 195 $ 4,400 $ 1,540 $ 2,860

Grow’s free cash flow to the firm (FCFF) isclosest to: A) $2,900. B) $2,260. C) $2,640.

Version 1

7) The following footnote appeared in Crabtree Company’s 20X7 annual report:

“On December 31, 20X7, Crabtree recognized a restructuring charge of $20 million, of which $5 million was for severance pay for employees who will be terminated in 20X8 and $15 million was for land that became permanently impaired in 20X7.” Based only on these changes, Crabtree’s net profit margin and fixed asset turnover ratio (using year- end financial statement values) in 20X8 as compared to 20X7 will be: Net profit margin

Fixed asset turnover

Lower Higher Higher

Higher Unchanged Higher

A) B) C) A) Option A B) Option B C) Option C

8) Do the following characteristics have to be met in order to classify a liability as current on

the balance sheet? Characteristic #1 – Settlement is expected within one year or operating cycle, whichever is less. Characteristic #2 – Settlement will require the use of cash within one year or operating cycle, whichever is greater. Characteristic #1

Characteristic #2

No Yes No

No No Yes

A) B) C) A) Option A B) Option B C) Option C

Version 1

9) Which of the following transactions would least likely be reported in the cash flow statement

as investing cash flows? A) Sale of held-to-maturity securities for cash. B) Purchase of plant and equipment used in the manufacturing process with financing provided by the seller. C) Principal payments received from loans made to others. 10) During 2007, Brownfield Incorporated purchased $140 million of inventory. For the year just

ended, Brownfield reported cost of goods sold of $130 million. Inventory at year-end was $45 million. Calculate inventory turnover for the year. A) 2.89. B) 3.25. C) 3.71. 11) McQueen Corporation prepared the following common-size income statement for the year ended December 31, 20X7: Sales 100% Cost of goods sold 60% Gross profit 40%

For 20X7, McQueen sold 250 million units at a sales price of $1 each. For 20X8, McQueen has decided to reduce its sales price by 10%. McQueen believes the price cut will double unit sales. The cost of each unit sold is expected to remain the same. Calculate the change in McQueen’s expected gross profit for 20X8 assuming the price cut doubles sales. A) $80 million increase. B) $50 million increase. C) $150 million increase.

Version 1

12) What would be the impact on a firm’s return on assets ratio (ROA) of the following

independent transactions, assuming ROA is less than one? Transaction #1 – A firm owned investment securities that were classified as available-forsale and there was a recent decrease in the fair value of these securities. Transaction #2 – A firm owned investment securities that were classified as trading securities and there was recent increase in the fair value of the securities. Transaction #1

Transaction #2

Higher Higher Lower

Lower Higher Higher

A) B) C) A) Option A B) Option B C) Option C

13) A segment of a common-size balance sheet for Olsen Company in its most recent year shows

the following data: Common stock Additional paid-in capital Preferred stock

1% 19% 15%

How should an analyst most appropriately interpret these data? A) Proceeds from the issuance of common stock are 20% of total assets. B) Shareholders’ equity is 35% of total assets. C) Preferred stock is 15% of shareholders’ equity. 14) Orange Company’s net income for 2004 was $7,600,000 with 2,000,000 shares outstanding.

The average share price in 2004 was $55. Orange had 10,000 shares of eight percent $1,000 par value convertible preferred stock outstanding since 2003. Each preferred share was convertible into 20 shares of common stock. Orange Company’s diluted earnings per share (Diluted EPS) for 2004 is closest to: A) $3.80. B) $3.45. C) $3.40.

Version 1

15) In converting a statement of cash flows from the indirect to the direct method, which of the

following adjustments should be made for a decrease in unearned revenue when calculating cash collected from customers, and for an inventory writedown (when market value is less than cost) when calculating cash payments to suppliers? Cash collections from customers:

Cash payments to suppliers

A) Add decrease in unearned revenue Subtract an inventory writedown B) Subtract decrease in unearned Add an inventory writedown revenue C) Subtract decrease in unearned Subtract an inventory writedown revenue A) Option A B) Option B C) Option C

Version 1

16) In preparing its cash flow statement for the year ended December 31, 20x4, Giant

Corporation collected the following data: Gain on sale of equipment

$ 6,000

Proceeds from sale of equipment

10,000

Purchase of Zip Company bonds for Amortization of bond discount

180,000

Dividends paid

(75,000)

Proceeds from sale of Treasury stock

(maturity value $200,000)

2,000

38,000

In its December 31, 20x4, statement of cash flows, under U.S. GAAP, what amounts should Giant report as net cash used in investing activities and net cash used in financing activities? Investing Activities A) B) C)

$178,000 $170,000 $170,000

Financing Activities −$37,000 $37,000 −$38,000

A) Option A B) Option B C) Option C 17) According to International Financial Reporting Standards, how do cash dividends received

from trading securities and financial securities measured at fair value through OCI affect net income? Trading securities

Fair value through OCI

No effect Increase Increase

Increase No effect Increase

A) B) C) A) Option A B) Option B C) Option C

Version 1

18) The following data pertains to the Sapphire Company:

Net income equals $15,000. 5,000 shares of common stock issued on January 1st. 10% stock dividend issued on June 1st. 1,000 shares of common stock were repurchased on July 1st. 1,000 shares of 10%, $100 par preferred stock each convertible into 8 shares of common were outstanding the whole year. What is the company’s diluted earnings per share (EPS)? A) $2.50. B) $1.00. C) $1.15. 19) Duster Company reported the following financial information at the end of 2007: in millions Unearned revenue Common stock at par Capital in excess of par Accounts payable Treasury stock Retained earnings Accrued expenses Accumulated other comprehensive loss Long-term debt

$ 240 30 440 1,150 2,000 5,160 830 210 1,570

Calculate Duster’s liabilities and stockholders’ equity as of December 31, 2007.

A) B) C)

Liabilities

Stockholders' equity

$3,790 million $3,550 million $3,790 million

$3,420 million $7,840 million $7,420 million

A) Option A B) Option B C) Option C

Version 1

20) Matrix, Incorporated’s common size income statement for the years ended December 31,

20X1 and 20X2 included the following information (percent of net sales): 20X1

20X2

Sales Cost of Goods Sold

100 (55) 45

100 (60) 40

Selling General & Administrative Depreciation

(5) (7) 33

(5) (8) 27

Interest Expense

(15) 18

(6) 21

Income Tax Expense

(6) 12

(7) 14

Analysis of this data indicates that from 20X1 to 20X2: A) the effective tax rate increased. B) interest expense per dollar of sales declined. C) cost of goods sold increased.

Version 1

21) Convenience Travel Corporation’s financial information for the year ended December 31,

20X4 included the following: Property Plant & Equipment Accumulated Depreciation

$15,000,000 9,000,000

The only asset owned by Convenience Travel in 20X5 was a corporate jet airplane. The airplane was being depreciated over a 15-year period on a straight-line basis at a rate of $1,000,000 per year. On December 31, 20X5 Convenience Travel sold the airplane for $10,000,000 cash. Net income for the year ended December 31, 20X5 was $12,000,000. Based on the above information, and ignoring taxes, what is cash flow from operations (CFO) for Convenience Travel for the year ended December 31, 20X5? A) $8,000,000. B) $11,000,000. C) $13,000,000. 22) Joplin Corporation reports the following in its year-end financial statements:

Net income of $43.7 million. Depreciation expense of $4.2 million. Increase in accounts receivable of $1.5 million. Decrease in accounts payable of $2.3 million. Increase in capital stock of $50 million. Sold equipment with a book value of $7 million for $15 million after-tax. Purchased equipment for $35 million. Joplin’s free cash flow to the firm (FCFF) is closest to: A) $66 million. B) $24 million. C) $16 million. 23) What is the appropriate measurement basis for equipment used in the manufacturing process? A) Historical cost B) Fair value C) Lower of cost or net realizable value

Version 1

24) Financial information for Jefferson Corporation for the year ended December 31st, was as

follows: Sales Purchases Inventory at Beginning Inventory at Ending Accounts Receivable at Beginning Accounts Receivable at Ending Accounts Payable at Beginning Accounts Payable at Ending Other Operating Expenses Paid

$ 3,000,000 1,800,000 500,000 800,000 300,000 200,000 100,000 100,000 400,000

Based upon this data and using the direct method, what was Jefferson Corporation’s cash flow from operations (CFO) for the year ended December 31st? A) $1,200,000. B) $900,000. C) $800,000. 25) A firm’s balance sheet prepared under IFRS is least likely to include: A) market value of inventory. B) fair value of firm PPE. C) market value of the firm’s equity. 26) Is an acquisition of treasury stock or a loss from the write-down of inventory under the

lower-of-cost-or- market rule included in comprehensive income? Inventory write-down

Acquisition of treasury stock

No No Yes

No Yes No

A) B) C) A) Option A B) Option B C) Option C

27) To convert an indirect statement of cash flows to a direct basis, the analyst would: A) reduce cost of goods sold by any decreases in inventory. B) increase cost of goods sold by any depreciation that was included. C) reduce cost of goods sold by any decreases in accounts payable.

Version 1

28) A company reports a gain of €100,000 on the sale of an asset and a loss of €100,000 due to

foreign currency translation adjustment. Which of these items will be included in the company’s comprehensive income? A) Only one of these items is included in comprehensive income. B) Both of these items are included in comprehensive income. C) Neither of these items is included in comprehensive income. 29) An analyst compiled the following information for Universe, Incorporated for the year ended

December 31, 20X4: Net income was $850,000. Depreciation expense was $200,000. Common stock was sold for $100,000. Preferred stock (eight percent annual dividend) was sold at par value of $125,000. Common stock dividends of $25,000 were paid. Preferred stock dividends of $10,000 were paid. Equipment with a book value of $50,000 was sold for $100,000. Using the indirect method and assuming U.S. GAAP, what was Universe Incorporated’s cash flow from operations (CFO) for the year ended December 31, 20X4? A) $1,000,000. B) $1,050,000. C) $1,015,000.

Version 1

30) Wells Incorporated reported the following common size data for the year ended December

31, 20X7: Income Statement Sales Cost of goods sold Operating expenses Interest expense Income Statement Income tax Net income Balance sheet

% 100.0 58.2 30.2 0.7 % 5.7 5.2 %

Cash Accounts receivable Inventory Net fixed assets Total assets

4.8 14.9 49.4 30.9 100.00

% Accounts payable Accrued liabilities Long-term debt Common equity Total liabilities & equity

15.0 13.8 23.2 48.0 100.0

For 20X6, Wells reported sales of $183,100,000 and for 20X7, sales of $215,600,000. At the end of 20X6, Wells’ total assets were $75,900,000 and common equity was $37,800,000. At the end of 20X7, total assets were $95,300,000. Calculate Wells’ current ratio and return on equity ratio for 20X7. A) B) C)

Current ratio

Return on equity

2.4 4.6 2.4

24.5% 25.2% 26.8%

A) Option A B) Option B C) Option C

Version 1

31) The following information is for Trotters Diversified as of year-end:

Average common shares outstanding of 5.0 million. Average market price for common stock of $35.00 per share. Net income of $9.0 million. Common stock dividends paid of $1.2 million. Tax rate of 40%. 500,000 shares of cumulative convertible preferred stock with $30 par value and 10% dividend. Each preferred share is convertible into 5 common shares. Preferred dividends of $1.5 million were paid. 10,000 convertible $1,000 par bonds with a 6.0% coupon, each convertible into 8 shares of common stock. 400,000 stock options with an exercise price of $32.00 per share. All of these securities were outstanding for the full year. Diluted EPS for Trotters Diversified is closest to: A) $1.19. B) $1.23. C) $1.50.

Version 1

32) For the year ended December 31, 2007, Challenger Company reported the following

financial information: Revenue Cost of goods sold Cash operating expenses Depreciation expense Tax expense Net income Increase in accounts receivable Decrease in inventory Increase in short-term notes payable Decrease in accounts payable

$ 100,000 (40,000) (20,000) (5,000) (3,000) $ 32,000 $ 7,500 $ 2,500 $ 3,000 $ 1,000

Calculate cash flow from operating activities using the direct method and the indirect method. A) B) C)

Direct method

Indirect method

$34,000 $31,000 $31,000

$34,000 $34,000 $31,000

A) Option A B) Option B C) Option C 33) Galaxy, Incorporated’s U.S. GAAP balance sheet as of December 31, 20X4 included the

following information (in $):

Accounts Payable Dividends Payable Common Stock Retained Earnings

12-31-X3

12-31-X4

300,000 200,000 1,000,000 700,000

500,000 300,000 1,000,000 1,000,000

Galaxy’s net income in 20X4 was $800,000. What was Galaxy’s cash flow from financing (CFF) in 20X4? A) −$300,000. B) −$500,000. C) −$400,000.

Version 1

34) Darth Corporation’s most recent income statement shows net sales of $6,000, and Darth’s

marginal tax rate is 40%. Cash expenses reported were $3,200. In addition, depreciation expense was reported at $800. A further examination of the most recent balance sheets reveals that accounts receivable during that period increased by $1,000. The cash flow from operating activities reported by Darth should be: A) $2,200. B) $1,000. C) $1,200. 35) Galaxy Corporation manufactures custom motorcycles. Galaxy finances the motorcycles over

36 months for customers who make a minimum down payment of 10%. Historically, Galaxy has experienced bad debt losses equal to 1% of sales. Galaxy also provides a 24 month unlimited warranty on all new motorcycles. In the past, warranty expense has averaged 3% of sales. Ignoring taxes, how does the recognition of bad debt expense and warranty expense at the time of sale affect Galaxy’s liabilities? Bad debt expense

Warranty expense

No effect No effect Increase

No effect Increase No effect

A) B) C) A) Option A B) Option B C) Option C

36) A 12 percent $100,000 convertible bond was issued on October 1, 2004. It is dilutive and can

be converted into 18,000 shares. The effective income tax rate for the year was 40%. What adjustments should be made to calculate diluted earnings per share? Interest added to the numerator Shares added to the denominator A) B) C)

$3,000 $3,000 $1,800

18,000 4,500 4,500

A) Option A B) Option B C) Option C

Version 1

37) Holden Company’s fixed asset footnote included the following:

During 20X7, Holden sold machinery for a gain of $100,000. The machinery had an original cost of $500,000 and its accumulated depreciation was $240,000. At the end of 20X7, Holden purchased machinery at a cost of $1,000,000. Holden paid $400,000 cash. The balance was financed by the seller at 8% interest. Depreciation expense was $2,080,000 for the year ended 20X7. Calculate Holden’s cash flow from investing activities for the year ended 20X7. A) $300,000 outflow. B) $40,000 outflow. C) $360,000 inflow. 38) A company reports the following unusual events:

Loss on discontinued operations. Restructuring and severance costs applicable to asset sales. Plant shutdown costs. Which of these items would most likely be considered nonrecurring and included in operating income? A) Loss on discontinued operations and restructuring and severance costs applicable to asset sales. B) Restructuring and severance costs applicable to asset sales and plant shutdown costs. C) Loss on discontinued operations and plant shutdown costs.

Version 1

39) Red Oak Corporation is a furniture manufacturer located in Canada. Red Oak is financed

with a combination of debt and equity. The debt consists of unsecured zero-coupon bonds that mature in 20 years. For income tax purposes, interest on the bonds is deductible when accrued. Red Oak’s equity consists of common stock and preferred stock. No dividends have ever been paid on Red Oak’s common stock; however, dividends are paid quarterly to the preferred shareholders. Should the accrued interest on the zero-coupon bonds and the dividends paid to the preferred shareholders be reported as a nonoperating component of Red Oak’s net income? Accrued interest

Preferred dividends

Yes Yes No

Yes No Yes

A) B) C) A) Option A B) Option B C) Option C

40) Selected information from Feder Corporation’s financial activities for the year is as follows:

Net income was $7,650,000. 1,100,000 shares of common stock were outstanding on January 1. The average market price per share was $62. Dividends were paid during the year. The tax rate was 40%. 10,000 shares of 6% $1,000 par value preferred shares convertible into common shares at a rate of 20 common shares for each preferred share were outstanding for the entire year. 70,000 options, which allow the holder to purchase 10 shares of common stock at an exercise price of $50 per common share, were outstanding the entire year. Feder Corporation’s diluted earnings per share (EPS) was closest to: A) $5.32. B) $5.87. C) $4.91.

Version 1

41) Consider the following:

Statement #1: One approach to presenting a common-size cash flow statement is to express each inflow of cash as a percentage of total cash inflows and each outflow of cash as a percentage of total cash outflows. Statement #2: Expressing each line item of the cash flow statement as a percentage of revenue is useful in forecasting future cash flows. Which of these statements regarding a common-size cash flow statement is (are) CORRECT? A) Only statement #1 is correct. B) Both statements are correct. C) Only statement #2 is correct. 42) Statement #1 – As compared to the price-to-earnings ratio, the price-to-cash flow ratio is

easier to manipulate because management can easily control the timing of the cash flows. Statement #2 – A firm with earnings per share of $2 is more profitable than a firm with earnings per share of $1. With respect to these statements: A) both are incorrect. B) both are correct. C) only one is correct. 43) A common-size cash flow statement is least likely to provide payments to employees as a

percentage of: A) total cash outflows for the period. B) revenues for the period. C) operating cash flow for the period.

Version 1

44) The First National Bank is a commercial bank that specializes in consumer financing,

particularly automobile loans. The majority of the loans are funded from customer deposits. In addition, the bank purchases various investment securities with available cash. The investments are debt securities and have an average maturity date of less than 30 days. Should First National Bank report the interest received from the consumer loans and the interest received from the investment securities as an operating or as a nonoperating component in its year-end income statement? Consumer loans

Investment securities

Nonoperating Operating Operating

Operating Nonoperating Operating

A) B) C) A) Option A B) Option B C) Option C

45) Young Distributors, Incorporated issued convertible bonds two years ago, and those bonds

are the only potentially dilutive security Young has issued. In 20X5, Young’s basic earnings per share (EPS) and diluted EPS were identical, but in 20X4 they were different. Which of the following factors is least likely to explain the difference between basic and diluted EPS? The: A) bonds were antidilutive in 20X5 but not in 20X4. B) bonds were redeemed by Young Distributors at the beginning of 20X5. C) average market price of Young common stock increased in 20X5.

Version 1

46) Selected financial information gathered from the Matador Corporation follows:

Average debt Average equity Return on assets Quick ratio Sales Cost of goods sold

2007

2006

2005

$ 792,000 $ 215,000 5.9%

$ 800,000 $ 294,000 6.6%

$ 820,000 $ 364,000 7.2%

0.3 $ 1,650,000 $ 1,345,000

0.5 $ 1,452,000 $ 1,176,000

0.6 $ 1,304,000 $ 1,043,000

Using only the data presented, which of the following statements ismost correct? A) Gross profit margin has improved. B) Leverage has declined. C) Return on equity has improved. 47) A firm has a cash conversion cycle of 80 days. The firm's payables turnover goes from 11 to

12, what happens to the firm's cash conversion cycle? It: A) may shorten or lengthen. B) lengthens. C) shortens. 48) An analyst compiled the following information from Hampshire, Incorporated’s financial

activities in the most recent year: Net income was $2,800,000. 100,000 shares of common stock were outstanding on January 1. The average market price per share for the year was $250. 10,000 shares of 6%, $1,000 par value preferred shares were outstanding the entire year. 10,000 warrants, which allow the holder to purchase 10 shares of common stock for each warrant held at a price of $150 per common share, were outstanding the entire year. 30,000 shares of common stock were issued on September 1. Hampshire, Incorporated’s diluted earnings per share are closest to: A) $14.67. B) $18.38. C) $20.00.

Version 1

49) Selected information from Gerrard, Incorporated’s financial activities in the most recent year

was as follows: Net income was $330,000. The tax rate was 40%. 700,000 shares of common stock were outstanding on January 1. The average market price per share for the year was $6. Dividends were paid during the year. 2,000 shares of 8% $500 par value preferred shares, convertible into common shares at a rate of 200 common shares for each preferred share, were outstanding for the entire year. 200,000 shares of common stock were issued on March 1. Gerrard, Incorporated’s diluted earnings per share (diluted EPS) was closest to: A) $0.261. B) $0.289. C) $0.197. 50) 50. Which of the following statements about a firm with convertible preferred stock

outstanding is most accurate? A) If diluted EPS is less than basic EPS then the convertible preferred is said to be antidilutive. B) Diluted EPS is calculated with net income minus preferred dividends in the numerator. C) If diluted and basic EPS are equal, the firm must report both basic and diluted EPS. 51) Barracuda Corporation, a U.S. corporation, owns a subsidiary located in Germany. The

German subsidiary’s financial statements are maintained in euros. If the euro recently appreciated relative to the U.S. dollar, how would the unrealized translation gain affect Barracuda’s retained earnings and total stockholders’ equity? Retained earnings

Total stockholders' equity

No effect No effect Increase

No effect Increase Increase

A) B) C) A) Option A B) Option B C) Option C

Version 1

52) The “All Faiths” church is building a new church for $2 million on land acquired several

years ago. The contractor estimates the cost at $1.3 million and the project is to be completed over a 2-year period with the payments split evenly between the 2 years. During the first year, the total costs incurred were $700,000. During the second year the contractor experienced cost overruns and costs incurred were $1.0 million. How much revenue and income should the contractor recognize in the second year of the project?

A) B) C)

Revenue

Income

$ 923,077 $ 1,076,923 $ 1,000,000

−$ 76,923 $ 376,923 $ 0

A) Option A B) Option B C) Option C 53) Jodi Lein, small business consultant, is currently working with RJ Landscaping, a sole

proprietorship. She is trying to educate the owner on the importance of monitoring cash flows. Operating information as of the end of the most recent month appears below: Cash from sale of truck of $7,000. Cash salaries paid of $17,000. Cash from customers of $45,000. Depreciation expense of $5,500. Interest on bank line of credit of $1,000. Cash paid to suppliers of $22,000. Other cash expenses, including rent, of $6,300. No taxes due. Using this information and U.S. GAAP, what is the cash flow from operations for the month? A) −$1,300. B) $11,200. C) −$300. 54) Which costs are least likely to be reported as an expense in the current accounting period? A) Period costs. B) Loan interest that has not yet been paid. C) Costs of producing inventory.

Version 1

55) Determine the cash flow from operations given the following table. Item Cash payment of dividends Sale of equipment Net income Purchase of land Increase in accounts payable Sale of preferred stock Increase in deferred taxes Profit on sale of equipment

Amount $ 30 $ 25 $ 25 $ 15 $ 20 $ 25 $ 5 $ 15

A) $20. B) $45. C) $35. 56) For a manufacturing company reporting under U.S. GAAP, interest received is most likely

reported as: A) an investing cash flow and as non-operating income. B) an operating cash flow but as non-operating income. C) both an operating cash flow and operating income. 57) Which costs are least likely to be reported as an expense in the current accounting period? A) Period costs. B) Loan interest that has not yet been paid. C) Costs of producing inventory. 58) A U.S. GAAP reporting company invests $50 million in a bond portfolio yielding 4% with

an average maturity of seven years. After one year, interest rates have fallen by 50 basis points. The company will report the highest retained earnings if the securities in the portfolio are classified as: A) trading securities. B) available-for-sale. C) held-to-maturity.

Version 1

59) From Thorpe Company’s cash flow statement, an analyst discovers that during the most

recent period Thorpe spent $2 million on what the firm describes as “investment in capital improvements.” If the analyst believes this expenditure will not give Thorpe any enduring benefit beyond the current period, the most appropriate adjustment is to: A) decrease both CFO and CFI. B) increase CFO and decrease CFI. C) decrease CFO and increase CFI. 60) A common-size cash flow statement is least likely to show each cash inflow as a percentage

of: A) revenue. B) total cash flows. C) all cash inflows. 61) Which of the following items would affect owners’ equity and also appear on the income

statement? A) Unrealized gains and losses on available-for-sale securities. B) Dividends paid to shareholders. C) Unrealized gains and losses on trading securities. 62) The revaluation model for investment property is permitted under: A) both IFRS and U.S. GAAP. B) neither IFRS nor U.S. GAAP. C) IFRS, but not U.S. GAAP. 63) Train, Incorporated’s cash flow from operations (CFO) in 20X8 was $14 million. Train paid

$8 million cash to acquire a franchise at the beginning of 20X8 that was expensed in 20X8. If Train had elected to amortize the cost of the franchise over eight years, 20X8 cash flow from operations (CFO) would have been: A) $21 million. B) $14 million. C) $22 million.

Version 1

64) A manufacturing firm shuts down production at one of its plants and offers the facility for

rent. Based on the market for similar properties, the firm determines that the fair value of the plant is €500,000 more than its carrying value. If this firm uses the cost model for plant and equipment and the fair value model for investment property, should it recognize a gain on its income statement? A) No, because the firm must continue to use the cost model for valuation of this asset. B) Yes, because the plant will be reclassified as investment property. C) No, because the increase in value does not reverse a previously recognized loss. 65) A firm acquires investment property for €3 million and chooses the fair value model for

financial reporting. In Year 1 the market value of the investment property decreases by €150,000. In Year 2 the market value of the investment property increases by €200,000. On its financial statements for Year 2, the firm will recognize a: A) €150,000 increase in shareholders’ equity. B) €200,000 gain on its income statement. C) €150,000 gain on its income statement and a €50,000 revaluation surplus in shareholders’ equity. 66) For a company which owns a majority of the equity of a subsidiary, whether to create a

deferred tax liability for undistributed profits from the subsidiary depends on an “indefinite reversal criterion” under: A) U.S. GAAP, but not IFRS. B) both IFRS and U.S. GAAP. C) IFRS, but not U.S. GAAP. 67) Diabelli Incorporated is a manufacturing company that is operating at normal capacity levels.

Which of the following inventory costs is most likely to be recognized as an expense on Diabelli’s financial statements when the inventory is sold? A) Selling cost. B) Administrative overhead. C) Allocation of fixed production overhead.

Version 1

68) Christophe Incorporated is an electronics manufacturing firm. It owns equipment with a tax

basis of $800,000 and a carrying value of $600,000 as the result an impairment charge. It also has a tax loss carryforward of $300,000 that is expected to be utilized within the next year or two. The tax rate on these items is 40% but the tax rate will decrease to 35%. Which of the following is closest to the effect on the income statement of the change in tax rate? A) Decrease income tax expense by $5,000. B) Increase income tax expense by $5,000. C) Increase income tax expense by $25,000. 69) A tax rate that has been substantively enacted is used to determine the balance sheet values of

deferred tax assets and deferred tax liabilities under: A) both IFRS and U.S. GAAP. B) IFRS only. C) U.S. GAAP only. 70) A company issues 5% semiannual coupon, 3-year, $1,000 par value bonds on January 1,

20X0, when the market interest rate is 13.3%. The sale proceeds are $800. Under the effective interest rate method, what amount of interest expense per $1,000 par value will the company record for the year ending December 31, 20X1? A) $106.40. B) $116.29. C) $66.29. 71) For a firm that uses the cost basis for valuing its long-lived assets, fair value is a

consideration when calculating a gain or loss on: A) selling an asset. B) abandoning an asset. C) exchanging an asset. 72) The inventory turnover ratio and the number of days in inventory are least likely used to

evaluate the: A) age of a firm's inventory. B) effectiveness of a firm's inventory management. C) stability of a firm's inventory levels.

Version 1

73) Which of the following statements regarding the disclosure of deferred taxes in a company’s

balance sheet is most accurate? A) Current deferred tax liability and noncurrent deferred tax asset are netted, resulting in the disclosure of a net noncurrent deferred tax liability or asset. B) There should be a combined disclosure of all deferred tax assets and liabilities that are likely to reverse in the current period. C) Deferred tax assets and liabilities are classified as noncurrent. 74) Which set of accounting standards requires firms to disclose estimated amortization expense

for the next five years on intangible assets? A) U.S. GAAP. B) Both IFRS and U.S. GAAP. C) IFRS. 75) Which of the following factors is least likely to cause a difference between a firm’s effective

tax rate and statutory rate? A) Tax credits. B) Non-deductible expenses. C) Deductible expenses. 76) When bonds are issued at a premium: A) earnings of the firm increase over the life of the bond as the bond premium is

amortized. B) coupon interest paid decreases each period as bond premium is amortized. C) earnings of the firm decrease over the life of the bond as the bond premium is amortized. 77) Under which financial reporting standards is the full amount of a deferred tax asset shown on

the balance sheet, regardless of its probability of being realized fully? A) IFRS, but not U.S. GAAP. B) U.S. GAAP, but not IFRS. C) Neither IFRS nor U.S. GAAP.

Version 1

78) Barber Incorporated, which uses LIFO inventory accounting under U.S. GAAP, sells DVD

recorders. On October 14, it purchased a large number of recorders at a cost of $90 each. Due to an oversupply of recorders remaining in the marketplace due to lower than anticipated demand during the Christmas season, the selling price at December 31 is $80 and the replacement cost is $73. The normal profit margin is 5 percent of the selling price and the selling costs are $2 per recorder. What is the value of the recorders on December 31? A) $78. B) $73. C) $74. 79) Selected information from the financial statements of Salvo Company for the years ended

December 31, 20X3 and 20X4 is as follows (in $ millions):

Sales Cost of Goods Sold Gross Profit Cost of Franchise Other Expenses Net Income Cash Accounts Receivable Inventory Property, Plant & Equipment (net) Total Assets Accounts Payable Long-term Debt Common Stock Retained Earnings Total Liabilities and Equity

20X3

20X4

$ 21 (8) 13 (6) (6) $ 1 $ 4 6 9 12 $ 31 $ 7 10 8 6 $ 31

$ 23 (9) 14 0 (6) $ 8 $ 5 5 7 15 $ 32 $ 5 5 8 14 $ 32

If Salvo had amortized the cost of the franchise acquired in 20X3 over six years instead of expensing it, Salvo’s return on average total equity for 20X4 would have beenclosest to: A) 31.1%. B) 35.6%. C) 38.9%.

Version 1

80) Under U.S. GAAP, a lessee must recognize a balance sheet liability for: A) finance leases, but not operating leases. B) operating leases, but not finance leases. C) both finance leases and operating leases. 81) Cushinson Corporation had a beginning inventory of $9,500 (250 units) and made three

inventory purchases during the fiscal year:

3/1/X6 7/1/X6 9/1/X6

Purchases

Units Total Cost

400 450 550

$ 14,800 $ 14,850 $ 15,950

The company began operations on Jan. 1, 20X6. Costing uses the LIFO method of determining cost of goods sold. First year sales were 1,300 units. Themost likely effects of using LIFO inventory costing as compared to FIFO in Cushinson’s 20X6 financial statements are: A) lower net income; lower working capital. B) higher net income; higher working capital. C) higher net income; lower working capital. 82) A reconciliation of beginning and ending carrying values for each class of property, plant,

and equipment is required for firms reporting under: A) U.S. GAAP. B) both U.S. GAAP and IFRS. C) IFRS. 83) An IFRS-reporting firm reclassifies a building it owns from “owner-occupied” to

“investment property.” The fair value of the building is greater than its carrying value. Under the fair value model for investment property, the firm will recognize a gain: A) in other comprehensive income but not on the income statement. B) only if it reverses a previously recognized loss. C) equal to the difference between fair value and carrying value.

Version 1

84) Alter Incorporated determines that it has $35,000 of accounts receivable outstanding at the

end of 20X8. Based on past experience, it recognizes an allowance for bad debt equal to 10% of its credit sales. The tax base of Alter’s accounts receivable at the end of 20X8 is closest to: A) $35,000. B) $31,500. C) $3,500. 85) A bond is issued at the end of the year 20X0 with an 8% semiannual coupon rate, 5 years to

maturity, and a par value of $1,000. The bond's yield at issuance is 10%. Using the effective interest method, if the yield has decreased to 9% at the end of the year 20X1, the balance sheet liability for the bond is closest to: A) $967. B) $935. C) $923. 86) A company purchases a new pizza oven for $12,675. It will work for 5 years and have no

salvage value. The company will depreciate the oven over 5 years using the straight-line method for financial reporting, and over 3 years for tax reporting. If the tax rate for years 4 and 5 changes from 41% to 31%, the deferred tax liability as of the end of year 3 is closest to: A) $1,040. B) $2,080. C) $1,570. 87) The effect of an inventory writedown on a firm’s return on assets (ROA) is most accurately

described as: A) higher ROA in the current period and lower ROA in later periods. B) lower ROA in the current period and higher ROA in later periods. C) lower ROA in the current period and no effect on ROA in later periods.

Version 1

88) Selected information from Jenner, Incorporated’s financial statements for the year ended

December 31 included the following (in $): Cash Accounts Receivable

$ 200,000 300,000

Inventory Property, Plant & Equipment Total Assets

1,500,000 11,000,000

LIFO Reserve at January 1 LIFO Reserve at December 31 Net Income (after 40% tax rate)

400,000

13,000,000

Accounts Payable Deferred Tax Liability Long-term Debt Common Stock Retained Earnings Total Liabilities & Equity

$ 300,000 600,000 8,100,000 2,200,000 1,800,000 $ 13,000,000

600,000 800,000

Jenner uses the last in, first out (LIFO) inventory cost flow assumption. If Jenner had used first in, first out (FIFO), return on total equity would: A) increase to 21.1%. B) decrease to 18.3%. C) increase to 23.0%.

Version 1

89) Selected financial data from Krandall, Incorporated’s balance sheet for the year ended

December 31 was as follows (in $): Cash Accounts Receivable

$ 1,100,000 300,000

Inventory Property, Plant & Equipment Total Assets

2,400,000 8,000,000

LIFO Reserve at January 1 LIFO Reserve at December 31

11,800,000

Accounts Payable Deferred Tax Liability Long-term Debt Common Stock

$ 400,000 700,000

Retained Earnings Total Liabilities & Equity

1,500,000 11,800,000

8,200,000 1,000,000

600,000 900,000

Krandall uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate is 40%. If Krandall used first in, first out (FIFO) instead of LIFO and paid any additional tax due, its assets-to-equity ratio would beclosest to: A) 3.73 B) 4.06 C) 4.18

Version 1

90) A health care company purchased a new MRI machine on 1/1/X3. At year-end the company

recorded straight-line depreciation expense of $75,000 for book purposes and accelerated depreciation expense of $94,000 for tax purposes. Management estimates warranty expense related to corrective eye surgeries performed in 20X3 to be $250,000. Actual warranty expenses of $100,000 were incurred in 20X3 related to surgeries performed in 20X2. The company’s tax rate for the current year was 35%, but a tax rate of 37% has been enacted into law and will apply in future periods. Assuming these are the only relevant entries for deferred taxes, the company’s recorded changes in deferred tax assets and liabilities on 12/31/X3 are closest to:

A) B) C)

DTA

DTL

$52,500 $55,500 $55,500

$6,650 $6,650 $7,030

A) Option A B) Option B C) Option C 91) U.S. GAAP least likely requires property, plant, and equipment to be tested for impairment: A) when events indicate the firm may not recover the asset’s carrying value. B) when an asset is reclassified as held-for-sale. C) at least annually. 92) Moore Limited uses the LIFO inventory cost flow assumption. Its cost of goods sold in 20X8

was $800. A footnote in its financial statements reads: “Using FIFO, inventories would have been $70 higher in 20X8 and $80 higher in 20X7.” Moore’s COGS if FIFO inventory costing were used in 20X8 is closest to: A) $730. B) $790. C) $810. 93) Using the lower of cost or market principle under U.S. GAAP, if the market value of

inventory falls below its historical cost, the minimum value at which the inventory can be reported in the financial statements is the: A) net realizable value minus selling costs. B) market price minus selling costs minus normal profit margin. C) net realizable value.

Version 1

94) Enduring Corporation operates in a country where net income from sales of goods are taxed

at 40%, net gains from sales of investments are taxed at 20%, and net gains from sales of used equipment are exempt from tax. Installment sale revenues are taxed upon receipt. For the year ended December 31, 2004, Enduring recorded the following before taxes were considered: Net income from the sale of goods was $2,000,000, half was received in 2004 and half will be received in 2005. Net gains from the sale of investments were $4,000,000, of which 25% was received in 2004 and the balance will be received in the 3 following years. Net gains from the sale of equipment were $1,000,000, of which 50% was received in 2004 and 50% in 2005. On its financial statements for the year ended December 31, 2004, Enduring should apply an effective tax rate of: A) 26.67% and increase its deferred tax liability by $1,000,000. B) 22.86% and increase its deferred tax liability by $1,000,000. C) 22.86% and increase its deferred tax asset by $1,000,000. 95) Capitalizing interest costs related to a company’s construction of assets for its own use is

required by: A) U.S. GAAP only. B) IFRS only. C) both IFRS and U.S. GAAP. 96) A U.S. company uses the LIFO method to value its inventory for their income tax return. For

its financial statements prepared for shareholders, the company may: A) use the FIFO method, but must disclose a LIFO reserve. B) only use the LIFO method. C) use any other inventory method under generally accepted accounting principles (GAAP). 97) Novak, Incorporated owns equipment with a historical cost of $20,000, a useful life of 5

years, and an estimated salvage value of $5,000. Using the double declining balance method, depreciation expense in Year 3 for this equipment is: A) $3,000.00 B) $2,200.00 C) $2,880.00

Version 1

98) A company redeems $10,000,000 of bonds that it issued at par value for 101% of par or

$10,100,000. In its statement of cash flows, the company will report this transaction as a: A) $10,100,000 CFO outflow. B) 10,100,000 CFF outflow. C) $10,000,000 CFF outflow and $100,000 CFO outflow. 99) For a lessor that reports under U.S. GAAP, a lease is classified as an operating lease if: A) ownership risks are not substantially transferred to the lessee. B) the fair value of the asset is greater than the sum of the lease payments and the asset’s

expected residual value. C) it cannot be classified as a sales-type lease or a direct financing lease. 100)

A firm has deferred tax assets of $315,000 and deferred tax liabilities of $190,000. If the tax rate increases, adjusting the value of the firm's deferred tax items will: A) have no effect on income tax expense. B) decrease income tax expense. C) increase income tax expense.

101)

For a firm financed with common stock and long-term fixed-rate debt, an analyst should most appropriately adjust which of the following items for a change in market interest rates? A) Cash flow from financing. B) Interest paid. C) Debt-to-equity ratio.

102)

On December 31, 20X3 Okay Company issued 10,000 $1000 face value 10-year, 9% bonds to yield 7%. The bonds pay interest semi-annually. On its financial statements (prepared under U.S. GAAP) for the year ended December 31, 20X4, the effect of this bond on Okay's cash flow from operations is: A) −$755,735. B) −$900,000. C) −$700,000.

103)

A U.S. GAAP firm writes down inventory to net realizable value. In the period of the writedown, what is the most likely effect on cost of goods sold? A) No effect. B) Increase. C) Decrease.

Version 1

104) A company issues an annual-pay bond with the following characteristics: Face value $ 67,831 Maturity Coupon

4 7%

Market interest rates

years

What is the unamortized discount at the end of the first year? A) $1,209. B) $1,750. C) $499. 105)

Deferred tax items should be measured based on the: A) tax rate that will apply when the temporary difference reverses. B) firm’s effective tax rate at the time when the temporary difference reverses. C) statutory tax rate at the time when the temporary difference is recognized.

106)

A company acquires an intangible asset for $100,000 and expects it to have a value of $20,000 at the end of its 5-year useful life. If the company amortizes the asset using the double-declining balance method, amortization expense in year 4 of the asset’s useful life is closest to: A) $8,640. B) $6,910. C) $1,600.

107)

In analyzing disclosures related to the financing liabilities of a company, which of the following disclosures would be least helpful to the analyst? A) The present value of the future bond payments discounted at the coupon rate of the bonds. B) The interest expense for the period as provided on the income statement or in a footnote. C) Filings with the Securities and Exchange Commission (SEC) that disclose all outstanding securities and their features.

Version 1

Dubois Company bought land for company use five years ago for €2 million and presents its balance sheet value as €2.2 million. If the fair value of the land decreases to €1.8 million, Dubois will: A) decrease shareholders’ equity by €400,000 but will not recognize a loss. B) recognize a loss of €400,000 and decrease shareholders’ equity by €200,000. C) recognize a loss of €200,000 and decrease shareholders’ equity by €400,000.

108)

109)

Under IFRS, deferred tax assets and deferred tax liabilities are classified on the balance sheet as: A) either current or noncurrent items. B) noncurrent items. C) current items.

110)

Deferred taxes must be recognized for undistributed earnings from an investment in an associate firm under: A) neither IFRS nor U.S. GAAP. B) U.S. GAAP only. C) both IFRS and U.S. GAAP.

111)

Fred Company has a deferred tax liability of $1,200,000. If Fred’s tax rate increases from 30% to 40%, the impact of this tax rate change will: A) increase Fred’s income tax expense by $400,000. B) decrease Fred’s income tax expense by $120,000. C) increase Fred’s income tax expense by $120,000.

112)

Robbins, Incorporated, reports under IFRS and uses the effective interest rate method for valuing its bond liabilities. Robbins sells a 10-year, $100 million, 5% annual coupon bond issue for $98 million and paid $500,000 in issuance costs. Two years later, the bond liability Robbins will report on its balance sheet for this debt is closest to: A) $98.1 million. B) $98.0 million. C) $97.9 million.

113)

Which of the following is least likely required for a lease to be classified as a direct financing lease by the lessor under U.S. GAAP? A) The lease transfers substantially all the benefits and risks of ownership to the lessee. B) The sum of the lease payments and asset’s residual value is not less than the asset value. C) A third party guarantees the payment of the residual value of the lease to the lessor.

Version 1

114)

Cody Scott would like to screen potential equity investments to identify value stocks and selects firms that have low price-to-sales ratios. Unfortunately, screening stocks based only on this criterion may result in stocks that have poor profitability or high financial leverage, which are undesirable to Scott. Which of the following filters could be added to the stock screen to best control for poor profitability and high financial leverage? Filter #1 – Include only stocks with a debt-to-equity ratio that is above a certain benchmark value. Filter #2 – Include only dividend paying stocks. Filter #3 – Include only stocks with an assets-to-equity ratio that is below a certain benchmark value. Filter #4 – Include only stocks with a positive return-on-equity. Poor profitability

High financial leverage

Filter #2 Filter #4 Filter #4

Filter #3 Filter #3 Filter #1

A) B) C) A) Option A B) Option B C) Option C 115)

Mechanisms that enforce discipline over financial reporting quality least likely include: A) government securities regulators. B) counterparties to private contracts. C) accounting standard-setting bodies.

116)

Portsmouth Industries has stated that in the market for their medical imaging product, their strategy is to grow their market share in the premium segment by leveraging their research and development capabilities to produce machines with greater resolution for the most challenging cases of spinal degeneration. An analyst examining their financials for subsequent periods would most likely conclude that they are successfully pursuing this strategy if she finds: A) increasing research and development expense and decreasing operating margins. B) an increase in revenue and operating margins. C) an increase in gross margins greater than the increase in operating margins.

Version 1

117)

A significant increase in days payables above historical levels is most likely associated with: A) an unsustainable increase in reported earnings. B) an increase in net working capital. C) low quality of the cash flow statement.

118)

Baetica Company reported the following selected financial statement data for the year ended December 31, 20X7: in millions For the year ended December 31, 20X7: Sales Cost of goods sold Selling and administration expenses Depreciation Net income As of December 31, 20X7: Non-cash operating working capitala Cash balance a

% of Sales

$ 500 (300) (125) (50) $ 25

100% 60% 25% 10% 5%

$ 100 $ 35

20% N/A

Non-cash operating working capital = Receivables + Inventory − Payables

Baetica expects that sales will increase 20% in 20X8. In addition, Baetica expects to make fixed capital expenditures of $75 million in 20X8. Ignoring taxes, calculate Baetica’s expected cash balance, as of December 31, 2008, assuming all of the common-size percentages remain constant. A) $80 million. B) $30 million. C) $40 million. 119)

An analyst has decided to identify value stocks for investment by screening for companies with high book-to-market ratios and high dividend yields. A potential drawback of using these screens to find value stocks is that the firms selected may: A) be those that have significantly underperformed the market. B) be concentrated in specific industries. C) have unsustainable dividend payments.

Version 1

120)

National Scooter Company and Continental Chopper Company are motorcycle manufacturing companies. National’s target market includes consumers that are switching to motorcycles because of the high cost of operating automobiles and they compete on price with other manufacturers. The average age of National’s customers is 24 years. Continental manufactures premium motorcycles and aftermarket accessories and competes on the basis of quality and innovative design. Continental is in the third year of a five-year project to develop a customized hybrid motorcycle. Which of the two firms would most likely report higher gross profit margin, and which firm would most likely report higher operating expense stated as a percentage of total cost? Higher gross profit margin A) B) C)

National Continental Continental

Higher percentage operating expense Continental National Continental

A) Option A B) Option B C) Option C 121)

The most likely problem with using financial statement ratios to screen for stocks to include in a portfolio is that: A) specific industries are often over-represented. B) firm characteristics are not identified well by financial statement measures. C) firms with undesirable characteristics will be included.

Version 1

Answer Key Test name: Financial Reporting and Analysis 1) C

International Accounting Standard (IAS) No. 1 defines which financial statements are required and how they must be presented. The required financial statements are: Balance sheet. Statement of comprehensive income. Cash flow statement. Statement of changes in equity. Explanatory notes, including a summary of accounting policies. Disclosures of material events that affect the company are required by the Securities and Exchange Commission (Form 8-K) for firms that are publicly traded in the United States. 2) C

IFRS recommends that management commentary address the company’s key relationships, resources, and risks, as well as the nature of the business, management’s objectives, the company’s past performance, and the performance measures used. Securities regulators may impose requirements for publicly traded firms to address certain topics in management’s commentary, but accounting standards do not. 3) B

Able’s basic earnings per share ((Net Income − Preferred Stock Dividends) / weighted average shares outstanding) for 2004 was [($720,000 − ($500 × 6,000 × 0.03) − ($1,000 × 1,000 × 0.08)] / 1,000,000 =$0.55. If the convertible preferred were converted to common stock on January 1, 6,000 × 40 = 240,000 additional shares would have been issued. Also, dividends on the convertible preferred would not have been paid. So diluted EPS was ($720,000 − 80,000) / (1,000,000 + 240,000) = $0.52. 4) A

1,000,000(12) = 12,000,000 100,000(12) = 1,200,000 400,000(3) = 1,200,000 Total = 14,400,000 / 12 = 1,200,000

Version 1

5) A

As an example, start with CA = 2, CL = 1, and Inv = 1.2. We begin with a current ratio of 2 and a quick ratio of 0.8. If the firm increases short-term bank debt (a current liability) by 1 to buy inventory (a current asset) of 1, both the numerator and denominator increase by 1, resulting in 3 / 2 = 1.5 (new current ratio) and (3 − 2.2) / 2 = 0.4 (new quick ratio). 6) A

7) B

The restructuring charge and asset write-down are non-recurring transactions; thus, net income will be higher in 20X8, all else equal. In 20X8, fixed asset turnover will be the same as 20X7, all else equal. The asset impairment charge is a one-time charge, so fixed assets will not be reduced further in 20X8. 8) A

A current liability is expected to be settled within one year or operating cycle, whichever is greater. It is not necessary to settle a current liability with cash. There are a number of ways to settle a current liability. For example, unearned revenue is a liability that is settled by providing goods or services. 9) B

The purchase of plant and equipment with financing provided by the seller is a non-cash transaction. Non-cash transactions are disclosed separately in a note or supplementary schedule to the cash flow statement. 10) B

First, calculate beginning inventory given COGS, purchases, and ending inventory. Beginning inventory was $35 million [$130 million COGS + $45 million ending inventory – $140 million purchases]. Next, calculate average inventory of $40 million [($35 million beginning inventory + $45 million ending inventory) / 2]. Finally, calculate inventory turnover of 3.25 [$130 million COGS / $40 million average inventory]. 11) B

Version 1

20X7, gross profit is equal to $100 million ($1 × 250 million units sold × 40% gross profit margin). The 10% price cut to $0.90 will increase cost of goods sold to 67% of sales [COGS = 0.6($1) = $0.60; $0.60 / $0.90 = 67%.]. As a result, gross profit will decrease to 33% of sales. If unit sales double in 20X8, gross profit will equal $150 million ($0.90 × 500 million units × 33% gross profit margin). Therefore, gross profit will increase $50 million ($150 million 20X8 gross profit – $100 million 20X7 gross profit). 12) B

Available-for-sale securities are reported on the balance sheet at fair value and any unrealized gains and losses bypass the income statement and are reported as an adjustment to equity. Thus, a decrease in fair value will result in a higher ROA ratio (lower assets). Trading securities are also reported on the balance sheet at fair value; however, the unrealized gains and losses are recognized in the income statement. Therefore, an increase in fair value will result in higher ROA. In this case, both the numerator and denominator are higher; however, since the ratio is less than one, the percentage change of the numerator is greater than the percentage change of the denominator, so the ratio will increase. 13) A

Common-size balance sheets express each balance sheet item as a percentage of total assets. Contributed capital from issuing common shares may be included in common stock (at par value) or additional paid-in capital (for proceeds in excess of par value). Shareholders’ equity is unlikely to consist only of common and preferred stock, as it also includes components such as retained earnings and accumulated other comprehensive income. 14) C

Orange’s basic EPS ((net income − preferred dividends) / weighted average common shares outstanding) is [($7,600,000 − (10,000 × $1,000 × 0.08)] / 2,000,000 = $3.40. To check for dilution, EPS is calculated under the assumption that the convertible preferred shares are converted into common shares at the beginning of the year. The preferred dividends paid are added back to the numerator of the Diluted EPS equation, and the additional common shares are added to the denominator of the equation. Orange’s if-converted EPS is $7,600,000 / (2,000,000 + 200,000) = $3.45. Because if- converted EPS is higher than basic EPS, the preferred stock is antidilutive and no adjustment is made to basic EPS. 15) C

Version 1

Beginning with net sales, calculating cash collected from customers requires the addition (subtraction) of any increase (decrease) in unearned revenue. Cash advances from customers represent unearned revenue and are not included in net sales, so any advances must be added to net sales in order to calculate cash collected. An inventory writedown, as a result of applying the lower of cost or market rule, will reduce ending inventory and increase COGS for the period. However, no cash flow is associated with the writedown, so COGS is reduced by the amount of the writedown in calculating cash paid to suppliers. 16) B

Investing Activities: $10,000 − $180,000 = −$170,000 cash flow from investing or $170,000 used Financing Activities: $38,000 − $75,000 = −$37,000 cash flow from financing or $37,000 used Note that the question asked for net cash used therefore this is a positive cash outflow. 17) C

Dividends received from trading securities and available-for-sale securities are recognized in the income statement. The difference in trading and available-for-sale classifications relates to the treatment of any unrealized gains and losses. 18) B

Version 1

Number of average common shares: 1/1 5,500 shares issued (includes 10% stock dividend on 6/1) × 12 = 66,000 7/1 1,000 shares repurchased × 6 months = −6,000 = 60,000 60,000 shares / 12 months = 5,000 average shares Preferred dividends = ($10) (1,000) = $10,000 Number of shares from the conversion of the preferred shares = (1,000 preferred shares) (8 × 1.1 shares of common/share of preferred) = 8,800 common Diluted EPS = [$15,000(NI) − $10,000(pfd) + $10,000(pfd)] / (5,000 common shares + 8,800 shares from the convertible preferred) = $15,000 / 13,800 shares = $1.09/share This number needs to be compared to basic EPS to see if the preferred shares are antidilutive. Basic EPS = [$15,000(NI) − $10,000(preferred dividends)] / 5,000 shares = $5,000 / 5,000 shares = $1/share Since the EPS after the conversion of the preferred shares is greater than before the conversion the preferred shares are antidilutive and they should not be treated as common in computing diluted EPS. Therefore diluted EPS is the same as basic EPS or $1/share. 19) A

Liabilities are equal to $3,790 million ($240 million unearned revenue + $1,570 long-term debt + $1,150 accounts payable + $830 accrued expenses). Stockholders’ equity is equal to $3,420 million ($30 common stock at par + $440 capital in excess of par − $2,000 treasury stock + $5,160 retained earnings − $210 accumulated other comprehensive loss). 20) B

On a common size income statement, all amounts are stated as a percentage of sales. Interest expense per dollar of sales has declined from 0.15 to 0.06. The other interpretations listed are not necessarily correct. COGS increased as a percentage of sales, but if sales decreased, COGS may have decreased as well. The company's effective tax rate (income tax expense / pretax income) can be calculated from a common-size income statement. Here the effective tax rate was 33% in both years. 21) A

Version 1

Using the indirect method, CFO is net income increased by 20X5 depreciation ($1,000,000) and decreased by the gain recognized on the sale of the plane [$10,000,000 sale price − ($15,000,000 original cost − $10,000,000 accumulated depreciation including 20X5) = $5,000,000]. $12,000,000 + $1,000,000 − $5,000,000 = $8,000,000. 22) C

Operating cash flow is equal to $36.1 million ($43.7 million net income + $4.2 million depreciation expense − $8 million gain on sale − $1.5 million increase in receivables − $2.3 million decrease in payables). Net capital expenditures are equal to $20 million ($35 million equipment purchased − $15 million proceeds from sale). Free cash flow to the firm is equal to $16.1 million ($36.1 million operating cash flow − $20 million net capital expenditures). 23) A

Equipment is reported in the balance sheet at historical cost less accumulated depreciation. 24) B

CFO = sales $3,000,000 − change in accounts receivable ($200,000 − $300,000) − purchases $1,800,000 − other cash operating expenses $400,000 = $900,000. Note that no adjustment for inventories is necessary because purchases are given. From the inventory equation, P = COGS + EI − BI. 25) C

The market value of the firm’s common equity (common stock) is not included on the balance sheet. IFRS allows some PP&E assets to be carried at fair value and some types of inventory to be carried at their market values. 26) C

Comprehensive income includes all transactions that affect shareholders’ equity except transactions with shareholders. Thus, any transaction that affects net income would also affect comprehensive income. Since the inventory write-down is included in net income, it is part of comprehensive income. The acquisition of treasury stock is a transaction with shareholders; thus, it is not a part of comprehensive income. 27) A

Decreases in inventory represent a source of cash so these would be subtracted from cost of goods sold. Any depreciation and/or amortization included in the cost of goods sold does not represent an actual use of cash, so this amount should be subtracted from cost of goods sold. Decreases in accounts payable represent a use of cash so these should be added to cost of goods sold.

Version 1

28) B

Both items are included in comprehensive income. Comprehensive income includes all items that affect owners’ equity except transactions with the company’s owners. Any items that are included in net income are also included in comprehensive income. The gain on sale is reported in net income. The foreign currency translation loss is taken directly to owners’ equity (i.e., not reported in the income statement). 29) A

Cash flow from operations (CFO) using the indirect method is computed by taking net income plus non- cash expenses (i.e. depreciation) less gains from the equipment sale. Note that cash flow from operations must be adjusted downward for the amount of the gain on the sale of the equipment. Cash flow from operations is ($850,000 + $200,000 – ($100,000 – $50,000)) = $1,000,000. The other information relates to financing cash flows. 30) C

The current ratio is equal to 2.4 [(4.8% cash + 14.9% accounts receivable + 49.4% inventory) / (15.0% accounts payable + 13.8% accrued liabilities)]. This ratio can be calculated from the common size balance sheet because the percentages are all on the same base amount (total). Return on equity is equal to net income divided by average total equity. Since this ratio mixes an income statement item and a balance sheet item, it is necessary to convert the common-size inputs to dollars. Net income is $11,211,200 ($215,600,000 × 5.2%) and average equity is $41,772,000 [($95,300,000 × 48.0%) + $37,800,000] / 2. Thus, 2007 ROE is 26.8% ($11,211,200 net income / $41,772,000 average equity). 31) A

Version 1

Only the options and convertible preferred stock are dilutive. First, calculate basic EPS to use as a benchmark to determine dilutive capital components. Basic EPS = (net income − preferred dividends) / weighted average common shares outstanding = (9.0 − 1.5) / 5.0 = $1.50. Next, check for dilution. The stock options are dilutive because the exercise price is less than the average stock price. There is no numerator impact from the options. The denominator impact = # options − [(# options × exercise price) / average stock price)] = 400,000 − [(400,000 × 32) / 35] = 34,286 or 0.034 million. To check whether the convertible preferred stock is dilutive we need to determine whether it decreases EPS. To the numerator, we add back the preferred dividend. The denominator impact = (# preferred shares × conversion rate) = 500,000 × 5 = 2,500,000, or 2.5 million. Then, EPS = (9.0 − 1.5 + 1.5) / (5.0 + 2.5) = $1.20. Thus the convertible preferred stock is dilutive. To check whether the convertible bonds are dilutive we need to determine whether they decrease EPS. To the numerator, we add back the after-tax impact of the coupon, or (face value × coupon × (1 − t)), or (10,000 bonds × 1,000 par × 0.06 coupon × 0.6 ) = 360,000, or $0.360 million. The denominator impact = (# convertible bonds × conversion rate) = 10,000 × 8 = 80,000, or 0.080 million. Then, EPS = (9.0 − 1.5 + 0.360) / (5.0 + 0.080) = $1.55. Thus the bonds are antidilutive. Finally, calculate diluted EPS: Diluted EPS = (9.0 − 1.5 + 1.5) / (5.0 + 2.5 + 0.034) = $1.1946. 32) C

CFO is the same under both methods, the only difference is presentation. Direct method: $92,500 cash collections ($100,000 revenue − $7,500 increase in receivables) − $38,500 cash paid to suppliers (− $40,000 COGS + $2,500 decrease in inventory − $1,000 decrease in payables) − $20,000 cash operating expenses − $3,000 tax expense = $31,000. Indirect method: $32,000 net income + $5,000 depreciation expense − $7,500 increase in receivables + $2,500 decrease in inventory − $1,000 decrease in payables = $31,000. The increase in short-term notes payable is a financing activity. 33) C

Version 1

Dividends declared are net income less the increase in retained earnings ($800,000 − $300,000 = $500,000). Dividends declared less the increase in dividends payable is dividends paid ($500,000 − ($300,000 − $200,000) = $400,000). This is a cash outflow so it is a negative number. Dividends paid are always cash flow from financing under U.S. GAAP. Note that accounts payable changes are included in cash flow from operations (CFO). 34) B

Net income is ($6,000 − 3,200 − 800)(1 − 0.4) = $1,200. Adjustments to reconcile net income to cash flow from operating activities will require that depreciation ($800) be added back, and increase in accounts receivable ($1,000) be subtracted: $1,200 + 800 − 1,000 = $1,000. 35) B

The recognition of bad debt expense has no effect on liabilities, current revenues are reduced by the expected amount of uncollectable accounts. Bad debt expense reduces net income and reduces assets. The recognition of expected warranty expense decreases net income (following the matching principle), and since it is not currently paid (doesn’t reduce assets) it creates or increases a liability at the time of sale. 36) C

The interest expense for three months net of tax is added to the numerator (12% × $100,000 × 3/12 × 60 %) = $1,800. The number of shares added to the denominator are 4,500. (18,000 × 3 / 12). 37) B

Given the gain of $100,000 and book value of the machinery sold of $260,000 ($500,000 original cost −$240,000 accumulated depreciation), the proceeds from the sale of the machinery were $360,000 ($100,000 gain + $260,000 book value). For 20X7, CFI was an outflow of $40,000 ($360,000 sale proceeds − $400,000 machinery purchase). The $600,000 financed by the seller is a non-cash transaction and is reported in the notes to the cash flow statement. 38) B

Restructuring and plant shutdown costs are considered part of a company’s normal operations. Gains and losses related to discontinued operations are reported separately in the income statement because these activities are no longer included as part of the company’s continuing operations. 39) B

Version 1

Since Red Oak is a nonfinancial firm, the accrued interest is considered a nonoperating activity, related to how the firm is financed. Dividends paid to preferred shareholders do not affect net income. 40) A

Feder’s basic earnings per share ((net income − preferred dividends) / weighted average shares outstanding) was (($7,650,000 − ($1,000 × 10,000 × 0.06)) / 1,100,000 =) $6.41. If the convertible preferred stock was converted to common stock at January 1, (10,000 × 20 =) 200,000 additional common shares would have been issued, dividends on the preferred stock would not have been paid, and Diluted EPS would have been ($7,650,000 / (1,100,000 + 200,000) = $5.88. Because $5.88 is less than basic EPS of $6.41, the preferred shares are dilutive. Using the treasury stock method, if the options were exercised cash inflow would be (70,000 × 10 × $50 =) $35,000,000. The number of Feder shares that can be purchased with the inflow (cash inflow divided by the average share price) is ($35,000,000 / $62 =) 564,516. The number of shares that would have been created is (700,000 − 564,516 =) 135,484. Diluted EPS was [($7,650,000 − ($1,000 × 10,000 × 0.06)] / (1,100,000 + 135,484) =) $5.71. Because this is less than the EPS of $6.41, the options are dilutive. Combining the calculations, Diluted EPS was (($7,650,000) / (1,100,000 + 200,000 + 135,484) = $5.32. (Study Session 7, Module 21.4, LOS 21.h) 41) B

A cash flow statement can be presented in common-size format by expressing each line item as a percentage of total revenue or by expressing each inflow of cash as a percentage of total cash inflows and each outflow as a percentage of total cash outflows. Expressing each line item of the cash flow statement as a percentage of revenue is useful in forecasting future cash flows since revenue usually drives the forecast. 42) A

Although manipulation of cash flow can occur, the P/E ratio is easier to manipulate because earnings are based on the numerous estimates and judgments of accrual accounting. EPS does not facilitate direct comparisons of profitability. Two firms may have the same amount of earnings but their number of shares outstanding may differ significantly. 43) C

Version 1

There are two formats for a common-size cash flow statement, expressing each type of outflow as a percentage of total cash outflows or as a percentage of total revenue for the period. Operating cash flow for the period mixes inflows and outflows and is not used to calculate percentage flows for payment made. 44) C

Interest received from customers and interest received from investments are a part of normal operations of a financial institution. Thus, the First National Bank will report the interest income from both sources as components of operating income. 45) C

Average stock price is not a factor in determining whether convertible bonds are dilutive or antidilutive. If Young redeemed the bonds, they would have no potentially dilutive securities outstanding in 20X5 and diluted EPS, if the company reported it, would equal basic EPS. Basic and diluted EPS would also be equal in 20X5 if the bonds were antidilutive in that year. 46) C

Leverage increased as measured by the debt-to-equity ratio from 2.25 in 2005 to 3.68 in 2007. Gross profit margin declined from 20.0% in 2005 to 18.5% in 2007. Return on equity has improved since 2005. One measure of ROE is ROA × financial leverage. Financial leverage (assets / equity) can be derived by adding 1 to the debt-to-equity ratio. In 2005, ROE was 23.4% [7.2% ROA × (1 + 2.25 debt- to-equity)]. In 2007, ROE was 27.6% [5.9% ROA × (1 + 3.68 debt-to-equity)]. 47) B

CCC = collection period + Inv Period − Payment period. Payment period = (365 / payables turnover) = (365 / 11) = 33; (365 / 12) = 30. This means the CCC actually increased to 83. 48) A

Version 1

To compute Hampshire’s basic EPS ((net income − preferred dividends) / weighted average common shares outstanding), the weighted average common shares must be computed. 100,000 shares were outstanding from January 1, and 30,000 shares were issued on September 1, so the weighted average is 100,000 + (30,000 × 4 / 12) = 110,000. Basic EPS is ($2,800,000 − (10,000 × $1,000 × 0.06)) / 110,000 = $20.00. If the warrants were exercised, cash inflow would be 10,000 × $150 × 10 = $15,000,000 for 10 × 10,000 = 100,000 shares. Using the treasury stock method, the number of Hampshire shares that can be purchased with the cash inflow (cash inflow / average share price) is $15,000,000 / $250 = 60,000. The number of shares that would be created is 100,000 − 60,000 = 40,000. Diluted EPS is $2,200,000 / (110,000 + 40,000) = $14.67. 49) A

To compute Gerrard’s basic earnings per share (EPS) ((net income − preferred dividends) / weighted average common shares outstanding), the weighted average common shares outstanding must be computed. 700,000 shares were outstanding from January 1, and 200,000 shares were issued on March 1, so the weighted average is 700,000 + (200,000 × 10 / 12) = 866,667. Basic EPS was $330,000 − (2,000 × $500 × 0.08)) / 866,667 = $0.289. If the convertible preferred shares were converted to common stock, 2,000 × 200 = 400,000 additional common shares would have been issued and dividends on the preferred stock would not have been paid. Diluted EPS was $330,000 / (866,667 + 400,000) = $0.261. 50) C

A firm with any potentially dilutive securities outstanding must report both basic and diluted EPS, even if the two are equal. If convertible preferred stock is dilutive to earnings per share, the preferred dividend is added back to the numerator as if the preferred has been converted to common shares. If diluted EPS is less than basic EPS then the convertible preferred is said to be dilutive. 51) B

Unrealized foreign currency translation gains and losses are not reported in the income statement; thus, retained earnings are unaffected. However, unrealized foreign currency gains and losses are included in comprehensive income. Comprehensive income includes all changes in equity except those that result from transactions with shareholders. So, the translation gain increases stockholders’ equity by increasing comprehensive income. 52) A

Version 1

During the first year, the revenue was 700,000 / 1,300,000 × 2,000,000 = 1,076,923 The total revenue for both years = $2,000,000 The second year revenue was 2,000,000 − 1,076,923 = $923,077 The second year income = revenues − costs = 923,077 − 1,000,000 = $−76,923 53) A

The format of the question information suggests the use of the direct cash flow method. In this method, depreciation is not a component of cash flow from operations. Cash flow from operations = (all numbers in thousands of dollars) 45 − 17 − 22 − 6.3 − 1.0 = −1.3, or −$1,300. 54) C

Inventory costs are expensed when items are sold under the matching principle. As an extreme example, if no sales are made, no costs of inventory production are expensed for the period. Period costs are expensed during the period. Under the accrual method, interest accrued during the period is expensed, regardless of whether it has been paid during the period. 55) C

Using the indirect method, CFO = Net income 25 + increase in accounts payable 20 + increase in deferred taxes 5 − profit on sale of equipment 15 = $35. Increases in accounts payable and deferred taxes are sources of operating cash that are not included in net income and must be added. Profit on sale of equipment is a CFI item that must be removed from net income. No adjustment needs to be made for cash payment of dividends (CFF), sale of preferred stock (CFF), or purchase of land (CFI) because they are not included in net income. Only the profit on sale of equipment, not the full proceeds from sale, is included in net income. 56) B

Under U.S. GAAP, interest received is reported as an operating cash flow. For a non-financial services company, interest received is typically reported as non-operating income. 57) C

Version 1

58) A

The trading securities classification includes the unrealized gain from the bond in net income, which increases retained earnings. Unrealized gains on available-for-sale securities are reported as other comprehensive income for the period and are recorded in accumulated other comprehensive income, a component of owner's equity. Unrealized gains on held-to-maturity securities are not reported on the financial statements. 59) C

The analyst believes an expenditure the firm classified as an investing cash outflow should have been classified as an operating cash outflow. Thus, the analyst should adjust CFO downward and CFI upward. 60) B

Common-size cash flow statements show each cash flow item as a percentage of revenue or show each cash flow outflow as a percentage of all cash outflows and each cash inflow as a percentage of all cash inflows. 61) C

Unrealized gains and losses from trading securities are reflected in the income statement and affect owners' equity. However, unrealized gains and losses from available-for-sale securities are included in other comprehensive income. Transactions included in other comprehensive income affect equity but not net income. Dividends paid to shareholders reduce owners' equity but not net income. 62) B

For long-lived assets classified as investment property, IFRS allows either the cost model or the fair value model. The revaluation model is permitted for long-lived assets that are not classified as investment property. U.S. GAAP only permits the cost model for valuation of long-lived assets and does not identify investment property as a specific subset of long-lived assets. 63) C

If Train decided to amortize the cost, the franchise would be capitalized as a balance sheet asset and the cash outflow would have been classified as CFI. As a result CFO would have been $8 million higher, or $14 million + $8 million = $22 million. Amortization would be a non-cash expense. 64) C

Version 1

According to IFRS, property held for the purpose of earning rental income is classified as investment property. However, when a property is transferred from owner-occupied to investment property, a firm using the fair value model must treat any increase in the property's value as a revaluation. That is, the firm may only recognize a gain on the income statement to the extent that it reverses a previously recognized loss. 65) B

Under the fair value model, all gains and losses from changes in the value of investment property are recognized on the income statement. The firm will recognize a loss of €150,000 in Year 1 and a gain of €200,000 in Year 2. 66) A

Undistributed profits from a subsidiary do not require the creation of a deferred tax liability under U.S. GAAP if the subsidiary meets the indefinite reversal criterion. For IFRS, there are circumstances where a DTL is not created but the test for this treatment is not called or equivalent to the indefinite reversal criterion detailed in U.S. GAAP. 67) C

Assuming normal capacity levels, allocation of fixed production overhead is a product cost that is capitalized as part of inventory. Thus, this cost will not be recognized as an expense until the inventory is sold (it becomes part of COGS for that period). Administrative overhead and selling costs are period costs that must be expensed in the period incurred. 68) C

The $200,000 difference between the tax base and the carrying value of the equipment gives rise to a deductible temporary difference that leads to a deferred tax asset (DTA) of $80,000 ($200,000 × 40%). The tax loss carryforward of $300,000 also leads to a DTA but for $120,000 ($300,000 × 40%). The decrease in the tax rate from 40% to 35% will reduce the DTA of the equipment by $10,000 ($200,000 × 5%). It will reduce the DTA of the tax loss carryforward by $15,000 ($300,000 × 5%). In total, the DTA will decrease by $25,000. The decrease in the value of the DTA will increase income tax expense by $25,000 in the period when the DTA is decreased. 69) B

Under IFRS, a tax rate that has been enacted or substantively enacted is used to measure deferred tax items. Under U.S. GAAP, only a tax rate that has actually been enacted can be used. 70) B

Version 1

Based on a semiannual interest rate of 6.65% (13.30% / 2): Period

Coupon Payment

Interest Expense 0.00

1 2 3 4

53.20 55.08 57.08 59.21

25.00 25.00 25.00 25.00

Discount Amortization

28.20 30.08 32.08 34.21

Bond Carrying Value $ 800.00 828.20 858.28 890.36 $ 924.57

Interest expense for Year 2 is $57.08 + $59.21 = $116.29. 71) C

When exchanging one long-lived asset for another, a gain or loss is recorded as the difference between the old asset's carrying value and its fair value (or the fair value of the asset received in exchange, if that value is more evident). When selling an asset, the gain or loss is the difference between the carrying value and the cash received. When abandoning an asset, a firm records a loss equal to the carrying value of the asset. 72) C

Neither metric is directly relevant in evaluating the stability of a firm's inventory levels. Determining stability would presumably require other information such as purchase and sales levels, for example. The inventory turnover ratio and the number of days in inventory can be used to evaluate the relative age of a firm's inventory as well as the effectiveness of a firm's inventory management. 73) C

Deferred tax items are classified as noncurrent. 74) A

Estimated amortization expense for the next five years is required by U.S. GAAP but is not required by IFRS. 75) C

Permanent tax differences such as tax credits, non-deductible expenses, and tax differences between capital gains and operating income give rise to differences in the effective and statutory tax rates. 76) A

Version 1

As bond premium is amortized, interest expense will be successively lower each period, thus increasing earnings over the life of the bond. 77) B

Under U.S. GAAP, the full amount of a DTA is shown on the balance sheet, with a contra account (valuation allowance) if it is likely that the full amount of the DTA will not be realized in the future. Under IFRS, the reported value of a DTA is reduced if there is a positive probability that the full amount of the DTA will not be realized in the future. 78) C

Under U.S. GAAP, a LIFO firm values inventory at the lower of cost or market. Market is equal to the replacement cost subject to replacement cost being within a specific range. The upper bound is net realizable value (NRV), which is equal to selling price ($80) less selling costs ($2) for an NRV of $78. The lower bound is NRV ($78) less normal profit (5% of selling price = $4) for a net amount of $74. Since replacement cost ($73) is less than NRV minus normal profit ($74), then market equals NRV minus normal profit ($74). As well, we have to use the lower of cost ($90) or market ($74) principle so the recorders should be recorded at the lower amount of $74. 79) A

If the franchise cost had been amortized over six years beginning in 20X3, net income in 20X3 would have been $6 million instead of $1 million due to the cost of franchise expense of $6 million being eliminated and replaced by franchise amortization of $1 million. Net income in 20X4 would have been reduced by the franchise amortization to $7 million instead of $8 million. On the equity side, retained earnings at the end of 20X3 would have been $11 million ($5 million higher), and total equity for 20X3 would have been $8 + $11 = $19 million. Retained earnings for 20X4 would be the 20X3 retained earnings of $11 million increased by 20X4 net income of $7 million for a total of $18 million, and total equity for 20X4 would be $8 + $18 = $26 million. If the franchise cost were amortized, return on total equity for 20X4 would be $7 / ((19 + 26) / 2) = 31.1%. 80) C

U.S. GAAP requires the lessee to recognize a balance sheet liability for both finance leases and operating leases. 81) B

Version 1

The first step is to determine the direction of prices: Purchase Begin inventory 3/1/X6 Purchase 7/1/X6 9/1/X6

Total Cost $ 9,500 14,800 Total Cost 14,850 15,950

Units ÷ 250 ÷ 400 Units ÷ 450 ÷ 550

Per-unit Cost = $ 38 = $ 37 Per-unit Cost = $ 33 = $ 29

Notice that per-unit prices are falling. Under falling prices, LIFO inventory costing will result in higher net income because the recent units were cheaper than the older purchases (and beginning inventory), making the cost of goods sold lower and net income higher. Working capital will be higher because LIFO inventory is greater than FIFO inventory when prices are falling. 82) C

The required disclosures for long-lived assets under IFRS are more extensive than they are under U.S. GAAP. IFRS requires a reconciliation of beginning and ending carrying values for classes of PP&E, while U.S. GAAP does not. 83) B

When reclassifying a property from owner-occupied to investment property and using the fair value model for valuation of investment property, IFRS specifies that the firm should treat the event as a revaluation, recognizing a gain only if it reverses a previously recognized loss. 84) A

For tax purposes, bad debt expense cannot be deducted until the receivables are deemed worthless. Therefore, the tax base is $35,000 since no bad debt expense has been deducted on the tax return. Note that the carrying value would be $31,500 since bad debt expense is reflected on the income statement. 85) B

Using the effective interest method, the value of the liability is calculated using the bond’s yield at issuance. At the end of 20x1 the bond will have 8 semiannual periods remaining until maturity. N = 8; I/Y = 10 / 2 = 5; PMT = 8 / 2 × 1,000 = 40; FV = 1,000; CPT PV = −935.37. 86) C

Version 1

At the end of year 3, the oven has a tax base of zero (it has been fully depreciated for tax reporting) and a carrying value on the balance sheet of $12,675 − 3(0.2)($12,675) = $5,070. The deferred tax liability, valued at the 31% tax rate that will apply when the temporary difference reverses, is ($5,070 − $0)(0.31) = $1,571.70. 87) B

Writing down inventory to net realizable value decreases both net income and total assets in the period of the writedown. Because net income is most likely less than assets, the result in the period is a decrease in ROA. In later periods, lower-valued inventory will decrease COGS and increase net income. Combined with a lower value of total assets, this will increase ROA. 88) A

Return on total equity (net income / total equity) was $800,000 / ($2,200,000 + $1,800,000) = 20%. Under FIFO, net income increases by the increase in the LIFO reserve multiplied by (1 − tax rate). FIFO net income was $800,000 + ($600,000 − $400,000) (1 − 0.40) = $920,000. Total equity increases by the amount of accumulated FIFO profits that are added to retained earnings, which is calculated by multiplying the amount of the ending LIFO reserve by (1 − tax rate) for an increase of ($600,000) × (1 − 0.40) = $360,000. Total equity is $2,200,000 + $1,800,000 + $360,000 = $4,360,000. FIFO return on total equity is $920,000 / $4,360,000 = 21.1%. 89) B

With FIFO instead of LIFO: Inventory would be higher by $900,000, the amount of the ending LIFO reserve. Cumulative pretax income would also be higher by $900,000, so taxes paid would be higher by 0.40($900,000) = $360,000. Therefore cash would be lower by $360,000. Cumulative retained earnings would be higher by (1 − 0.40)($900,000) = $540,000. So assets under FIFO would be $11,800,000 + $900,000 − $360,000 = $12,340,000 and equity would be $1,000,000 + $1,500,000 + $540,000 = $3,040,000. The assets-to-equity ratio would be $12,340,000 / $3,040,000 = 4.06. 90) C

DTL = (tax depreciation − financial statement depreciation) × future tax rate = ($94,000 − $75,000) × 37% = $7,030. DTA = (estimated warranty expense − actual warranty expense) × future tax rate = ($250,000 − $100,000) × 37% = $55,500. 91) C

Version 1

Under U.S. GAAP, a PP&E asset is tested for impairment when events and circumstances indicate the firm may not recover its carrying value through future use, or if the asset is reclassified from held-for- use to held-for-sale. Under IFRS, firms are also required to assess at least annually whether events and circumstances indicate impairment may have occurred. 92) C

The ending LIFO reserve is $70 and the beginning LIFO reserve is $80. FIFO COGS = LIFO COGS − (ending LIFO reserve − beginning LIFO reserve) $800 − ($70 − $80) = $810 93) B

When inventory is written down to market, the replacement cost of the inventory is its market value, but the “market value” must fall between net realizable value (NRV) and NRV less normal profit margin. NRV is the market price of the inventory less selling costs. Therefore the minimum value is the market price minus selling costs minus normal profit margin. 94) B

Total taxes eventually due on 2004 activities were (($2,000,000 × 0.40) + ($4,000,000 × 0.20) =) $1,600,000. Permanent differences are adjusted in the effective tax rate, which is ($1,600,000 / $7,000,000 =) 22.86%. Of the $1,600,000 taxes due, (($2,000,000 × 0.50 × 0.40) + ($4,000,000 × 0.25 × 0.20) =) $600,000 were paid in 2004 and $1,000,000 ($1,600,000 − $600,000) is added to deferred tax liability. 95) C

Both U.S. GAAP and IFRS require companies to capitalize the interest that accrues during the construction of capital assets for their own use. 96) B

The LIFO conformity rule in the U.S. requires firms to use LIFO for their financial statements if they use LIFO for income tax purposes. 97) B

Version 1

DDB depreciation in each year is 2/5 of the carrying value at the beginning of the year, until the carrying value reaches the estimated salvage value. Year 1 DDB depreciation = $20,000 × 2/5 = $8,000 Carrying value = $20,000 − $8,000 = $12,000 Year 2 DDB depreciation = $12,000 × 2/5 = $4,800 Carrying value = $12,000 − $4,800 = $7,200 Year 3 DDB depreciation = $7,200 × 2/5 = $2,880 Because $7,200 − $2,880 = $4,320 would depreciate the equipment below its salvage value, depreciation in Year 3 is limited to $7,200 − $5,000 = $2,200. 98) B

Cash paid to redeem a bond is classified as a cash flow from financing activities. 99) C

Under U.S. GAAP accounting standards for lessors, a lease is classified as an operating lease if it cannot be classified as either a sales-type lease or a direct financing lease. If ownership risks are substantially transferred to the lessee and collection of the payments is reasonably assured, the lessor classifies the lease as a sales-type lease. If ownership risks are not substantially transferred, but a third party guarantees the residual value of the asset and the sum of the lease payments and the residual value is at least equal to the fair value of the asset, the lessor classifies the lease as a direct financing lease. 100)

B An increase in the tax rate increases the values of both DTAs and DTLs. Because the firm's DTAs are greater than its DTLs, the net effect of adjusting their values for an increase in the tax rate will be to decrease income tax expense. 101)

C For the purpose of analysis, the value of debt should be adjusted for a change in interest rates. This will change the debt-to-equity ratio. 102)

B The coupon payment is a cash outflow from operations. ($10,000,000 × 0.09) = $900,000. 103)

Version 1

A write-down of inventory to net realizable value is typically recognized under U.S. GAAP as an increase in cost of goods sold in the period of the write-down. Consider the inventory equation: ending inventory = beginning inventory + purchases − cost of goods sold A write-down to NRV decreases ending inventory, with no effect on beginning inventory or purchases. For the inventory equation to hold, cost of goods sold must increase. 104)

B Face value of bonds = $67,831 Proceeds from bond sale: I/Y = 8; N = 4; PMT = $67,831 × 0.07 = $4,748.17; FV = $67,831; CPT PV = $65,582 Unamortized discount at issuance = $67,831 − $65,582 = $2,249. First year interest expense = $65,582 × 0.08 $5,247 Coupon payment = $67,831 × 0.07 = $4,748 Change in discount = $5,247 − $4,748 = $499 Unamortized discount at end of first year = $2,249 − $499 = $1,750. 105)

A Measurement of deferred tax items is based on the tax rate that will apply when the temporary difference reverses. In some cases this may depend on how a temporary difference is settled, which determines whether a capital gains tax rate or income tax rate will apply. 106)

C Net book value at the end of year 3 is $100,000 × 3/5 × 3/5 × 3/5 = $21,600. DDB amortization in year 4 of 2/5 × $21,600 = $8,640 would amortize the asset below its salvage value, so amortization expense is the remaining $1,600 that will amortize net book value to $20,000. 107)

A When analyzing disclosures related to financing liabilities, analysts would review the balance sheet and find the present value of the promised future liability payments. These payments would then be discounted at the rate in effect at issuance (i.e., the yield to maturity), not the coupon rate of the bonds. 108)

Version 1

Because the land is valued above its historical cost on the balance sheet, Dubois is using the revaluation model. The land’s revaluation up to €2.2 million would have been reflected in shareholders’ equity with a revaluation surplus of €200,000. The decrease in fair value to €1.8 million will reduce the revaluation surplus to zero, and the amount of the writedown below historical cost (€2 million − €1.8 million = €200,000) will be recognized as a loss on Dubois’s income statement. This loss, combined with the removal of the revaluation surplus, will decrease shareholders’ equity by €400,000. Note that the land was purchased for company use and therefore would not be classified as investment property. 109)

B Under IFRS, deferred tax assets and liabilities are classified as noncurrent. Under U.S. GAAP, deferred tax items may be current or noncurrent, depending on how the underlying asset or liability is classified. 110)

B Deferred taxes must be recognized for undistributed earnings from an investment in an associate firm under U.S. GAAP. Under IFRS, no deferred taxes are reported for undistributed earnings if the investor firm controls the sharing of profits and it is probable the temporary difference will not be reversed in the future. 111)

A The change in Fred’s rates causes its deferred tax liability to increase [(40 − 30) / 30] × $1,200,000 = $400,000. This is reported on the income statement as an increase in current income tax expense. 112)

C Under IFRS, bond liabilities are reported under the effective interest method and issuance costs are deducted from the proceeds to determine the initial liability. The yield at issuance is: PV = 97.5 million; FV = −100 million; PMT = −5 million; N = 10; CPT I/Y = 5.33. Change N to 8 and CPT PV after two years as 97.9 million. 113)

A A direct finance lease under U.S. GAAP is a lessor classification for leases that do not meet the transfer of ownership criteria. The other two conditions must be met. If a lease transfers substantially all the benefits and risks of ownership to the lessee, the lessor classifies it as a salestype lease. 114)

Version 1

Firms that have poor profitability are more likely to be non-dividend paying. Selecting only dividend paying stocks can serve as a check on poor profitability. Using positive ROE to control for poor performance can result in bogus results without additional filters. For example, if both the numerator (net income) and the denominator (average equity) are negative, ROE will be positive. The higher the assets-to-equity ratio, the higher the leverage. Selecting only stocks with an assets-to-equity ratio below a certain cut-off point will eliminate stocks with high leverage. Debt-to-equity above a certain point would include firms with higher, not lower, financial leverage. 115)

C Accounting standard-setting bodies issue financial reporting standards but do not enforce compliance with them. Securities regulators and counterparties to private contracts are among the mechanisms that discipline financial reporting quality. 116)

C A shift to premium, rather than commodity-like, products should result in higher gross margins, higher average revenue per unit (selling price per unit), and an increase in gross margins relative to operating margins (because of the increase in R&D and marketing expenditures). A successful shift to a premium product should increase operating margins rather than increase operating income through increased unit sales. Revenue would not necessarily increase as the company shifted to premium products. 117)

C A significant increase in days payables may indicate that payables have been "stretched" (not paid or paid more slowly), which increases operating cash flow in an unsustainable manner and calls the quality of the reported cash flow values into question. Stretching payables does not affect earnings because the related expenses were recognized in the period incurred. An increase in days payables will decrease net working capital, other things equal. 118)

B 2008 sales are expected to be $600 million ($500 million 2007 sales × 1.2) and 20X8 net income is expected to be $30 million ($600 million 20X8 sales × 5%). 2008 non-cash operating working capital is expected to be $120 million ($600 million 20X8 sales × 20%). The change in cash is expected to be −$5 million ($30 million 20X8 net income + $60 million 20X8 depreciation − $20 million increase in non- cash operating working capital − $75 million 20X8 capital expenditures). The 20X8 ending balance of cash is expected to be $30 million ($35 million beginning cash balance − $5 million decrease in cash). 119)

Version 1

A screen for firms with high dividend yields and high book-to-market ratios would likely result in an inordinate proportion of financial services companies and add a significant element of industry (sector) risk. Uncertainty about sustainability of dividend payments and recent market underperformance are typical characteristics of value stocks in general and not a drawback to using this screen to identify them. 120)

C Continental likely has the highest gross profit margin percentage since it is selling a customized product and does not compete primarily based on price. Because of the research and development costs of developing a new hybrid motorcycle, Continental likely has the higher operating expense stated as a percentage of total cost. 121)

A It is often the case a screening metric, such as low P/E, high dividend yield, or high ROE, will identify many stocks in the same industry. Undesirable characteristics can be avoided by including additional screening metrics. Financial statement measures provide a great amount of information about a firm’s characteristics.

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) A 4 percent Treasury bond has 2.5 years to maturity. Spot rates are as follows: 6 month 2%

1 year 2.5%

1.5 years 3%

2 years 4%

2.5 years 6%

The note is currently selling for $976. Determine the arbitrage profit, if any, that is possible. A) $37.63. B) $43.22. C) $19.22. 2) An investor holds $100,000 (par value) worth of TIPS currently trading at par. The coupon

rate of 4% is paid semiannually, and the annual inflation rate is 2.5%. What coupon payment will the investor receive at the end of the first six months? A) $2,000. B) $2,025. C) $2,050. 3) Venenata Foods has a 10-year bond outstanding with an annual coupon of 6.5%. If the bond

is currently priced at $1,089.25, which of the following is closest to the semiannual-bond basis yield? A) 5.42%. B) 5.33%. C) 5.26%. 4) A yield curve for coupon bonds is composed of yields on bonds with similar: A) coupon rates. B) issuers. C) maturities. 5) In a commercial mortgage-backed security (CMBS), which of the following is an example of

CMBS- level call protection? A) Yield maintenance charges. B) Prepayment lockout. C) Residual tranche.

Version 1

6) Which of the following statements about floating-rate notes is most accurate? A) Inverse floating-rate notes are attractive to investors who expect interest rates to rise,

while floating-rate notes are attractive to investors who expect interest rates to fall. B) The coupon payment on a floating-rate note at each reset date is typically based on LIBOR as of that date. C) Floating-rate notes have built-in floors, while inverse floating-rate notes have built-in caps. 7) The interest rate on excess reserves borrowed by one bank from another bank is most

accurately described as a(n): A) reserve swap rate. B) interbank lending rate. C) central bank funds rate. 8) The reference rate for a floating-rate note should least likely match the note’s: A) reset frequency. B) maturity. C) currency. 9) A covenant that requires the issuer not to let the insurance coverage lapse on assets pledged

as collateral is an example of a(n): A) negative covenant. B) affirmative covenant. C) inhibiting covenant. 10) Which of the following statements about U.S. Treasury Inflation Protection Securities (TIPS)

is most accurate? A) The inflation-adjusted principal value cannot be less than par. B) Adjustments to principal values are made annually. C) The coupon rate is fixed for the life of the issue. 11) A bond’s indenture least likely specifies the: A) source of funds for repayment. B) covenants that apply to the issuer. C) identity of the lender.

Version 1

12) Allcans, an aluminum producer, needs to issue some debt to finance expansion plans, but

wants to hedge its bond interest payments against fluctuations in aluminum prices. Jerrod Price, the company’s investment banker, suggests a commodity index floater. This type of bond is least likely to provide which of the following advantages? A) Payment structure helps protect Allcan's credit rating. B) The bond's coupon rate is linked to the price of aluminum. C) Allows Allcans to set coupon payments based on business results. 13) Suppose that the six-month spot rate is equal to 7% and the two-year spot rate is 6%. The

one-and a half-year forward rate starting six months from now has to: A) be more than 6%. B) be less than 6%. C) lie between 6% and 7%. 14) A $1,000 par, semiannual-pay bond is trading for 89.14, has a coupon rate of 8.75%, and

accrued interest of $43.72. The flat price of the bond is: A) $935.12. B) $891.40. C) $847.69. 15) A five-year bond with a 7.75% semiannual coupon currently trades at 101.245% of a par

value of $1,000. Which of the following is closest to the current yield on the bond? A) 7.75%. B) 7.65%. C) 7.53%. 16) A waterfall structure is least likely describe: A) credit card ABS. B) auto loan ABS. C) agency RMBS. 17) Bond X is a noncallable corporate bond maturing in ten years. Bond Y is also a corporate

bond maturing in ten years, but Bond Y is callable at any time beginning three years from now. Both bonds carry a credit rating of AA. Based on this information: A) The zero-volatility spread of Bond X will be greater than its option-adjusted spread. B) Bond Y will have a higher zero-volatility spread than Bond X. C) The option adjusted spread of Bond Y will be greater than its zero-volatility spread.

Version 1

18) A renegotiable mortgage has a fixed interest rate that: A) the borrower may change to a variable rate. B) changes to a different fixed rate during its life. C) changes to a variable rate during its life. 19) Which of the following statements concerning the support tranche in a planned amortization

class (PAC) CMO backed by agency RMBS is least accurate? A) If prepayments are too low to maintain the scheduled PAC payments, the shortfall is provided by the support tranche. B) The purpose of a support tranche is to provide prepayment protection for one or more PAC tranches. C) The support tranches are exposed to high levels of credit risk. 20) A repurchase agreement is described as a “reverse repo” if: A) the repurchase price is lower than the sale price. B) a bond dealer is the lender. C) collateral is delivered to the lender and returned to the borrower. 21) The one-year spot rate is 7.00%. One-year forward rates are 8.15% one year from today,

10.30% two years from today, and 12.00% three years from today. The value of a 4-year, 11% annual pay, $1,000 per bond is closest to: A) $1,052. B) $1,060. C) $984. 22) One of the primary benefits of securitization is that it: A) removes problem assets from the issuing firm’s balance sheet. B) improves the collectability of the loans that are securitized. C) improves the legal claims of the security holders to the loans that are securitized. 23) If yield to maturity and risk factors remain constant over the remainder of a coupon bond's

life, and the bond is trading at a discount today, it will have a: A) positive current yield and a capital gain. B) positive current yield, only. C) negative current yield and a capital gain.

Version 1

24) Which of the following embedded bond options tends to benefit the borrower? A) Put option. B) Conversion option. C) Interest rate cap. 25) A 10-year spot rate is least likely the: A) yield-to-maturity on a 10-year zero-coupon bond. B) yield-to-maturity on a 10-year coupon bond. C) appropriate discount rate on the year 10 cash flow for a 20-year bond. 26) Austin Traynor is considering buying a $1,000 face value, semi-annual coupon bond with a

quoted price of 104.75 and accrued interest since the last coupon of $33.50. Ignoring transaction costs, how much will the seller receive at the settlement date? A) $1,081.00. B) $1,014.00. C) $1,047.50. 27) With respect to auto-loan backed ABS: A) the underlying loans are collateralized so no credit enhancement is necessary. B) all of them have some sort of credit enhancement. C) some of them have some sort of credit enhancement. 28) If a callable bond has an option-adjusted spread (OAS) of 75 basis points, this most likely

suggests: A) the bond has a zero-volatility spread greater than 75 basis points. B) the 75 basis points represent the investor’s compensation for credit risk, liquidity risk, and volatility risk. C) the implied cost of the call option is the bond’s nominal spread minus 75 basis points. 29) An investor most concerned with reinvestment risk would be least likely to: A) prefer a noncallable bond to a callable bond. B) eliminate reinvestment risk by holding a coupon bond until maturity. C) prefer a lower coupon bond to a higher coupon bond. 30) If the yield curve is downward-sloping, the no-arbitrage value of a bond calculated using spot

rates will be: A) greater than the market price of the bond. B) equal to the market price of the bond. C) less than the market price of the bond.

Version 1

31) Medium-term notes (MTNs) most likely: A) have maturities between 2 and 10 years. B) are sold through an underwritten offering. C) have less liquidity than long-term bonds of the same issuer. 32) The bonds of Grinder Corporation trade at a G-spread of 150 basis points above comparable

maturity U.S. Treasury securities. The option adjusted spread (OAS) on the Grinder bonds is 75 basis points. Using this information, and assuming that the Treasury yield curve is flat: A) the zero-volatility spread is 225 basis points. B) the option cost is 75 basis points. C) the zero-volatility spread is 75 basis points. 33) An annual-pay, 4% coupon, 10-year bond has a yield to maturity of 5.2%. If the price of this

bond is unchanged two years later, its yield to maturity at that time is: A) greater than 5.2%. B) 5.2%. C) less than 5.2%. 34) A five-year corporate bond and its benchmark government bond had the following yields

over a one- month period:

Corporate bond yield Government bond yield

Beginning of Month

End of Month

6.75% 4.25%

7.00% 4.75%

Over this month, the price of the corporate bond most likely experienced: A) unfavorable macroeconomic factors and favorable microeconomic factors. B) unfavorable macroeconomic and microeconomic factors. C) favorable macroeconomic factors and unfavorable microeconomic factors. 35) Which of the following is least likely an advantage of estimating the duration of a bond

portfolio as a weighted average of the durations of the bonds in the portfolio? A) It is easier to calculate than the alternative. B) It can be used when the portfolio contains bonds with embedded options. C) It is theoretically more sound than the alternative.

Version 1

36) An investor buys a bond that has a Macaulay duration of 3.0 and a yield to maturity of 4.5%.

The investor plans to sell the bond after three years. If the yield curve has a parallel downward shift of 100 basis points immediately after the investor buys the bond, her annualized horizon return is most likely to be: A) less than 4.5%. B) greater than 4.5%. C) approximately 4.5%. 37) The factors that must be considered when estimating the credit risk of a bond include: A) the bond rating, the recovery rate, and the yield volatility. B) only the bond rating and the recovery rate. C) only the bond rating. 38) Which of the following will be the greatest for a putable bond at relatively high yields? A) Modified duration of the bond ignoring the option. B) Macaulay duration of the bond ignoring the option. C) Effective duration of the bond. 39) The factors that must be considered when estimating the credit risk of a bond include: A) the bond rating, the recovery rate, and the yield volatility. B) only the bond rating and the recovery rate. C) only the bond rating. 40) Which of the following will be the greatest for a putable bond at relatively high yields? A) Modified duration of the bond ignoring the option. B) Macaulay duration of the bond ignoring the option. C) Effective duration of the bond. 41) Jane Walker has set a 7% yield as the goal for the bond portion of her portfolio. To achieve

this goal, she has purchased a 7%, 15-year corporate bond at a discount price of 93.50. What amount of reinvestment income will she need to earn over this 15-year period to achieve a compound return of 7% on a semiannual basis? A) $624. B) $574. C) $459.

Version 1

42) An investor purchases a fixed coupon bond with a Macaulay duration of 5.3. The bond’s

yield to maturity decreases before the first coupon payment. If the YTM then remains constant and the investor sells the bond after three years, the realized yield will be: A) lower than the YTM at the date of purchase. B) equal to the YTM at the date of purchase. C) higher than the YTM at the date of purchase. 43) Steven Company has EBITDA/interest and debt-to-capital ratios that are both higher

compared to Joseph Company to a degree consistent with one level of issuer credit rating. Based only on this information, the credit rating of Steven is most likely to be: A) the same as Joseph. B) lower than Joseph. C) higher than Joseph. 44) All else being equal, which of the following bond characteristics will lead to lower levels of

coupon reinvestment risk for bonds that are held to maturity? A) Shorter maturities and higher coupon levels. B) Longer maturities and higher coupon levels. C) Shorter maturities and lower coupon levels. 45) In comparing the price volatility of putable bonds to that of option-free bonds, a putable bond

will have: A) more price volatility at higher yields. B) less price volatility at higher yields. C) less price volatility at low yields. 46) When using duration and convexity to estimate the effect on a bond’s value of changes in its

credit spread, an analyst should most appropriately use: A) the same method used when estimating the effect of changes in yield. B) Macaulay duration rather than modified duration. C) a convexity measure that has been adjusted for the bond’s credit risk. 47) Structural subordination means that a parent company’s debt: A) ranks pari passu with a subsidiary’s debt with respect to the subsidiary’s cash flows. B) has a higher priority of claims to a subsidiary’s cash flows than the subsidiary’s debt. C) has a lower priority of claims to a subsidiary’s cash flows than the subsidiary’s debt.

Version 1

48) Duration and convexity are most likely to produce more accurate estimates of interest rate

risk when the term structure of yield volatility is: A) downward sloping. B) upward sloping. C) flat. 49) Holding other factors constant, the interest rate risk of a coupon bond is higher when the

bond's: A) yield to maturity is lower. B) coupon rate is higher. C) current yield is higher. 50) If the term structure of yield volatility slopes upward: A) short-term interest rates are less than long-term interest rates. B) long-term interest rates are more variable than short-term interest rates. C) forward interest rates are higher than spot interest rates. 51) An investment advisor states, “An investor’s annualized holding period return from investing

in a bond consists of three parts: the coupon interest payments, the return of principal, and any capital gain or loss that the investor realizes on the bond.” The advisor is: A) incorrect, because these are not the only sources of return from investing in a bond. B) incorrect, because an investor who holds a bond to maturity will not realize a capital gain or loss. C) correct. 52) All else equal, which of the following is least likely to increase the interest rate risk of a

bond? A) A longer maturity. B) A decrease in the YTM. C) Inclusion of a call feature.

Version 1

Answer Key Test name: Fixed Income 1) C

The no-arbitrage price of a bond is determined by discounting each of its cash flows at the appropriate spot rate. Any difference between the no-arbitrage price and the market price of a bond represents a potential arbitrage profit. = 19.80 + 19.51 + 19.13 + 18.48 + 879.86 = $956.78 976 − 956.78 = $19.22 2) B

This coupon payment is computed as follows:

3) C

First, find the annual yield to maturity of the bond as: FV = $1,000; PMT = $65; N = 10; PV = −1,089.25; CPT → I/Y = 5.33%. Then, find the semiannual-bond basis yield as:2 × [(1 + 0.0533)0.5 − 1] = 0.0526 = 5.26%. 4) B

Yield curves are typically constructed for bonds of the same or similar issuers, such as a government bond yield curve or AA rated corporate bond yield curve. 5) C

Call protection in the context of a CMBS refers to protection against prepayment risk. Structuring a CMBS with a residual (equity or first-loss) tranche provides investors in the senior tranches with CMBS- level call protection. Prepayment lockout periods and yield maintenance charges are examples of loan- level call protection because they apply to the individual loans. 6) C

The lowest possible reference rate is zero. If this occurs, the coupon on a floating-rate note cannot go lower than its quoted margin. Hence, the quoted margin is a floor coupon for a floating-rate note. The coupon on an inverse floater is determined by a formula such as “15% − 1.5 × reference rate.” If the reference rate goes to zero, the coupon on this inverse floater can go no higher than 15%. 7) C

Version 1

Required reserves are deposits with a country’s central bank. Banks that deposit more than the required amount with the central bank are said to have excess reserves and may lend these to other banks. This lending is said to take place in the central bank funds market and the interest rates on such loans are known as central bank funds rates. 8) B

An appropriate reference rate for a floating-rate note should match its currency and the frequency with which its coupon rate is reset, such as 90-day yen Libor for a yen-denominated note that resets quarterly. 9) B

Covenants are classified as negative or affirmative. Affirmative covenants specify administrative actions a bond issuer is required to take, such as maintaining insurance coverage on assets pledged as collateral. Negative covenants are restrictions on a bond issuer’s actions, such as preventing an issuer from selling any assets that have been pledged as collateral or pledging them again as collateral for additional debt. 10) C

The coupon rate is set at a fixed rate determined via auction. This is called the real rate. The principal that serves as the basis of the coupon payment and the maturity value is adjusted semiannually. Because of the possibility of deflation, the adjusted principal value may be less than par (however, at maturity the Treasury redeems the bonds at the greater of the inflation-adjusted principal and the initial par value). 11) C

The identity of the lender (i.e., the bondholder) is not specified in a bond’s indenture because a bond may be traded during its life. An indenture or trust deed is a legal contract that specifies a bond issuer’s obligations and restrictions. The indenture may include covenants that require the issuer to take or refrain from taking certain actions and may specify the source of funds for repayment, such as a project to be funded or the taxing power of a government. 12) C

Version 1

The coupon rate is set in the bond agreement (indenture) and cannot be changed unilaterally. Non- interest rate indexed floaters are indexed to a commodity price such as oil or aluminum. Business results could be impacted by numerous factors other than aluminum prices. Both of the other choices are true. By linking the coupon payments directly to the price of aluminum (meaning that when aluminum prices increase, the coupon rate increases and vice versa), the non- interest index floater allows Allcans to protect its credit rating during adverse circumstances. 13) B

The following relationship has to hold: (1 + spot rate0,0.5/2)1 × (1 + forward rate0.5,2/2)3 = (1 + spot rate0,2/2)4. For this relationship to hold the forward rate has to be less than 6%. 14) B

The flat price of the bond is the quoted price, 89.14% of par value, which is $891.40. 15) B

The current yield is computed as: (Annual Cash Coupon Payment) / (Current Bond Price). The annual coupon is: ($1,000)(0.0775) = $77.50. The current yield is then: ($77.50) / ($1,012.45) = 0.0765 = 7.65%. 16) C

A waterfall structure, where principal losses are allocated first to the lowest priority securities issued, would most likely describe auto loan ABS or credit card ABS, which often have a seniorsubordinated structure. Agency RMBS are pass-through securities and do not have a seniorsubordinated structure. 17) B

Bond Y will have the higher Z-spread due to the call option embedded in the bond. This option benefits the issuer, and investors will demand a higher yield to compensate for this feature. The option-adjusted spread removes the value of the option from the spread calculation, and would always be less than the Z-spread for a callable bond. Since Bond X is noncallable, the Z-spread and the OAS will be the same. 18) B

Version 1

A renegotiable or rollover mortgage has an initial fixed-rate period after which the interest rate changes to another fixed rate. A hybrid mortgage has an initial fixed-rate period after which the interest rate changes to a variable rate. A convertible mortgage may be changed from fixed-rate to variable-rate or from variable-rate to fixed-rate at the borrower’s option. 19) C

The support tranches are exposed to high levels of prepayment risk, not credit risk. 20) B

Bond dealers frequently use repurchase agreements as sources of funding. When a bond dealer enters a repo as the lender instead of the borrower, the agreement is referred to as a reverse repo. 21) B

Spot Rates: Year 1 = 7%. Year 2 = [(1.07)(1.0815)]1/2 − 1 = 7.57%. Year 3 = [(1.07)(1.0815)(1.103)]1/3 − 1 = 8.48%. Year 4 = [(1.07)(1.0815)(1.103)(1.120)]1/4 − 1 = 9.35%. Bond Value: N = 1; FV = 110; I/Y = 7; CPT → PV = 102.80 N = 2; FV = 110; I/Y = 7.57; CPT → PV = 95.06 N = 3; FV = 110; I/Y = 8.48; CPT → PV = 86.17 N = 4; FV = 1,110; I/Y = 9.35; CPT → PV = 776.33 102.80 + 95.06 + 86.17 + 776.33 = 1,060.36 22) C

Securitization reduces the cost of funding the assets. One way that is accomplished is through the transfer of the underlying financial assets to a special purpose entity so that securities holders have clear legal claim to them, something they may not have if they were to invest only in the securities of the securitizer, such as a bank. Securitization does not have improved collectability as a primary benefit. Problem loans are not good candidates for securitization because institutional investors require a minimum credit quality and even well performing loans can require internal or external credit enhancement for the securitized assets. 23) B

A coupon bond will have a positive current yield. It will not have a capital gain because its price will increase toward par along its constant-yield price trajectory as long as its YTM remains constant.

Version 1

24) C

The interest rate cap benefits the borrower who issues a floating rate bond. The cap places a restriction on how high the coupon rate can become during a rising interest rate environment. Therefore, the floating rate borrower is protected against ever-rising interest rates. 25) B

A 10-year spot rate is the yield-to-maturity on a 10-year zero-coupon security, and is the appropriate discount rate for the year 10 cash flow for a 20-year (or any maturity greater than or equal to 10 years) bond. Spot rates are used to value bonds and to ensure that bond prices eliminate any possibility for arbitrage resulting from buying a coupon security, stripping it of its coupons and principal payment, and reselling the strips as separate zero-coupon securities. The yield to maturity on a 10-year bond is the (complex) average of the spot rates for all its cash flows. 26) A

The full price is equal to the flat or clean price plus interest accrued from the last coupon date. Here, the flat price is 1,000 × 104.75%, or 1,000 × 1.0475 = 1,047.50. Thus, the full price = 1,047.50 + 33.50 = 1,081.00. 27) B

All automobile loan ABS have some sort of credit enhancement to make them attractive to institutional investors. 28) A

For a bond with an embedded call option, the OAS is less than its zero-volatility spread by the option cost. Therefore, the zero-volatility spread is greater than the OAS for callable bonds. If the embedded call option has any value to the issuer, a callable bond with an OAS of 75 basis points will have a Z- spread that is greater than 75 basis points. Because the OAS represents the bond’s spread to the spot yield curve excluding the effect of the embedded option, it does not include any compensation for the volatility risk related to the option. The implied cost of an embedded option is the difference between the bond’s zerovolatility spread (not the nominal spread) and its OAS. 29) B

Version 1

The key term here is coupon bond. While an investor in a fixed-coupon bond can usually eliminate interest rate risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupon payments exposes the investor to reinvestment risk. A noncallable bond reduces reinvestment risk by reducing the risk of repayment. Thus, an investor most concerned with reinvestment risk would prefer a noncallable bond to a callable bond. Since lower coupon bonds have lower reinvestment risk, this same investor would prefer a lower coupon bond to a higher coupon bond. (Study Session 14, Module 42.2, LOS 42.f, Study Session 15, Module 46.1, LOS 46.a) 30) B

The value of a bond calculated using appropriate spot rates is its no-arbitrage value. If no arbitrage opportunities are present, this value is equal to the market price of a bond. 31) C

As they are most often custom debt instruments, medium-term notes typically have less liquidity than a regular bond issue from the same issuer. Medium-term notes can have any maturity and are sold through agents. 32) B

The option cost is the difference between the zero volatility spread and the OAS, or 150 − 75 = 75 bp. With a flat yield curve, the G-spread and zero volatility spread will be the same. 33) A

This bond is priced at a discount to par value because its 4% coupon is less than its 5.2% yield to maturity. As the bond gets closer to maturity, the discount will amortize toward par value, which means its price will increase if its yield remains unchanged. For its price to remain unchanged, its yield would have to increase. Price with 10 years to maturity: N = 10; I/Y = 5.2; PMT = 40; FV = 1,000; CPT PV = −908.23 Yield with 8 years to maturity: N = 8; PMT = 40; FV = 1,000; PV = −908.23; CPT I/Y = 5.446% 34) A

Version 1

The benchmark yield increased, which suggests macroeconomic factors were unfavorable for bond prices overall. The corporate bond’s spread to its benchmark decreased from 250 basis points to 225 basis points, which suggests microeconomic factors were favorable for the bond’s price. 35) C

Compared to portfolio duration based on the cash flow yield of the portfolio, portfolio duration calculated as a weighted average of the durations of the individual bonds in the portfolio is easier to calculate and can be used for bonds with embedded options. Portfolio duration calculated using the cash flow yield for the entire portfolio is theoretically more correct. 36) C

With Macaulay duration equal to the investment horizon, market price risk and reinvestment risk approximately offset and the annualized horizon return should be close to the yield to maturity at purchase. 37) B

Credit risk is calculated with the probability of default (estimated from the bond rating) and the estimated recovery value should the bond default. Yield volatility is combined with duration to estimate the price risk of a bond. 38) B

Modified duration is less than Macaulay duration. The effective duration of a putable bond is less than its modified duration ignoring the put option. 39) B

Modified duration is less than Macaulay duration. The effective duration of a putable bond is less than its modified duration ignoring the put option. 41) B

935(1.035)30 = $2,624 Bond coupons: 30 × 35 = $1,050 Principal repayment: $1,000 2,624 − 1,000 − 1050 = $574 required reinvestment income

Version 1

42) C

If the investment horizon is shorter than the Macaulay duration, the price impact of a decrease in YTM dominates the loss of reinvestment income and the realized yield will be higher than the YTM at purchase. 43) A

Steven’s higher EBITDA/interest ratio is consistent with a higher credit rating than Joseph but its higher debt-to-capital ratio is consistent with a lower credit rating. Steven is most likely to have the same credit rating as Joseph. 44) C

Other things being equal, the amount of reinvestment risk embedded in a bond will decrease with lower coupons because there will be a lesser dollar amount to reinvest and with shorter maturities because the reinvestment period is shorter. 45) B

The only true statement is that putable bonds will have less price volatility at higher yields. At higher yields the put becomes more valuable and reduces the decline in price of the putable bond relative to the option-free bond. On the other hand, when yields are low, the put option has little or no value and the putable bond will behave much like an option-free bond. Therefore at low yields a putable bond will not have more price volatility nor will it have less price volatility than a similar option-free bond. 46) A

We can use duration and convexity to estimate the price effect of changes in spread in the same way we use them to estimate the price effect of changes in yield: Percent change in bond value = −duration (change in yield or spread) + (1/2) (convexity) (squared change in yield or spread) No adjustment for credit risk is needed and an analyst should use modified or effective duration. 47) C

Structural subordination means that cash flows from a subsidiary are used to pay the subsidiary’s debt before they may be paid to the parent company to service its debt. As a result, parent company debt is effectively subordinate to the subsidiary's debt. 48) C

Version 1

Duration and convexity assume the yield curve shifts in a parallel manner. A downward (upward) sloping term structure of yield volatility suggests shifts in the yield curve are likely to be non-parallel because short-term interest rates are more (less) volatile than long-term interest rates. 49) A

In this case the only determinant that will cause higher interest rate risk is having a low yield to maturity. A higher coupon rate and a higher current yield will result in lower interest rate risk. 50) B

If the term structure of yield volatility slopes upward, long-term interest rates are more variable than short-term interest rates. 51) A

The advisor’s description of the sources of return from investing in a bond is incomplete because it does not include the income from reinvesting the bond’s coupon payments. Although it is true that an investor who holds a bond to maturity will not realize a capital gain or loss, this is not why the advisor’s statement is incorrect. 52) C

Inclusion of a call feature will decrease the duration of a fixed income security. The other choices increase duration.

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Portfolios that plot on the security market line in equilibrium: A) have only systematic (beta) risk. B) may be concentrated in only a few stocks. C) must be well diversified. 2) Which of the following statements regarding the covariance of rates of return is least

accurate? A) Covariance is positive if two variables tend to both be above their mean values in the same time periods. B) Covariance is not a very useful measure of the strength of the relationship between rates of return. C) If the covariance is negative, the rates of return on two investments will always move in different directions relative to their means. 3) All portfolios on the capital market line: A) contain different risky assets. B) are perfectly positively correlated. C) are unrelated except that they all contain the risk-free asset. 4) Which of the following statements about active and passive asset management is most

accurate? A) Active management may use fundamental analysis, technical analysis, or a “smart beta” approach to outperform a chosen benchmark. B) Active management has been gaining market share over time versus passive management. C) Passive management’s share of industry revenues is smaller than its share of assets under management. 5) When comparing portfolios that plot on the security market line (SML) to those that plot on

the capital market line (CML), a financial analyst would most accurately state that portfolios that lie on the SML: A) have only systematic risk, while portfolios on the CML have both systematic and unsystematic risk. B) are not necessarily well diversified, while portfolios on the CML are well diversified. C) are not necessarily priced at their equilibrium values, while portfolios on the CML are priced at their equilibrium values.

Version 1

6) An investor with a buy-and-hold strategy who makes quarterly deposits into an account

should most appropriately evaluate portfolio performance using the portfolio’s: A) money-weighted return. B) geometric mean return. C) arithmetic mean return. 7) Three portfolios have the following expected returns and risk: Portfolio Expected return Jones 4% Kelly 6% Lewis 7%

Standard deviation 2% 5% 8%

A risk-averse investor choosing from these portfolios could rationally select: A) Jones or Kelly, but not Lewis. B) Jones, but not Kelly or Lewis. C) any of these portfolios. 8) An investor buys one share of stock for $100. At the end of year one she buys three more

shares at $89 per share. At the end of year two she sells all four shares for $98 each. The stock paid a dividend of $1.00 per share at the end of year one and year two. What is the investor’s time-weighted rate of return? A) 6.35%. B) 0.06%. C) 11.24%. 9) Charlie Smith holds two portfolios, Portfolio X and Portfolio Y. They are both liquid, well-

diversified portfolios with approximately equal market values. He expects Portfolio X to return 13% and Portfolio Y to return 14% over the upcoming year. Because of an unexpected need for cash, Smith is forced to sell at least one of the portfolios. He uses the security market line to determine whether his portfolios are undervalued or overvalued. Portfolio X's beta is 0.9 and Portfolio Y's beta is 1.1. The expected return on the market is 12% and the risk-free rate is 5%. Smith should sell: A) either portfolio X or Y because they are both properly valued. B) portfolio Y only. C) both portfolios X and Y because they are both overvalued.

Version 1

10) When the market is in equilibrium, all: A) assets plot on the CML. B) investors hold the market portfolio. C) assets plot on the SML. 11) In equilibrium, an inefficient portfolio will plot: A) on the CML and below the SML. B) below the CML and below the SML. C) below the CML and on the SML. 12) According to the capital asset pricing model (CAPM): A) a stock with high risk, measured as standard deviation of returns, will have high

expected returns in equilibrium. B) an investor who is risk averse should hold at least some of the risk-free asset in his portfolio. C) all investors who take on risk will hold the same risky-asset portfolio. 13) On January 1, Jonathan Wood invests $50,000. At the end of March, his investment is worth

$51,000. On April 1, Wood deposits $10,000 into his account, and by the end of June, his account is worth $60,000. Wood withdraws $30,000 on July 1 and makes no additional deposits or withdrawals the rest of the year. By the end of the year, his account is worth $33,000. The time-weighted return for the year is closest to: A) 5.5%. B) 7.0%. C) 10.4%. 14) Which of the following statements about the efficient frontier is least accurate? A) The efficient frontier shows the relationship that exists between expected return and

total risk in the absence of a risk-free asset. B) Portfolios falling on the efficient frontier are fully diversified. C) Investors will want to invest in the portfolio on the efficient frontier that offers the highest rate of return. 15) A model that estimates expected excess return on a security based on the ratio of the firm’s

book value to its market value is best described as a: A) single-factor model. B) multifactor model. C) market model.

Version 1

16) A portfolio’s excess return per unit of systematic risk is known as its: A) Treynor measure. B) Jensen’s alpha. C) Sharpe ratio. 17) An analyst wants to determine whether Dover Holdings is overvalued or undervalued, and by

how much (expressed as percentage return). The analyst gathers the following information on the stock: Market standard deviation = 0.70 Covariance of Dover with the market = 0.85 Dover’s current stock price (P0) = $35.00 The expected price in one year (P1) is $39.00 Expected annual dividend = $1.50 3-month Treasury bill yield = 4.50%. Historical average S&P 500 return = 12.0%. Dover Holdings stock is: A) overvalued by approximately 1.8%. B) undervalued by approximately 2.1%. C) undervalued by approximately 1.8%. 18) Which of the following is the most accurate description of the market portfolio in Capital

Market Theory? The market portfolio consists of all: A) risky assets in existence. B) risky and risk-free assets in existence. C) equity securities in existence. 19) Which of the following is least likely considered a source of systematic risk for bonds? A) Market risk. B) Purchasing power risk. C) Default risk. 20) A stock's abnormal rate of return is defined as the: A) expected risk-adjusted rate of return minus the market rate of return. B) actual rate of return less the expected risk-adjusted rate of return. C) rate of return during abnormal price movements.

Version 1

21) Kendra Jackson, CFA, is given the following information on two stocks, Rockaway and

Bridgeport. Covariance between the two stocks = 0.0325 Standard Deviation of Rockaway’s returns = 0.25 Standard Deviation of Bridgeport’s returns = 0.13 Assuming that Jackson must construct a portfolio using only these two stocks, which of the following combinations will result in the minimum variance portfolio? A) 80% in Bridgeport, 20% in Rockaway. B) 50% in Bridgeport, 50% in Rockaway. C) 100% in Bridgeport. 22) Which of the following statements best describes an investment that is not on the efficient

frontier? A) The portfolio has a very high return. B) There is a portfolio that has a lower return for the same risk. C) There is a portfolio that has a lower risk for the same return. 23) According to the CAPM, a rational investor would be least likely to choose as his optimal

portfolio: A) a 100% allocation to the risk-free asset. B) a 130% allocation to the market portfolio. C) the global minimum variance portfolio. 24) James Franklin, CFA, has high risk tolerance and seeks high returns. Based on capital market

theory, Franklin would most appropriately hold: A) the market portfolio as his only risky asset. B) a high risk biotech stock, as it will have high expected returns in equilibrium. C) a high-beta portfolio of risky assets financed in part by borrowing at the risk-free rate. 25) All portfolios that lie on the capital market line: A) contain at least some positive allocation to the risk-free asset. B) contain the same mix of risky assets unless only the risk-free asset is held. C) have some unsystematic risk unless only the risk-free asset is held.

Version 1

26) Which of the following pooled investment shares is least likely to trade at a price different

from its NAV? A) Exchange-traded fund shares. B) Closed-end mutual fund shares. C) Open-end mutual fund shares. 27) Smith has more steeply sloped risk-return indifference curves than Jones. Assuming these

investors have the same expectations, which of the following best describes their risk preferences and the characteristics of their optimal portfolios? Smith is: A) less risk averse than Jones and will choose an optimal portfolio with a lower expected return. B) more risk averse than Jones and will choose an optimal portfolio with a higher expected return. C) more risk averse than Jones and will choose an optimal portfolio with a lower expected return. 28) When a risk-free asset is combined with a portfolio of risky assets, which of the following is

least accurate? A) The standard deviation of the return for the newly created portfolio is the standard deviation of the returns of the risky asset portfolio multiplied by its portfolio weight. B) The variance of the resulting portfolio is a weighted average of the returns variances of the risk-free asset and of the portfolio of risky assets. C) The expected return for the newly created portfolio is the weighted average of the return on the risk-free asset and the expected return on the risky asset portfolio. 29) An investor buys a non-dividend paying stock for $100 at the beginning of the year with 50%

initial margin. At the end of the year, the stock price is $95. Deflation of 2% occurred during the year. Which of the following return measures for this investment will be greatest? A) Leveraged return. B) Real return. C) Nominal return. 30) Which of the following is not necessarily included in an investment policy statement? A) A benchmark against which to judge performance. B) An investment strategy based on the investor’s objectives and constraints. C) Procedures to update the IPS when circumstances change.

Version 1

31) A head and shoulders pattern is most likely to precede a reversal in trend if: A) volume decreases between the left shoulder and the head, then increases between the

head and the right shoulder. B) the left shoulder, the head, and the right shoulder occur on increasing volume. C) the left shoulder, the head, and the right shoulder occur on decreasing volume. 32) Which of the following uses of data is most accurately described as curation? A) An analyst adjusts daily stock index data from two countries for their different market

holidays. B) A data technician accesses an offsite archive to retrieve data that has been stored there. C) An investor creates a word cloud from financial analysts’ recent research reports about a company. 33) The advantages of using technical analysis include: A) the incorporation of psychological reasons behind price changes. B) complete objectivity. C) ease in interpreting reasons behind stock price trends. 34) While assessing an investor’s risk tolerance, a financial adviser is least likely to ask which of

the following questions? A) “What rate of investment return do you expect?” B) “Is your home life stable?” C) “How much insurance coverage do you have?” 35) A government decides it will privatize vehicle registrations if the province’s auto insurance

companies can record and maintain ownership titles using distributed ledger technology. This application of distributed ledger technology is best characterized as: A) blockchain. B) tokenization. C) smart contracts. 36) The resistance level signifies the price at which a stock's supply would be expected to: A) cause the stock price to "break out". B) increase substantially. C) decrease substantially.

Version 1

37) When performing strategic asset allocation, properly defined and specified asset classes

should: A) each contain assets that have a broad range of risk and expected return. B) have high returns correlations with other asset classes. C) approximate the investor's total investable universe as a group. 38) An endowment is required by statute to pay out a minimum percentage of its asset value each

period to its beneficiaries. This investment constraint is best classified as: A) unique circumstances. B) liquidity. C) legal and regulatory. 39) The manager of the Fullen Balanced Fund is putting together a report that breaks out the

percentage of the variation in portfolio return that is explained by the target asset allocation, security selection, and tactical variations from the target, respectively. Which of the following sets of numbers was the most likely conclusion for the report? A) 33%, 33%, 33%. B) 50%, 25%, 25%. C) 90%, 6%, 4%. 40) Based on a questionnaire about investment risk, an advisor concludes that an investor’s risk

tolerance is high, but based on an analysis of the client's income needs and time horizon, he concludes the investor's risk tolerance is low. The most appropriate action for the advisor is to: A) educate the client about investment risk and re-administer the questionnaire. B) emphasize bonds over stocks. C) emphasize stocks over bonds.

Version 1

Answer Key Test name: Portfolio Management 1) B

All portfolios plot on the SML in equilibrium according to the capital asset pricing model. 2) C

Negative covariance means rates of return for one security will tend to be above its mean return in periods when the other is below its mean return, and vice versa. Positive covariance means that returns on both securities will tend to be above (or below) their mean returns in the same time periods. For the returns to always move in opposite directions, they would have to be perfectly negatively correlated. Negative covariance by itself does not imply anything about the strength of the negative correlation, it must be standardized by dividing by the product of the securities’ standard deviations of return. 3) B

The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is called the capital market line (CML). Since the line is straight, the math implies that the returns on any two portfolios on this line will be perfectly, positively correlated with each other. Note: Whenra,b = 1, then the equation for risk changes tosport = WAsA + WBsB, which is a straight line. The risky assets for each portfolio on the CML are the same, the tangency (or market) portfolio of risky assets. 4) C

Because fees for passive management are lower than fees for active management, passive management represents a smaller share of industry revenues than assets under management. Passive management has been gaining market share over time versus active management. Smart beta is a passive management strategy that focuses on a specific market risk factor. 5) B

Although the risk measure on the capital market line diagram is total risk, all portfolios that lie on the CML are well diversified and have only systematic risk. This is because portfolios on the CML are all constructed from the risk-free asset and the (well-diversified) market portfolio. Any portfolio, including single securities, will plot along the SML in equilibrium. Their unsystematic risk can be significant, but it is not measured on the SML diagram because unsystematic risk is not related to expected return. Both the CML and the SML reflect relations that hold when prices are in equilibrium.

Version 1

6) B

Geometric mean return (time-weighted return) is the most appropriate method for performance measurement as it does not consider additions to or withdrawals from the account. 7) C

Risk aversion means that to accept greater risk, an investor must be compensated with a higher expected return. For the three portfolios given, higher risk is associated with higher expected return. Therefore a risk-averse investor may select any of these portfolios. A risk-averse investor will not select a portfolio if another portfolio offers a higher expected return with the same risk, or lower risk with the same expected return. 8) B

The holding period return in year one is ($89.00 − $100.00 + $1.00) / $100.00 = −10.00%. The holding period return in year two is ($98.00 − $89.00 + $1.00) / $89 = 11.24%. The time-weighted return is [{1 + (−0.1000)}{1 + 0.1124}]1/2 − 1 = 0.06%. 9) B

Portfolio X’s required return is 0.05 + 0.9 × (0.12 − 0.05) = 11.3%. It is expected to return 13%. The portfolio has an expected excess return of 1.7% Portfolio Y’s required return is 0.05 + 1.1 × (0.12 − 0.05) = 12.7%. It is expected to return 14%. The portfolio has an expected excess return of 1.3%. Since both portfolios are undervalued, the investor should sell the portfolio that offers less excess return. Sell Portfolio Y because its excess return is less than that of Portfolio X. 10) C

When the market is in equilibrium, expected returns equal required returns. Since this means that all assets are correctly priced, all assets plot on the SML. By definition, all stocks and portfolios other than the market portfolio fall below the CML. (Only the market portfolio is efficient). 11) C

An inefficient portfolio will plot below the CML. In equilibrium, all portfolios will plot on the SML. 12) C

Version 1

One of the assumptions of the CAPM is that all investors who hold risky assets will hold the same portfolio of risky assets (the market portfolio). Risk aversion means an investor will accept more risk only if compensated with a higher expected return. In capital market theory, all investors exhibit risk aversion, even an investor who is short the risk-free asset. In the CAPM, a stock’s risk is measured as its beta, not its standard deviation of returns. 13) C

January − March return = 51,000 / 50,000 − 1 = 2.00% April − June return = 60,000 / (51,000 + 10,000) − 1 = −1.64% July − December return = 33,000 / (60,000 − 30,000) − 1 = 10.00% Time-weighted return = [(1 + 0.02)(1 − 0.0164)(1 + 0.10)] − 1 = 0.1036 or 10.36% 14) C

The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier. 15) A

A model that estimates a stock’s expected excess return based only on the book-to-market ratio is a single-factor model. The market model is a single-factor model that estimates expected excess return based on a security’s sensitivity to the expected excess return of the market portfolio. A multifactor model would estimate expected excess return based on more than one factor. 16) A

The Treynor measure is excess return relative to beta. The Sharpe ratio measures excess return relative to standard deviation. Jensen’s alpha measures a portfolio’s excess return relative to return of a portfolio on the SML that has the same beta. 17) A

Version 1

To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM). Step 1: Calculate Expected Return (Holding period return) The formula for the (one-year) holding period return is: HPR = (D1 + S1 − S0) / S0, where D = dividend and S = stock price. Here, HPR = (1.50 + 39 − 35) / 35 = 15.71% Step 2: Calculate Required Return The formula for the required return is from the CAPM:RR = Rf + (ERM − Rf) × Beta Here, we are given the information we need except for Beta. Remember that Beta can be calculated with:Betastock = [covS,M] / [σ2M]. Here we are given the numerator and the denominator, so the calculation is: 0.85 / 0.702 = 1.73. RR = 4.50% + (12.0 − 4.50%) × 1.73 = 17.48%. Step 3: Determine over/under valuation The required return is greater than the expected return, so the security is overvalued. The amount = 17.48% − 15.71% = 1.77%. 18) A

The market portfolio, in theory, contains all risky assets in existence. It does not contain any risk-free assets. 19) C

Default risk is based on company-specific or unsystematic risk. 20) B

Abnormal return = Actual return − expected risk-adjusted return 21) C

Version 1

First, calculate the correlation coefficient to check whether diversification will provide any benefit. rBridgeport, Rockaway = covBridgeport, Rockaway / [( σBridgeport) × (σRockaway)] = 0.0325 / (0.13 × 0.25) = 1.00 Since the stocks are perfectly positively correlated, there are no diversification benefits and we select the stock with the lowest risk (as measured by variance or standard deviation), which is Bridgeport. 22) C

The efficient frontier outlines the set of portfolios that gives investors the highest return for a given level of risk or the lowest risk for a given level of return. Therefore, if a portfolio is not on the efficient frontier, there must be a portfolio that has lower risk for the same return. Equivalently, there must be a portfolio that produces a higher return for the same risk. 23) C

According to the CAPM, rational, risk-averse investors will optimally choose to hold a portfolio along the capital market line. This can range from a 100% allocation to the risk-free asset to a leveraged position in the market portfolio constructed by borrowing at the risk-free rate to invest more than 100% of the portfolio equity value in the market portfolio. The global minimum variance portfolio lies below the CML and is not an efficient portfolio under the assumptions of the CAPM. 24) A

According to capital market theory, all investors will choose a combination of the market portfolio and borrowing or lending at the risk-free rate; that is, a portfolio on the CML. (Study Session 18, Module 53.1, LOS 53.a) 25) B

All portfolios on the CML include the same tangency portfolio of risky assets, except the intercept (all invested in risk-free asset). The tangency portfolio contains none of the risk-free asset and “borrowing portfolios” can be constructed with a negative allocation to the risk-free asset. Portfolios on the CML are efficient (well-diversified) and have no unsystematic risk. (Study Session 18, Module 53.1, LOS 53.b, 53.c) 26) C

Shares of open-end mutual funds trade at NAV. The others may deviate from NAV. 27) C

Version 1

Steeply sloped risk-return indifference curves indicate that a greater increase in expected return is required as compensation for assuming an additional unit of risk, compared to less-steep indifference curves. The more risk-averse Smith will choose an optimal portfolio with lower risk and a lower expected return than the less risk-averse Jones's optimal portfolio. 28) B

This statement is not correct; the standard deviation of returns for the resulting portfolio is a weighted average of the returns standard deviation of the risk-free asset (zero) and the returns standard deviation of the risky-asset portfolio. 29) B

No calculations are needed. The real return is greater than the nominal return because the inflation rate is negative. The leveraged return is more negative than the nominal return because the investment lost value and leverage magnifies the loss. 30) C

At a minimum an IPS should contain a clear statement of client circumstances and constraints, an investment strategy based on these, and some benchmark against which to evaluate the account performance. The investment must periodically update the IPS as circumstances change, but explicit procedures for these updates are not necessarily included in the IPS itself. 31) C

Decreasing volume on each of the high prices in a head and shoulders pattern (or each of the low prices in an inverse head and shoulders) suggests weakening in the supply and demand forces that were driving the price trend. 32) A

Curation is ensuring the quality of data—for example, by adjusting for bad or missing data. Word clouds are a visualization technique. Moving data from a storage medium to where they are needed is referred to as transfer. 33) A

Technical analysis avoids having to use fundamental data and adjusting for accounting problems, incorporates psychological as well as economic reasons behind price changes, and tells WHEN to buy; not WHY investors are buying. Drawbacks include subjective interpretation of charts and graphs. 34) A

Version 1

While the degree of risk tolerance will have an affect on expected returns, assessing the risk tolerance comes first, and the resulting set of feasible returns follows. The other questions address risk tolerance. 35) B

Tokenization refers to maintaining ownership records for physical assets on a distributed ledger. This might, but would not necessarily, use a blockchain, which is a subcategory of distributed ledgers. Smart contracts are computerized agreements designed to automatically carry out certain actions if defined conditions are met. 36) B

Support and resistance levels. Most stock prices remain relatively stable and fluctuate up and down from their true value. The lower limit to these fluctuations is called a support level – the price range where a stock appears cheap and attracts buyers. The upper limit is called a resistance level – the price range where a stock appears expensive and initiates selling. Generally, a resistance level tends to develop after a stock has experienced a steady decline from a higher price level. Technicians believe that the decline in price will cause some investors who acquired the stock at a higher price to look for an opportunity to sell it near their break-even points. Therefore, the supply of stock owned by investors is overhanging the market. When the price rebounds to the target price set by these investors, this overhanging supply of stock comes to the market and dramatically reverses the price increase on heavy volume. 37) C

When taken together, the asset classes should approximate the investor's total investible universe. Properly defined and specified asset classes should each have a low return correlation to the other asset classes, and within each asset class should be assets that have similar expected risk and return. 38) C

Legal and regulatory constraints are those that apply to an investor by law. 39) C

Several studies support the idea that approximately 90% of the variation in a single portfolio’s returns can be explained by its target asset allocations, with security selection and tactical variations from the target (market timing) playing a much less significant role. In fact, for actively managed funds, actual portfolio returns are slightly less than those that would have been achieved if the manager strictly maintained the target allocation, thus illustrating the difficultly of improving returns through security selection or market timing.

Version 1

40) B

When determining an investor's risk tolerance, an advisor must consider both the investor's ability and willingness to bear risk. Even though the investor has a high willingness to bear risk, his ability to take risk (based on his financial situation) is low, and this should take precedence. A portfolio that emphasizes bonds over stocks has less investment risk and is the most appropriate choice.

Version 1

Student name:__________ MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) A successful investor has decided to set up a scholarship fund for deserving students at her alma mater. Her plan is for the fund to be capable of awarding $25,000 annually in perpetuity. The first scholarship is to be awarded and paid out exactly four years from today. The funds will be deposited into an account immediately and will grow at a rate of 4%, compounded semiannually, for the foreseeable future. How much money must the investor donate today to fund the scholarship? A) $528,150. B) $549,487. C) $574,253. 2) An investment manager has a pool of five security analysts he can choose from to cover three

different industries. In how many different ways can the manager assign one analyst to each industry? A) 60. B) 10. C) 125. 3) A company says that whether it increases its dividends depends on whether its earnings

increase. From this we know: A) P(dividend increase | earnings increase) is not equal to P(earnings increase). B) P(earnings increase | dividend increase) is not equal to P(earnings increase). C) P(both dividend increase and earnings increase) = P(dividend increase). 4) Determining the number of ways five tasks can be done in order, requires: A) only the factorial function. B) the permutation formula. C) the labeling formula. 5) Which of the following is an a priori probability? A) The probability the Fed will lower interest rates prior to the end of the year. B) For a stock, based on prior patterns of up and down days, the probability of the stock

having a down day tomorrow. C) On a random draw, the probability of choosing a stock of a particular industry from the S&P 500.

Version 1

6) The probability of a new office building being built in town is 64%. The probability of a new

office building that includes a coffee shop being built in town is 58%. If a new office building is built in town, the probability that it includes a coffee shop is closest to: A) 58%. B) 37%. C) 91%. 7) A firm is going to create three teams of four from twelve employees. How many ways can

the twelve employees be selected for the three teams? A) 34,650. B) 495. C) 1,320. 8) The "likelihood" of an event occurring is defined as: A) an unconditional probability. B) a conditional probability. C) a joint probability. 9) Compute the present value of a perpetuity with $100 payments beginning four years from

now. Assume the appropriate annual interest rate is 10%. A) $1,000. B) $751. C) $683. 10) Nikki Ali and Donald Ankard borrowed $15,000 to help finance their wedding and reception.

The annual payment loan carries a term of seven years and an 11% interest rate. Respectively, the amount of the first payment that is interest and the amount of the second payment that is principal are approximately: A) $1,650; $1,702. B) $1,650; $1,468. C) $1,468; $1,702. 11) Marc Schmitz borrows $20,000 to be paid back in four equal annual payments at an interest

rate of 8%. The interest amount in the second year’s payment would be: A) $6038.40. B) $1116.90. C) $1244.90.

Version 1

12) Natalie Brunswick, neurosurgeon at a large U.S. university, was recently granted permission

to take an 18-month sabbatical that will begin one year from today. During the sabbatical, Brunswick will need $2,500 at the beginning of each month for living expenses that month. Her financial planner estimates that she will earn an annual rate of 9% over the next year on any money she saves. The annual rate of return during her sabbatical term will likely increase to 10%. At the end of each month during the year before the sabbatical, Brunswick should save approximately: A) $3,505.00 B) $3,330.00 C) $3,356.00 13) A parking lot has 100 red and blue cars in it.

40% of the cars are red. 70% of the red cars have radios. 80% of the blue cars have radios. What is the probability that the car is red given that it has a radio? A) 47%. B) 28%. C) 37%. 14) Optimal Insurance is offering a deferred annuity that promises to pay 10% per annum with

equal annual payments beginning at the end of 10 years and continuing for a total of 10 annual payments. For an initial investment of $100,000, what will be the amount of the annual payments? A) $42,212. B) $38,375. C) $25,937. 15) The real risk-free rate can be thought of as: A) exactly the nominal risk-free rate reduced by the expected inflation rate. B) approximately the nominal risk-free rate plus the expected inflation rate. C) approximately the nominal risk-free rate reduced by the expected inflation rate.

Version 1

16) A local loan shark offers 4 for 5 on payday. What it involves is that you borrow $4 from him

and repay $5 on the next payday (one week later). What would the stated annual interest rate be on this loan, with weekly compounding? Assuming 52 weeks in one year, what is the effective annual interest rate on this loan? Select the respective answer choices closest to your numbers. A) 25%; 300%. B) 1,300%; 10,947,544%. C) 25%; 1,300%. 17) At a charity fundraiser there have been a total of 342 raffle tickets already sold. If a person

then purchases two tickets rather than one, how much more likely are they to win? A) 0.50. B) 2.10. C) 1.99. 18) Consider the following set of stock returns: 12%, 23%, 27%, 10%, 7%, 20%,15%. The third

quartile is: A) 23%. B) 20.0%. C) 21.5%. 19) Jim Franklin recently purchased a home for $300,000 on which he made a down payment of

$100,000. He obtained a 30-year mortgage to finance the balance on which he pays a fixed annual rate of 6%. If he makes regular, fixed monthly payments, what loan balance will remain just after the 48th payment? A) $186,109. B) $192,444. C) $189,229.

Version 1

20) The probability of each of three independent events is shown in the table below. What is the

probability of A and C occurring, but not B? Table 1: Event A B C

Probability of Occurrence 25% 15% 42%

A) 8.9%. B) 3.8%. C) 10.5%. 21) Which of the following statements about probability is most accurate? A) A conditional probability is the probability that two or more events will happen

concurrently. B) An outcome is the calculated probability of an event. C) An event is a set of one or more possible values of a random variable. 22) As the number of compounding periods increases, what is the effect on the EAR? EAR: A) increases at an increasing rate. B) does not increase. C) increases at a decreasing rate. 23) Elise Corrs, hedge fund manager and avid downhill skier, was recently granted permission to

take a 4 month sabbatical. During the sabbatical, (scheduled to start in 11 months), Corrs will ski at approximately 12 resorts located in the Austrian, Italian, and Swiss Alps. Corrs estimates that she will need $6,000 at the beginning of each month for expenses that month. (She has already financed her initial travel and equipment costs.) Her financial planner estimates that she will earn an annual rate of 8.5% during her savings period and an annual rate of return during her sabbatical of 9.5%. How much does she need to put in her savings account at the end of each month for the next 11 months to ensure the cash flow she needs over her sabbatical? Each month, Corrs should save approximately: A) $2,070. B) $2,080. C) $2,065.

Version 1

24) Distribution X has a mean of 10 and a standard deviation of 20. Distribution Y is identical to

Distribution X in all respects except that each observation in Distribution Y is three times the value of a corresponding observation in Distribution X. The mean and standard deviation of Distribution Y are closest to:

A) B) C)

Mean

Standard deviation

30 10 30

20 60 60

A) Option A B) Option B C) Option C 25) Which of the following statements is least accurate regarding covariance? A) The covariance of a variable with itself is one. B) Covariance can only apply to two variables at a time. C) Covariance can exceed one. 26) If 10 equal annual deposits of $1,000 are made into an investment account earning 9%

starting today, how much will you have in 20 years? A) $42,165. B) $39,204. C) $35,967. 27) To compare the returns over the past three years on a mutual fund to the returns on a

certificate of deposit with annual compounding over the same period, an analyst is least likely to use the mutual fund’s annual: A) geometric mean return. B) arithmetic mean return. C) time-weighted return. 28) Selmer Jones has just inherited some money and wants to set some of it aside for a vacation

in Hawaii one year from today. His bank will pay him 5% interest on any funds he deposits. In order to determine how much of the money must be set aside and held for the trip, he should use the 5% as a: A) required rate of return. B) discount rate. C) opportunity cost.

Version 1

29) Given the following table about employees of a company based on whether they are smokers

or nonsmokers and whether or not they suffer from any allergies, what is the probability of both suffering from allergies and not suffering from allergies? Table 2:

Smoker Nonsmoker Total

Suffer from Allergies 35 55 90

Don't Suffer from Allergies 25 185 210

Total 60 240 300

A) 1.00. B) 0.00. C) 0.50. 30) There is a 40% chance that an investment will earn 10%, a 40% chance that the investment

will earn 12.5%, and a 20% chance that the investment will earn 30%. What is the mean expected return and the standard deviation of expected returns, respectively? A) 17.5%; 5.75%. B) 15.0%; 7.58%. C) 15.0%; 5.75%. 31) An investor will receive an annuity of $5,000 a year for seven years. The first payment is to

be received 5 years from today. If the annual interest rate is 11.5%, what is the present value of the annuity? A) $23,185.00 B) $15,000.00 C) $13,453.00 32) Compute the standard deviation of a two-stock portfolio if stock A (40% weight) has a

variance of 0.0015, stock B (60% weight) has a variance of 0.0021, and the correlation coefficient for the two stocks is −0.35? A) 0.07%. B) 2.64%. C) 1.39%.

Version 1

33) How much should an investor have in a retirement account on his 65th birthday if he wishes

to withdraw $40,000 on that birthday and each of the following 14 birthdays, assuming his retirement account is expected to earn 14.5%? A) $272,977. B) $234,422. C) $274,422. 34) Based on the annual returns on a stock index over the last ten years, the arithmetic mean

return is calculated as zero percent. It is most likely that the average compound rate of return for an investment in the index over that period is: A) positive. B) zero. C) negative. 35) Which of the following rules is used to calculate an unconditional probability? A) Addition rule. B) Total probability rule. C) Multiplication rule. 36) The probability of A is 0.4. The probability ofAC is 0.6. The probability of (B | A) is 0.5, and

the probability of(B | AC) is 0.2. Using Bayes’ formula, what is the probability of (A | B)? A) 0.125. B) 0.625. C) 0.375. 37) Which of the following is a joint probability? The probability that a: A) stock increases in value after an increase in interest rates has occurred. B) stock pays a dividend and splits next year. C) company merges with another firm next year. 38) What is the standard deviation of a portfolio if you invest 30% in stock one (standard

deviation of 4.6%) and 70% in stock two (standard deviation of 7.8%) if the correlation coefficient for the two stocks is 0.45? A) 6.83%. B) 0.38%. C) 6.20%.

Version 1

39) If X and Y are independent events, which of the following is most accurate? A) P(X or Y) = P(X) + P(Y). B) P(X or Y) = (P(X)) × (P(Y)). C) P(X | Y) = P(X). 40) Shawn Choate wants to choose a variable of study that has the most desirable statistical

properties. The statistic he is presently considering has the following characteristics: The expected value of the sample mean is equal to the population mean. The variance of the sampling distribution is smaller than that for other estimators of the parameter. As the sample size increases, the standard error of the sample mean increases and the sampling distribution is centered more closely on the mean. Choate’s estimator is: A) unbiased and consistent. B) efficient and consistent. C) unbiased and efficient. 41) Which of the following could be the set of all possible outcomes for a random variable that

follows a binomial distribution? A) (1,2). B) (0, 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11). C) (-1, 0,1). 42) For a test of the equality of the mean returns of two non-independent populations based on a

sample, the numerator of the appropriate test statistic is the: A) larger of the two sample means. B) average difference between pairs of returns. C) difference between the sample means for each population. 43) The number of days a particular stock increases in a given five-day period is uniformly

distributed between zero and five inclusive. In a given five-day trading week, what is the probability that the stock will increase exactly three days? A) 0.600. B) 0.167. C) 0.333.

Version 1

44) Which of the following statements about a confidence interval for a population mean is most

accurate? A) When a z-statistic is acceptable, a 95% confidence interval for a population mean is the sample mean plus-or-minus 1.96 times the sample standard deviation. B) If the population variance is unknown, a large sample size is required in order to estimate a confidence interval for the population mean. C) For a sample size of 30, using a t-statistic will result in a wider confidence interval for a population mean than using a z-statistic. 45) A stock price decreases in one period and then increases by an equal amount in the next

period. The investor calculates a holding period return for each period and calculates their arithmetic mean. The investor also calculates the continuously compounded rate of return for each period and calculates the arithmetic mean of these. Which of the arithmetic means will be greater? A) The mean of the continuously compounded returns. B) The mean of the holding period returns. C) Neither, because both will equal zero. 46) Suppose the mean debt/equity ratio of the population of all banks in the United States is 20

and the population variance is 25. A banking industry analyst uses a computer program to select a random sample of 50 banks from this population and compute the sample mean. The program repeats this exercise 1000 times and computes the sample mean each time. According to the central limit theorem, the sampling distribution of the 1000 sample means will be approximately normal if the population of bank debt/equity ratios has: A) any probability distribution. B) a normal distribution, because the sample is random. C) a Student's t-distribution, because the sample size is greater than 30. 47) For a certain class of junk bonds, the probability of default in a given year is 0.2. Whether

one bond defaults is independent of whether another bond defaults. For a portfolio of five of these junk bonds, what is the probability that zero or one bond of the five defaults in the year ahead? A) 0.4096. B) 0.7373. C) 0.0819.

Version 1

48) A researcher is testing whether the average age of employees in a large firm is statistically

different from 35 years (either above or below). A sample is drawn of 250 employees and the researcher determines that the appropriate critical value for the test statistic is 1.96. The value of the computed test statistic is 4.35. Given this information, which of the following statements is least accurate? The test: A) indicates that the researcher is 95% confident that the average employee age is different than 35 years. B) indicates that the researcher will reject the null hypothesis. C) has a significance level of 95%. 49) Cumulative Z-Table z 1.2 1.3 1.4 1.5 1.6

0.04 0.8925 0.9099 0.9251 0.9382 0.9495

0.05 0.8944 0.9115 0.9265 0.9394 0.9505

0.06 0.8962 0.9131 0.9279 0.9406 0.9515

0.07 0.8980 0.9147 0.9292 0.9418 0.9525

0.08 0.8997 0.9162 0.9306 0.9429 0.9535

0.09 0.9015 0.9177 0.9319 0.9441 0.9545

Maria Huffman is the Vice President of Human Resources for a large regional car rental company. Last year, she hired Graham Brickley as Manager of Employee Retention. Part of the compensation package was the chance to earn one of the following two bonuses: if Brickley can reduce turnover to less than 30%, he will receive a 25% bonus. If he can reduce turnover to less than 25%, he will receive a 50% bonus (using a significance level of 10%). The population of turnover rates is normally distributed. The population standard deviation of turnover rates is 1.5%. A recent sample of 100 branch offices resulted in an average turnover rate of 24.2%. Which of the following statements ismost accurate? A) Brickley should not receive either bonus. B) For the 50% bonus level, the critical value is -1.65 and Huffman should give Brickley a 50% bonus. C) For the 50% bonus level, the test statistic is -5.33 and Huffman should give Brickley a 50% bonus. 50) A stock increased in value last year. Which will be greater, its continuously compounded or

its holding period return? A) Neither, they will be equal. B) Its continuously compounded return. C) Its holding period return.

Version 1

51) Consider a random variable X that follows a continuous uniform distribution: 7 ≤ X ≤ 20.

Which of the following statements is least accurate? A) F(10) = 0.23 B) F(12 ≤ X ≤ 16) = 0.307. C) F(21) = 0.00. 52) A multivariate distribution is best defined as describing the behavior of: A) two or more independent random variables. B) two or more dependent random variables. C) a random variable with more than two possible outcomes. 53) A p-value of 0.02% means that a researcher: A) cannot reject the null hypothesis at either the 5% or 1% significance levels. B) can reject the null hypothesis at both the 5% and 1% significance levels. C) can reject the null hypothesis at the 5% significance level but cannot reject at the 1%

significance level. 54) Which of the following statements regarding the central limit theorem (CLT) is least

accurate? The CLT: A) holds for any population distribution, assuming a large sample size. B) gives the variance of the distribution of sample means as σ2/n, where σ2 is the population variance and n is the sample size. C) states that for a population with mean µ and variance σ2, the sampling distribution of the sample means for any sample of size n will be approximately normally distributed. 55) Which of the following statements about probability distributions is most accurate? A) A binomial distribution gives the probabilities only for whole number outcomes for a

random variable. B) A discrete uniform random variable has varying probabilities for each outcome that total to one. C) A continuous uniform distribution has a lower limit but no upper limit. 56) When sampling from a population, the most appropriate sample size: A) is at least 30. B) minimizes the sampling error and the standard deviation of the sample statistic around

its population value. C) involves a trade-off between the cost of increasing the sample size and the value of increasing the precision of the estimates.

Version 1

57) A discount brokerage firm states that the time between a customer order for a trade and the

execution of the order is uniformly distributed between three minutes and fifteen minutes. If a customer orders a trade at 11:54 A.M., what is the probability that the order is executed after noon? A) 0.250. B) 0.750. C) 0.500. 58) In addition to the usual parameters that describe a normal distribution, to completely describe

10 random variables, a multivariate normal distribution requires knowing the: A) 10 correlations. B) 45 correlations. C) overall correlation. 59) Critical values from Student’s t-distribution for a two-tailed test at a 5%

significance level: df 28 29 30

2.048 2.045 2.042

A researcher wants to test a hypothesis that two variables have a population correlation coefficient equal to zero. For a sample size of 30, the appropriate critical value for this test is plus-or-minus: A) 2.048 B) 2.045 C) 2.042

Version 1

60) What kind of test is being used for the following hypothesis and what would a z-statistic of

1.68 tell us about a hypothesis with the appropriate test and a level of significance of 5%, respectively? H0: B ≤ 0 HA: B > 0 A) Two-tailed test; fail to reject the null. B) One-tailed test; reject the null. C) One-tailed test; fail to reject the null. 61) Which of the following would least likely be categorized as a multivariate distribution? A) The returns of the stocks in the DJIA. B) The return of a stock and the return of the DJIA. C) The days a stock traded and the days it did not trade. 62) The sample mean is an unbiased estimator of the population mean because the: A) sample mean provides a more accurate estimate of the population mean as the sample

size increases. B) expected value of the sample mean is equal to the population mean. C) sampling distribution of the sample mean has the smallest variance of any other unbiased estimators of the population mean. 63) An analyst wants to determine whether the mean returns on two stocks over the last year

were the same or not. What test should she use, assuming returns are normally distributed? A) Chi-square test. B) Paired comparisons test. C) Difference in means test. 64) Which of the following is least likely a step in stratified random sampling? A) The sub-samples are pooled to create the complete sample. B) The size of each sub-sample is selected to be the same across strata. C) The population is divided into strata based on some classification scheme. 65) A range of estimated values within which the actual value of a population parameter will lie

with a given probability of 1 − α is a(n): A) α percent point estimate. B) (1 − α) percent confidence interval. C) α percent confidence interval.

Version 1

66) The probability density function of a continuous uniform distribution is best described by a: A) line segment with a 45-degree slope. B) line segment with a curvilinear slope. C) horizontal line segment. 67) The standard normal distribution is most completely described as a: A) symmetrical distribution with a mean equal to its median. B) normal distribution with a mean of zero and a standard deviation of one. C) distribution that exhibits zero skewness and no excess kurtosis. 68) Mei Tekei just celebrated her 22nd birthday. When she is 27, she will receive a $100,000

inheritance. Tekei needs funds for the down payment on a co-op in Manhattan and has found a bank that will give her the present value of her inheritance amount, assuming an 8.0% stated annual interest rate with continuous compounding. Will the proceeds from the bank be sufficient to cover her down payment of $65,000? A) Yes, Tekei will receive $68,058. B) No, Tekei will only receive $61,878. C) Yes, Tekei will receive $67,028. 69) The variance of 100 daily stock returns for Stock A is 0.0078. The variance of 90 daily stock

returns for Stock B is 0.0083. Using a 5% level of significance, the critical value for this test is 1.61. The most appropriate conclusion regarding whether the variance of Stock A is different from the variance of Stock B is that the: A) variances are not equal. B) variances are equal. C) variance of Stock B is significantly greater than the variance of Stock A. 70) An article in a trade journal suggests that a strategy of buying the seven stocks in the S&P

500 with the highest earnings-to-price ratio at the end of the calendar year and holding them until March 20 of the following year produces significant trading profits. Upon reading further, you discover that the study is based on data from 1993 to 1997, and the earnings-toprice ratio is calculated using the stock price on December 31 of each year and the annual reported earnings per share for that year. Which of the following biases is least likely to influence the reported results? A) Time-period bias. B) Look-ahead bias. C) Survivorship bias.

Version 1

71) An analyst conducts a two-tailed test to determine if mean earnings estimates are

significantly different from reported earnings. The sample size is greater than 25 and the computed test statistic is 1.25. Using a 5% significance level, which of the following statements is most accurate? A) To test the null hypothesis, the analyst must determine the exact sample size and calculate the degrees of freedom for the test. B) The analyst should reject the null hypothesis and conclude that the earnings estimates are significantly different from reported earnings. C) The analyst should fail to reject the null hypothesis and conclude that the earnings estimates are not significantly different from reported earnings. 72) The average return on small stocks over the period 1926-1997 was 17.7%, and the standard

deviation of the sample was 33.9%. Assuming returns are normally distributed, the 95% confidence interval for the return on small stocks next year is: A) −16.2% to 51.6%. B) −48.7% to 84.1%. C) 16.8% to 18.6%. 73) A sample of five numbers drawn from a population is (5, 2, 4, 5, 4). Which of the following

statements concerning this sample is most accurate? A) The mean of the sample is ∑X / (n − 1) = 5. B) The sample variance is: ∑(x1 − mean of the sample) 2 / (n − 1) = 1.5. C) The sampling error of the sample mean is equal to the standard error of the sample. 74) A test of a hypothesis that the means of two normally distributed populations are equal based

on two independent random samples: A) is done with a t-statistic. B) is a paired-comparisons test. C) is based on a chi-square statistic.

Version 1

75) A cumulative distribution function for a random variable X is given as follows: x 5 10 15 20

F(x) 0.14 0.25 0.86 1.00

The probability of an outcome less than or equal to 10 is: A) 25%. B) 39%. C) 14%.

Version 1

Answer Key Test name: Quantitative Methods 1) B

The investor has to ensure that the amount deposited now will grow into the amount needed to fund the perpetuity. With semiannual compounding, the effective annual rate (EAR) earned on funds in the account is: The present value of the perpetuity = $25,000/0.0404 = $618,811.88. Note that since the first scholarship award is paid out in four years, the present value of the perpetuity represents the amount that must be in the account at time t = 3. We can find the required deposit from: FV = −618,811.88; N = 3; I = 4.04; CPT → PV = $549,487.24 or 618, 811.88/1.04043 = $549,487.24 2) A

We can view this problem as the number of ways to choose three analysts from five analysts when the order they are chosen matters. The formula for the number of permutations is

On the TI financial calculator: 5 2nd nPr 3 = 60. Alternatively, there are 5 2nd nCr 3 = 10 ways to select three of the five analysts, and for each group of selected analysts, there are 3! = 3 × 2 × 1 = 6 ways to assign them the three industries. Therefore, there are 10 × 6 = 60 ways to assign the industries to the analysts. 3) B

If two events A and B are dependent, then the conditional probabilities of P(A | B) and P(B | A) will not equal their respective unconditional probabilities (of P(A) and P(B), respectively). Both remaining choices may or may not occur, e.g., P(A | B) = P(B) is possible but not necessary. 4) A

The factorial function, denoted n!, tells how many different ways n items can be arranged where all the items are included. 5) C

Version 1

A priori probability is based on formal reasoning and inspection. Given the number of stocks in the airline industry in the S&P500 for example, the a priori probability of selecting an airline stock would be that number divided by 500. 6) C

P(A|B) = P(AB) / P(B). The probability of a new coffee shop given a new office building is 58% / 64% = 90.63%. 7) A

This problem is a labeling problem where the 12 employees will be assigned one of three labels. It requires the labeling formula. There are [(12!) / (4! × 4! × 4!)] = 34,650 ways to group the employees. 8) B

“Likelihood” is defined in the Level I curriculum as a conditional probability, the probability of an observation, given a particular set of conditions (although, in general, it is often used as a synonym for probability). An unconditional probability refers to the probability of an event occurring regardless of past of future events. A joint probability is the probability that two events will both occur. 9) B

Compute the present value of the perpetuity at (t = 3). Recall, the present value of a perpetuity or annuity is valued one period before the first payment. So, the present value at t = 3 is 100 / 0.10 = 1,000. Now it is necessary to discount this lump sum to t = 0. Therefore, present value att = 0 is 1,000 / (1.10)3 = 751. 10) A

Version 1

Step 1: Calculate the annual payment. Using a financial calculator (remember to clear your registers): PV = 15,000; FV = 0; I/Y = 11; N = 7; PMT = $3,183 Step 2: Calculate the portion of the first payment that is interest. Interest1 = Principal × Interest rate = (15,000 × 0.11) = 1,650 Step 3: Calculate the portion of the second payment that is principal. Principal1 = Payment − Interest1 = 3,183 − 1,650 = 1,533 (interest calculation is from Step 2) Interest2 = Principal remaining × Interest rate = [(15,000 − 1.533) × 0.11] = 1,481 Principal2 = Payment − Interest1 = 3,183 − 1,481 = 1,702 11) C

With PV = 20,000, N = 4, I/Y = 8, computed Pmt = 6,038.42. Interest (Yr1) = 20,000(0.08) = 1600. Interest (Yr2) = (20,000 − (6038.42 − 1600))(0.08) = 1244.93 12) C

This is a two-step problem. First, we need to calculate the present value of the amount she needs over her sabbatical. (This amount will be in the form of an annuity due since she requires the payment at the beginning of the month.) Then, we will use future value formulas to determine how much she needs to save each month (ordinary annuity). Step 1: Calculate present value of amount required during the sabbatical Using a financial calculator: Set to BEGIN Mode, then N = 12 × 1.5 = 18; I/Y = 10 / 12 = 0.8333; PMT = 2,500; FV = 0; CPT → PV = 41,974 Step 2: Calculate amount to save each month Make sure the calculator is set to END mode, then N = 12; I/Y = 9 / 12 = 0.75; PV = 0; FV = 41,974; CPT → PMT = -3,356 13) C

Version 1

Given a set of prior probabilities for an event of interest, Bayes’ formula is used to update the probability of the event, in this case that the car we already know has a radio is red. Bayes’ formula says to divide the Probability of New Information given Event by the Unconditional Probability of New Information and multiply that result by the Prior Probability of the Event. In this case, P(red car has a radio) = 0.70 is divided by 0.76 (which is the Unconditional Probability of a car having a radio (40% are red of which 70% have radios) plus (60% are blue of which 80% have radios) or ((0.40) × (0.70)) + ((0.60) × (0.80)) = 0.76.) This result is then multiplied by the Prior Probability of a car being red, 0.40. The result is (0.70 / 0.76) × (0.40) = 0.37 or 37%. 14) B 0

$ 100,000

At the end of the 10-year deferral period, the value will be: $100,000 × (1 + 0.10)10 = $259,374.25. Using a financial calculator: N = 10, I = 10, PV = $100,000, PMT = 0, Compute FV = $259,374.25. Using a financial calculator and solving for a 10-year annuity due because the payments are made at the beginning of each period (you need to put your calculator in the “begin” mode), with a present value of $259,374.25, a number of payments equal to 10, an interest rate equal to ten percent, and a future value of $0.00, the resultant payment amount is $38,374.51. Alternately, the same payment amount can be determined by taking the future value after nine years of deferral ($235,794.77), and then solving for the amount of an ordinary (payments at the end of each period) annuity payment over 10 years. 15) C

The approximate relationship between nominal rates, real rates and expected inflation rates can be written as: Nominal risk-free rate = real risk-free rate + expected inflation rate. Therefore we can rewrite this equation in terms of the real risk-free rate as: Real risk-free rate = Nominal risk-free rate − expected inflation rate The exact relation is: (1 + real)(1 + expected inflation) = (1 + nominal) 16) B

Version 1

Stated Weekly Rate = 5/4 − 1 = 25% Stated Annual Rate = 1,300% Annual Effective Interest Rate = (1 + 0.25)52 − 1 = 109,476.44 − 1 = 10,947,544% 17) C

If you purchase one ticket, the probability of your ticket being drawn is 1/343 or 0.00292. If you purchase two tickets, your probability becomes 2/344 or 0.00581, so you are 0.00581 / 0.00292 = 1.99 times more likely to win. 18) A

The third quartile is calculated as:Ly = (7 + 1) (75/100) = 6. When we order the observations in ascending order: 7%, 10%, 12%, 15%, 20%, 23%, 27%, “23%” is the sixth observation from the left. 19) C

With monthly payments, we need a monthly rate: 6% / 12 = 0.5%. Next, solve for the monthly payment. The calculator keystrokes are: PV = 200,000; FV = 0; N = 360; I/Y = 0.5; CPT → PMT = −$1,199.10. The balance at any time on an amortizing loan is the present value of the remaining payments. There are 312 payments remaining after the 48th payment is made. The loan balance at this point is: PMT = −1,199.10; FV = 0; N = 312; I/Y = 0.5; CPT → PV = $189,228.90. Note that only N has to be changed to calculate this new present value; the other inputs are unchanged. 20) A

Using the multiplication rule: (0.25)(0.42) − (0.25)(0.15)(0.42) = 0.08925 or 8.9% 21) C

Conditional probability is the probability of one event happening given that another event has happened. An outcome is the numerical result associated with a random variable. 22) C

There is an upper limit to the EAR as the frequency of compounding increases. In the limit, with continuous compounding the EAR = eAPR –1. Hence, the EAR increases at a decreasing rate. 23) B

Version 1

This is a two-step problem. First, we need to calculate the present value of the amount she needs over her sabbatical. (This amount will be in the form of an annuity due since she requires the payment at the beginning of the month.) Then, we will use future value formulas to determine how much she needs to save each month. Step 1: Calculate present value of amount required during the sabbatical Using a financial calculator: Set to BEGIN Mode, then N = 4; I/Y = 9.5 / 12 = 0.79167; PMT = 6,000; FV = 0; CPT → PV = -23,719. Step 2: Calculate amount to save each month Using a financial calculator: Make sure it is set to END mode, then N = 11; I/Y = 8.5 / 12.0 = 0.70833; PV = 0; FV = 23,719; CPT → PMT= -2,081, or approximately $2,080. 24) C

If the observations in Distribution Y are three times the observations in Distribution X, the mean and standard deviation of Distribution Y are three times the mean and standard deviation of Distribution X. The standard deviation of a data set measured in feet, for example, will be 3 times the standard deviation of the data set measured in yards (since 1 yard = 3 feet). 25) A

The covariance of a variable with itself is its variance. Both remaining statements are true. Covariance represents the linear relationship between two variables and is not limited in value (i.e., it can range from negative infinity to positive infinity). 26) B

Switch to BGN mode. PMT = –1,000; N = 10, I/Y = 9, PV = 0; CPT → FV = 16,560.29. Remember the answer will be one year after the last payment in annuity due FV problems. Now PV10 = 16,560.29; N = 10; I/Y = 9; PMT = 0; CPT → FV = 39,204.23. Switch back to END mode. 27) B

The arithmetic mean will overstate the average annual compound return of the mutual fund. The average annual compound rate of return is calculated as the geometric mean return over the period. The annual time-weighted return is a geometric mean return. 28) B

He needs to figure out how much the trip will cost in one year, and use the 5% as a discount rate to convert the future cost to a present value. Thus, in this context the rate is best viewed as a discount rate. 29) B

Version 1

These are mutually exclusive, so the joint probability is zero. 30) B

Mean = (0.4)(10) + (0.4)(12.5) + (0.2)(30) = 15% Var = (0.4)(10 − 15)2 + (0.4)(12.5 − 15)2 + (0.2)(30 − 15)2 = 57.5 Standard deviation = √57.5 = 7.58 31) B

With PMT = 5,000; N = 7; I/Y = 11.5; value (at t = 4) = 23,185.175. Therefore, PV (at t = 0) = 23,185.175 / (1.115)4 = $15,000.68. 32) B

The standard deviation of the portfolio is found by: [w12σ12 + w22σ22 + 2w1w2σ1σ2ρ1,2]0.5 = [(0.40)2(0.0015) + (0.60)2(0.0021) + (2)(0.40)(0.60)(0.0387)(0.0458)(−0.35)]0.5 = 0.0264, or 2.64%. 33) C

This is an annuity due so set your calculator to the BGN mode. N = 15; I/Y = 14.5; PMT = – 40,000; FV = 0; CPT → PV = 274,422.50. Switch back to END mode. 34) C

Unless the returns were equal for all ten years (unlikely), the geometric mean return over the period will be less than the arithmetic mean return. 35) B

Given a mutually exclusive and exhaustive set of outcomes for random variable R, the total probability rule for expected value states that the unconditional expected value of R is the sum of the conditional expected values of R for each outcome multiplied by their probabilities: E(R) = E(R | S1) × P(S1) + E(R | S2) × P(S2) + ... + E(R | Sn) × P(Sn) 36) B

Version 1

Using the total probability rule, we can compute the P(B): P(B) = [P(B | A) × P(A)] + [P(B | AC) × P(AC)] P(B) = [0.5 × 0.4] + [0.2 × 0.6] = 0.32 Using Bayes’ formula, we can solve for P(A | B): P(A | B) = [ P(B | A) ÷ P(B) ] × P(A) = [0.5 ÷ 0.32] × 0.4 = 0.625 37) B

A joint probability applies to two events that both must occur. 38) C

The standard deviation of the portfolio is found by:

[W12σ12 + W22σ22 + 2W1W2σ1σ2r1,2]0.5,

or [(0.30)2(0.046)2 + (0.70)2(0.078)2 + (2)(0.30)(0.70)(0.046)(0.078)(0.45)]0.5 = 0.0620, or 6.20%. 39) C

Note that events being independent means that they have no influence on each other. It does not necessarily mean that they are mutually exclusive. Accordingly, P(X or Y) = P(X) + P(Y) − P(X and Y). By the definition of independent events, P(X|Y) = P(X). 40) C

The estimator is unbiased because the expected value of the sample mean is equal to the population mean. The estimator is efficient because the variance of the sampling distribution is smaller than that for other estimators of the parameter. The estimator is not consistent. To be consistent, as the sample size increases, the standard error of the sample mean must decrease. 41) B

This reflects a basic property of binomial outcomes. They take on whole number values that must start at zero up to the upper limit n. The upper limit in this case is 11. 42) B

Version 1

A hypothesis test of the equality of the means of two normally distributed non-independent populations (hypothesized mean difference = 0) is a t-test and the numerator is the average difference between the sample returns over the sample period. 43) B

If the possible outcomes are X: (0,1,2,3,4,5), then the probability of each of the six outcomes is 1 / 6 = 0.167. 44) C

Although the t-distribution begins to approach the shape of a normal distribution for large sample sizes, at a sample size of 30 a t-statistic produces a wider confidence interval than a z-statistic. A confidence interval for the population mean is the sample mean plus-or-minus the appropriate critical value times the standard error, which is the standard deviation divided by the square root of the sample size. If a population is normally distributed, we can use a t-statistic to construct a confidence interval for the population mean from a small sample, even if the population variance is unknown. 45) B

The holding period returns will have a positive arithmetic mean. For example, a fall from 100 to 90 is a decrease of 10%, but a rise from 90 to 100 is an increase of 11.1%. The continuously compounded returns will have an arithmetic mean of zero. Using the same example values, ln (90/100) = −10.54% and ln (100/90) = 10.54%. 46) A

The central limit theorem tells us that for a population with a mean µ and a finite variance σ2, the sampling distribution of the sample means of all possible samples of size n will be approximately normally distributed with a mean equal to µ and a variance equal to σ2/n, no matter the distribution of the population, assuming a large sample size. 47) B

The outcome follows a binomial distribution where n = 5 and p = 0.2. In this case p(0) = 0.85 = 0.3277 and p(1) = 5 × 0.84 × 0.2 = 0.4096, so P(X=0 or X=1) = 0.3277 + 0.4096. 48) C

This test has a significance level of 5%. The relationship between confidence and significance is: significance level = 1 – confidence level. We know that the significance level is 5% because the sample size is large and the critical value of the test statistic is 1.96 (2.5% of probability is in both the upper and lower tails).

Version 1

49) C

Using the process of Hypothesis testing: Step 1: State the Hypothesis. For 25% bonus level -Ho: m ≥ 30% Ha: m < 30%; For 50% bonus level - Ho: m ≥ 25% Ha: m < 25%. Step 2: Select Appropriate Test Statistic. Here, we have a normally distributed population with a known variance (standard deviation is the square root of the variance) and a large sample size (greater than 30.) Thus, we will use thez-statistic. Step 3: Specify the Level of Significance. α = 0.10. Step 4: State the Decision Rule. This is a one-tailed test. The critical value for this question will be thez-statistic that corresponds to an α of 0.10, or an area to the left of the mean of 40% (with 50% to the right of the mean). Using thez-table (normal table), we determine that the appropriate critical value = -1.28(Remember that we highly recommend that you have the “common” zstatistics memorized!) Thus, we will reject the null hypothesis if the calculated test statistic is less than -1.28. Step 5: Calculate sample (test) statistics. Z (for 50% bonus) = (24.2 − 25) / (1.5 / √ 100) = −5.333. Z (for 25% bonus) = (24.2 − 30) / (1.5 / √ 100) = −38.67. Step 6: Make a decision. Reject the null hypothesis for both the 25% and 50% bonus level because the test statistic is less than the critical value. Thus, Huffman should give So berg a 50% bonus.The other statements are false. The critical value of −1.28 is based on the significance level, and is thus the same for both the 50% and 25% bonus levels. 50) C

When a stock increases in value, the holding period return is always greater than the continuously compounded return that would be required to generate that holding period return. For example, if a stock increases from $1 to $1.10 in a year, the holding period return is 10%. The continuously compounded rate needed to increase a stock's value by 10% is Ln(1.10) = 9.53%. 51) C

Version 1

F(21) = 1.00. For a cumulative distribution function, the expression F(x) refers to the probability of an outcome less than or equal to x. In this distribution all the possible outcomes are between 7 and 20. Therefore the probability of an outcome less than or equal to 21 is 100%.

The other choices are true. A. F(10) = (10 − 7) / (20 − 7) = 3 / 13 = 0.23 B. F(12 ≤ X ≤ 16) = F(16) − F(12) = [(16 − 7) / (20 − 7)] − [(12 − 7) / (20 − 7)] = 0.692 − 0.385 = 0.307 52) B

A multivariate distribution describes the relationships between two or more random variables, when the behavior of each random variable is dependent on the others in some way. 53) B

A p-value of 0.02% means that the smallest significance level at which the hypothesis can be rejected is 0.0002, which is smaller than 0.05 or 0.01. Therefore the null hypothesis can be rejected at both the 5% and 1% significance levels. 54) C

This question is asking you to select the inaccurate statement. The CLT states that for a population with mean µ and a finite varianceσ2, the sampling distribution of the sample means becomes approximately normally distributed as the sample size becomes large. The other statements are accurate. 55) A

Binomial probability distributions give the result of a single outcome and are used to study discrete random variables where you want to know the probability that an exact event will happen. A continuous uniform distribution has both an upper and a lower limit. A discrete uniform random variable has equal probabilities for each outcome. 56) C

Version 1

A larger sample reduces the sampling error and the standard deviation of the sample statistic around its population value. However, this does not imply that the sample should be as large as possible, or that the sampling error must be as small as can be achieved. Larger samples might contain observations that come from a different population, in which case they would not necessarily improve the estimates of the population parameters. Cost also increases with the sample size. When the cost of increasing the sample size is greater than the value of the extra precision gained, increasing the sample size is not appropriate. 57) B

The limits of the uniform distribution are three and 15. Since the problem concerns time, it is continuous. Noon is six minutes after 11:54 A.M. The probability the order is executed after noon is (15 − 6) / (15 − 3) = 0.75. 58) B

The number of correlations in a multivariate normal distribution of n variables is computed by the formula ((n) × (n-1)) / 2, in this case (10 × 9) / 2 = 45. 59) A

The test statistic for a hypothesis test concerning population correlation follows a t-distribution with n − 2 degrees of freedom. For a sample size of 30 and a significance level of 5%, the sample statistic must be greater than 2.048 or less than −2.048 to reject the hypothesis that the population correlation equals zero. 60) B

The way the alternative hypothesis is written you are only looking at the right side of the distribution. You are only interested in showing that B is greater than 0. You don't care if it is less than zero. For a one-tailed test at the 5% level of significance, the critical z value is 1.645. Since the test statistic of 1.68 is greater than the critical value we would reject the null hypothesis. 61) C

The number of days a stock traded and did not trade describes only one random variable. Both of the other cases involve two or more random variables. 62) B

An unbiased estimator is one for which the expected value of the estimator is equal to the parameter you are trying to estimate. 63) B

Version 1

Portfolio theory teaches us that returns on two stocks over the same time period are unlikely to be independent since both have some systematic risk. Because the samples are not independent, a paired comparisons test is appropriate to test whether the means of the two stocks’ returns distributions are equal. A difference in means test is not appropriate because it requires that the samples be independent. A chi-square test compares the variances of two samples, rather than their means. 64) B

In stratified random sampling we first divide the population into subgroups, called strata, based on some classification scheme. Then we randomly select a sample from each stratum and pool the results. The size of the samples from each strata is based on the relative size of the strata relative to the population and are not necessarily the same across strata. 65) B

A 95% confidence interval for the population mean (α = 5%), for example, is a range of estimates within which the actual value of the population mean will lie with a probability of 95%. Point estimates, on the other hand, are single (sample) values used to estimate population parameters. There is no such thing as a α percent point estimate or a (1 − α) percent crosssectional point estimate. 66) C

By definition, for a continuous uniform distribution, the probability density function is a horizontal line segment over a range of values such that the area under the segment (total probability of an outcome in the range) equals one. 67) B

The standard normal distribution is defined as a normal distribution that has a mean of zero and a standard deviation of one. The other choices apply to any normal distribution. 68) C

Because the rate is 8% compounded continuously, the effective annual rate ise0.08 - 1 = 8.33%. To find the present value of the inheritance, enter N=5, I/Y=8.33, PMT=0, FV=100,000 CPT PV = 67,028. Alternatively,100,000e-0.08(5) = 67,032. 69) B

Version 1

A test of the equality of variances requires an F-statistic. The calculated F-statistic is 0.0083/0.0078 = 1.064. Since the calculated F value of 1.064 is less than the critical F value of 1.61, we cannot reject the null hypothesis that the variances of the 2 stocks are equal. 70) C

Survivorship bias is not likely to significantly influence the results of this study because the authors looked at the stocks in the S&P 500 at the beginning of the year and measured performance over the following three months. Look-ahead bias could be a problem because earnings-price ratios are calculated and the trading strategy implemented at a time before earnings are actually reported. Finally, the study is conducted over a relatively short time period during the long bull market of the 1990s. This suggests the results may be time-specific and the result of time-period bias. 71) C

The null hypothesis is that earnings estimates are equal to reported earnings. To reject the null hypothesis, the calculated test statistic must fall outside the two critical values. IF the analyst tests the null hypothesis with a z-statistic, the critical values at a 5% confidence level are ±1.96. Because the calculated test statistic, 1.25, lies between the two critical values, the analyst should fail to reject the null hypothesis and conclude that earnings estimates are not significantly different from reported earnings. If the analyst uses a t-statistic, the upper critical value will be even greater than 1.96, never less, so even without the exact degrees of freedom the analyst knows any t-test would fail to reject the null. 72) B

A 95% confidence interval is ± 1.96 standard deviations from the mean, so 0.177 ± 1.96(0.339) = (− 48.7%, 84.1%). 73) B

The mean of the sample is ∑X / n = 20 / 5 = 4. The sampling error of the sample is the difference between a sample statistic and its corresponding population parameter. 74) A

We have two formulas for test statistics for the hypothesis of equal sample means. Which one we use depends on whether or not we assume the samples have equal variances. Either formula generates a test statistic that follows a T-distribution. 75) A

Version 1

A cumulative distribution function (cdf) gives the probability of an outcome for a random variable less than or equal to a specific value. For the random variable X, the cdf for the outcome 10 is 0.25, which means there is a 25% probability that X will take a value less than or equal to 10.

Version 1